Freedom to Fail

Am I alone in seeing the collapse of our capital markets as a "canary in the mine", warning of a much greater decay at work in our society? The hortatory efforts of our leaders - from both the left and the right - have cowed us into believing that we "have to do something" or doomsday will be upon us. They tell us that now isn't the time for blame or finger-pointing, that can be addressed later, but that we must act now! And that the best course of action is bailing out the interest rate markets. It's essentially being sold to us - the folks paying the bills - as something that we don't/can't understand, but we have to do or else. Well folks, I'm here to do some 'splainin'. As some of you know, I have a background in market and credit risk management, actually having sold AIG their risk management system. I think we all have to think a bit about what's really happening, and more importantly, learn the lesson that I believe we all must learn from this catastrophe.

Consider the chart above, from the British Bankers Association Derivatives Survey, 2006 Data. Ah, ah - I can feel you wanting to click to something more interesting - DON'T YOU DARE!! THESE SOBs MAY DESTROY THE ENTIRE GLOBAL FINANCIAL SYSTEM IF WE DON'T STOP THEM, SO PLEASE TAKE A MINUTE TO UNDERSTAND SOMETHING A LITTLE MORE COMPLICATED THAN YOUR LATEST OBAMA PLATITUDE OR RALLYING BEHIND SARAH PALIN.

The "interest derivatives market" has exploded in the past 5 years. 2008 notional principal outstanding of just "credit default swaps" was forecast to be somewhere around 60 trillion usd. Just to put that in perspective , Global GDP for '08 is forecast to be about 64 trillion usd. So, just this market (which is a minority of the estimated 500 trillion plus OTC derivatives market) is trading massive, unimaginably large quantities of capital. And it's not as though these trading firms and hedge funds actually have that much capital - no, they've borrowed it. There is so much leverage in these markets that the participants can't possibly ride out "gaps" in the market - gaps that are inevitable, btw. "Gaps" are discontinuities, sudden variations in the rate of change that are statistically improbable but also hard to predict the frequency of, particularly given the newness of this market. Given the leverage involved, a cascade of what essentially look like margin calls in an ordinary brokerage account, have brought the global debt markets to it's knees from a "technical" standpoint, meaning that due to the rapid change in credit quality of both sellers and buyers of credit/debt/interest rate products and the related pricing of these securities, having moved to ridiculous price levels in search of buyers and sellers, there are essentially no buyers or sellers in these markets. In fact, if they did liquidate these positions, many participants would become instantly insolvent. It's like you bought IBM stock, paid for the trade with borrowed money, which is all you had because your actual net worth was 3-4 cents per dollar of capital you are trading. Only remember, you could never do that. Lehman Brothers, for example, would have never let you borrow anywhere near that much to trade with in your account, while all the while they are leveraged 30 - 1. It's very simple at a certain point. The investment geniuses in the derivatives market went crazy. Oh yeah, and don't for a minute think they didn't know what they were doing. During my time in the derivatives market, it was pretty clear to most folks involved that they were going to blow up the global financial system someday, it was only a question of when. Well that day has come.

What's truly galling about it all is that due to the resultant systemic risk, there does have to be some kind of intervention or we will face a global depression of a large magnitude which is simply unacceptable, so these guys will get bailed out to some degree versus being laughed out of the market, treated as the greedy, pathetic and ultimately stupid fools that they are (when are we going to learn that an ivy league degree is just proof of just about nothing?)

But the cretins on Wall Street aren't the only culprits, not by a long shot. Let's talk about John Q. Citizen, happily taking out mortgage after mortgage, buying house after house, with higher and higher prices. It was a classic speculative bubble. So many people bought houses that they knew they wouldn't be able to afford in a couple of years, based on the reset structure of the interest rates of the mortgages they signed for. Yes, these folks were abetted by a Federal Reserve ladling easy money out, trying to ward off a needed recession, by government agencies promoting relaxed lending standards and by a greedy mortgage industry selling the mortgages as fast as they could. But nonetheless, at the moment of truth, there is incredibly clear disclosure of the costs of a mortgage for an individual borrower. Those of you who have taken a mortgage recently can surely testify to the pages and pages of warnings and disclosures incorporated in mortgage documents. It's simply not plausible to now claim that somehow a significant percentage of these borrowers have been duped. Nope, people gladly got in line, smugly playing this Ponzi scheme out, pushing from their minds any concern of actually paying the mortgage off. They were going to borrow again at a later date, after they'd bought the new car, boat, vacation home, paid their kids private school tuition, built the salt water swimming pool - whatever luxury they'd imagined they were entitled to after watching too much TV. Now, surprise - they can't pay, so they are walking away. These people were stupid and greedy and now we are seeing record defaults, creating a huge devaluation in the securities created out of these mortgages, which has been the tripwire of the credit derivatives market meltdown. Shame on you people, shame on you for what you've done. You are just as guilty as the investment bankers, letting greed guide you, while simultaneously exercising some kind of mass blindness, willfully ignoring risks that were all to plainly laid out for you.

I'm tempted to continue to explain how Freddie Mac and Fannie Mae were manipulated, largely by Democrats, at the behest of those "housing activists" who are fellow travelers of Barak Obama, to encourage "access to the American dream" and other such platitudes, chief amongst them Senators Barney Frank and Chris Dodd (who has a sweetheart mortgage deal from now defunct Countrywide Financial). Or the Republicans who all too gladly go along with the anti-regulatory crowd on Wall Street, letting the largest securities market in the world - the OTC derivatives market - operate largely without oversight. But that's a different article, and would distract from my key point, which is what the hell is wrong with our society? How could we collectively act with such bad and corrupt judgement? Willfully ignoring the consequences of our actions, just grabbing the short term gratification while damning our future? That's not how this great country was built.

Folks, our collective freedom and prosperity are a reflection of of our individual behavior in our personal, professional and civic affairs. I see an unmistakable pattern of greed and short term thinking in this debacle that goes to the very core of our society, crossing ALL PARTY LINES - you Democrats out there, don't for a second take any comfort in this. Your folks are as guilty as anyone in all this. To put this on Bush is to simply not understand what is happening - btw, he and his cronies have been trying to reign in Freddie Mac and Fannie Mae since '01, viciously opposed by Democrats, as the foolhardiness of their policies was evident even then. This is not to offer comfort to the right either, who need to once and for all drop their reflexive anti-regulatory posture. Capitalism can't function without adequate regulation - wake up!

Here's my conclusion, and what I really want all of you to think about. We live in such unbelievable prosperity that I think many of us believe a continuation of these conditions is somehow inevitable. That's not the history of other great nations, in fact the history of most great nations is decay from within. We all need to act more prudently in our lives. Let's consider the future consequences of today's actions and of the bigger picture, individually and I suspect that thinking will be reflected collectively in our politics. Let those thoughts be reflected in your personal, professional and civic actions. If we don't, who will? Congress? The President? Take a good look at these folks. They aren't the "b" or even the "c" team. How many of them would make it through a job interview where you work? How much do they even understand about capital markets and economics? How do we have such knaves and fools leading us? I say that's the first place to start. Let's get rid of all these clowns and start over. Let's not be swayed by their glib promises of ever-expanding horizons and limitless prosperity for all. It's just not so. How about we elect someone who will encourage us to live within our means and be careful stewards of this precious gift freedom? Oh, snap, none of them are about any of that. We are well and truly screwed folks if we don't change, it's just a matter of when - not if - our great nations will collapse if we keep on the track we're on.

You know the toughest thing about democracy? Ultimately, we get exactly the leadership we want. It's up to us to change, folks, not them, they're just doing what makes us vote for them, which seems to currently be short term gain at the expense of the very foundation of our society. That should scare the living daylights out of all of us. It sure scares me.