Wednesday, February 13, 2008

System Instability, Redundancy and the Domino Effect

The potential for a systemic collapse of the global financial system is finally hitting the mainstream
. For instance, this from the Wall Street Journal: New Hitches In Markets May Widen Credit Woes :

"A widening array of financial-market problems threatens to trigger a new phase in the global credit crunch, extending it beyond the risky mortgages that have cost banks and investors more than $100 billion in losses and helped push the U.S. economy toward recession.

In the past few days, low-rated corporate loans -- the kind that fueled the buyout boom of recent years -- have plummeted in value. As a result, banks are expected to try to unload some of those loans this week at fire-sale prices.

Nervous buyers also have retreated in recent days from the market for securities backed by student loans and municipal bonds, roiling some corners of the short-term money markets. Similarly, investors have recoiled from debt backed by commercial real estate, such as office buildings."

In the blogosphere, many analysts have warned of this possibility. For example, Nouriel Roubini posted this on The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster. Michael Panzner over at Financial Armageddon has written a sobering book on the topic and provides blog updates on the meltdown's progress.

Even your amateurish correspondent here at OTM could see it coming a few years ago:

As we discussed yesterday, the entire system is built on a series of incentives to obfuscate or hide risk and then pass the risky asset on to the next player.

--The borrower lies about income and creditworthiness, hiding the true risk.
--The broker happily goes along, otherwise the loan won't fund and he won't get paid.
--The lender goes along in order to reap a fat profit from selling the loan to Wall Street.
--The ratings agencies go along in order to earn their fat fees for masking risk-laden debt with a AAA rating.
--Wall Street goes along to sell the bundled loans and derivatives constructed from the loans to investors seeking a "safe, AAA investment."
--Traders and sales reps distribute the asset as "safe" around the globe in order to reap huge commissions/trading profits.
--Politicians look the other way as Wall Street ponies up big-bucks contributions.
--The Mainstream Media gloss over the layers of risk so as not to offend their big-bucks real estate/banking advertisers.

These incentives to cloak the true risks of loans aren't just built into the home mortgage market--they're built into all loans which have been bundled and sold as "low-risk": student, auto, commercial real estate, corporate buy-outs, you name it.

Consider a spacecraft as a metaphor for a system which is designed not to fail. There are two basic ways the spacecraft can fail: a single essential component can fail, or a single failure can trigger a domino-like cascade which leads to the entire craft failing.

If the craft's single oxygen tank ruptures, the crew dies. 99% of the spacecraft is still working perfectly, but the system failed in its primary purpose: keeping the crew alive.

If an electrical failure causes a cascade of subsystem failures, you end up with the same result: a powerless craft and a dead crew.

Redundant systems--as in Nature, two eyes, etc.--are one safeguard against catastrophic system failure. Thus having the oxygen in two separate tanks minimizes the risk that a tank leak could kill the crew.

Inserting breaks in dependent systems, e.g. "spacing the dominoes far apart" also works to stop a subsystem failure from cascading into others. Thus an electrical breaker wills top a short circuit from bringing down the entire electrical system.

In a way, this is the idea behind the "checks and balances" of modern republics. A bicameral legislature provides a kind of "breaker:" if one legislative body passes some harebrained scheme, hopefully the other house will kill it or at least water it down. Similarly, the President can veto the lamebrained idea. If he/she fails to do so, then as a final "breaker" the Supreme Court is supposed to step in and protect the Constitution and the Republic by striking down the law. (The Patriot Act shows how even this system can fail.)

So where is the redundancy in the global financial debt machine? Where are the checks and balances, or breakers? There are none. Here and there, you find a bit of redundancy, but nothing on a global scale.

For instance, there are still small local banks and credit unions in the U.S. which fund and service their own home mortgages. (Yes, they do exist.) But the number of mortgages funded and serviced by such responsible lenders is small compared to the trillions in risky mortgage debt dumped on the world markets.

Theoretically, there are government regulators who are supposed to act as checks or breakers against abuses or fraud in the system. But in the past seven years we have seen a wholesale surrender of responsibility by the Federal Reserve, the SEC, the FDIC, etc. Individuals within each agency issued clarion calls of concern, but their political masters didn't want to rock the boat. The breakers failed to go off, insuring systemic failure.

There is little or no regulation which requires transparency of risk or even the market valuation of loan-based assets such as CDOs. The ratings agencies were supposed to objectively assess risk, but with their fees dependent on issuing AAA ratings to 90% of all debt instruments, this supposed "check" failed catastrophically.

Here then is a system close to the perfection of instability: the risks are cloaked, and there is no redundancy or breakers in place to stop the dominoes once the first one falls. The subprime domino fell last year, and now other dominoes are falling rapidly, as described in the above quote from the Wall Street Journal article.

Roubini's article describes 12 dominoes; you can choose whatever number you prefer, but they're all falling, and there is nothing to stop them except more attempts at masking the risks of default or masking the defaults themselves.

All such attempts will of course eventually fail.

It would be better for all of us if the whole rotten structure collapsed in a month: Moody's, Fitch, et. al. confessed their liability and declared bankruptcy, investment and money-center banks admitted their insolvency by marking all the "off-balance sheet" assets they've been hiding to actual market, 10 million homeowners who can't afford their mortgages demanded market valuations on their houses and lower rates from lenders, monoline bond insurers gave up the delusion they will ever be solvent and declared bankruptcy, etc.

Yes, trillions would be lost/written off. But the trillions have already been lost. All we're doing is stretching out the pain. Such a confession of reality by all players would clear the decks of bad debt and allow regulators to start from scratch. No more appraisers paid by those whose only interest is a falsely high appraisal; another model would be put in place.

No more ratings agencies paid by investment banks for masking the real risks of debt being packaged. A new rating system could be put in place, perhaps based on the subscription model which worked well until the SEC abolished it. No more CDOs, CLOs, etc. No more hiding of assets off-balance sheet, "marked to myth"; all assets will have to be stated and marked to market at the end of each trading day.

Such reforms are just common sense; nothing fancy or arcane is required.

Will it happen? No. There are too many powerful players hoping the trillions can be restored with some fancy footwork, i.e. "restoring faith in the system." They will continue to obfuscate the risk and mask the bad debt, for years if necessary. Only when the entire system finally implodes will a reckoning take place.

When will that occur? Nobody knows. Some think it might happen soon, in a matter of months. My best guess is four or five years hence, for it will take that long for the "crew" to try twirling every useless knob in the hopes of staving off system failure.

You can't restore stability to an inherently unstable system.

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