Thursday, September 25, 2008

What Crisis? a.k.a. Creative Destruction Is The Beating Heart of Capitalism
September 25, 2008

The well-oiled propaganda machine that is the mainstream media would have you believe the world was mere moments away from complete financial Apocalypse last Friday. Yet here we are, a week later, and the world still exists. So we have to ask: what crisis?

It is instructive to remove ourselves from the breathless propaganda for a moment and refer back to the core of Capitalism with a Capital C: creative destruction. Yes, destruction, as in closing the doors, going bankrupt, folding, game over.

Let's be honest. This entire crisis is best summarized like this: players leveraged 30-to-1, bet big and lost. End of story. Nice try, pal, now clear out and let another player take your still-warm chair.

Let's turn to Joseph Schumpeter for an apt summation of creative destruction:
The process of Creative Destruction is the essential fact about capitalism. Every business strategy acquires its true significance only against the background of that process and within the situation created by it.

This is a long entry but an important one, so let's dig in.
Let's be clear about four critical points:

1. Banking and lending are essentially low-profit commodity businesses. Banks accept deposits, and then lend out the cash to qualified borrowers at an interest rate above what they pay on deposits. There is no magic in that, and the qualifying process is basically automated now so transaction costs are low.

How did Wall Street generate huge profits off an essentially low-profit commodity business? With huge leverage and 2+2=5 legerdemain/trickery. If you leverage $1 into $30 (yes, they all went for 30-1 leverage) and make 10 cents on a deal, thanks to leverage you made $3 instead of 10 cents--300% rather than 10%.

To mask the inevitable risk, then you have to present the "financial instruments" with a veneer of low risk, which the ratings agencies were pleased to provide for a fat fee. You also need to re-package the vanilla mortgages into instruments which enable you to charge huge fees, so you slice the low-yield mortgages into tranches which can be sold with hefty premiums. Then you sell derivatives (CDOs) based on the tranched mortgage-back securities, and you've effectively turned a commodity into a high-value "family" of instruments, the selling of which generates stupendous fees.

Now that the game is over, leverage has been shut down and the business has been forced back to a low-profit commodity model. Wall Street will not "come back" any more than the $100,000 condo in Florida will suddenly jump back to fetching $400,000. The outsized profits are gone, and the share of U.S. corporate profits will fall back to a much more modest slice--say, 1% rather than 4%:

2. Creative Destruction can be likened to a forest fire which burns away the deadwood. The President, Federal Reserve, Treasury and alphabet-soup agencies under their control have tried for years to stamp out any "blazes" of creative destruction as soon as the smoke was visible. They succeeded, but now the "forest" of our financial system is piled so high with flammable deadwood it will take a huge conflagration to clear it out and let the "forest" regenerate in a healthy fashion.

The devastating fires that swept Yellowstone National Park in the early 90s were the result of just this sort of short-sighted "any creative destruction is bad" forest management, and now Paulson, Bernanke and their boss, President Bush, are all desperately trying to beat out the flames licking at the bottom of an entire vast forest piled high with dry deadwood.
It won't work. They've "backstopped" and "saved" the system for so long that only a massive conflagration will clear the financial deadwood. Nothing they can possibly do will change the fact that the U.S. economy is loaded with the deadwood of unprecedented easy (and thus high-risk) credit:

Bernanke keeps bleating about "we need to free up credit," but he ignores the inconvenient fact that nobody needs to borrow more; they're already maxed out.

Various pundits have gleefully noted evidence that Americans are now starting to spend less and save more, but this is like gathering a few twigs from 100-square mile 10-foot thick tangle of branches and claiming the forest is now clear.

As noted yesterday, the reality is not quite so rosy: Consumers are increasing their debt burden even as they pay less and less on their credit cards. Card payments fell 6.2% YOY (year over year) in July, for the 9th month even as consumer borrowing on credit cards grew at 4.8% YOY.
Nothing they do will change the fact that there are millions of existing dwellings without residents or buyers, or the fact that the housing bubble was enabled by "qualifying" millions of previously unqualified buyers. With those millions now once again excluded by tightening lending standards, there is literally nothing to prop up a housing market which clearly exceeded all previous extremes:

As is supposed to happen in free-market capitalism, excessive supply and plummeting demand has led to a free-fall in prices:

3. Creative destruction is like natural selection: the unlucky, the mismanaged, and the foolish get wiped out, clearing the market for faster, better, cheaper competitors. I know it's not polite, but the reality is a free market for goods and services is Darwinian: you mess up, you fail.
If you take huge risks and/or you're dumb, you typically are at a big disadvantage, as illustrated by the painfully amusing Darwin Award Winners "who improve our gene pool by removing themselves from it."

In a similar fashion, firms which are no longer competitive or solvent do the economy a favor by closing. Bailing out dying/badly-managed companies is a horrible misallocation of scarce capital, and that robs the economy and taxpayers: failing firms don't pay taxes, further burdening remaining taxpayers. Capital poured down the rathole of insolvent firms is capital that is no longer available to healthy firms seeking funds to grow.

The banks that gambled and lost deserve to die, and those who gambled in the Ponzi Scheme and lost should also suck their losses.

4. There is no "crisis" in banking: well-managed banks like Wells Fargo which did not indulge in leverage and gambling are in fine fettle, ready and able to lend to qualified borrowers. A great number of banks which were managed prudently are quite solvent and in no need of bailouts.
In Capitalism, they should be rewarded by the disappearance of insolvent competitors. With the losers cleared out like deadwood, then the healthy, prudent firms can expand by offering their competent, well-managed goods and services.

Hindering this process will destroy any economy, and that's precisely what Paulson and Bernanke are seeking to do in bailing out the losers and the fools who just happen to be their buddies and pals.

The moment I read that Warren Buffett said the Bailout should be passed, I lost all respect for the man, who sadly has sunk to being a Toadie and Propaganda mouthpiece for Paulson.

Correspondent Mike D., who has lived and worked in China for many years, raised a possibility that many have pondered: the bailout is fundamentally a bailout of non-U.S. investors, without whom our bond markets would cease to function:

I fully agree that Paulson's $700 billion bailout plan looks like a Fascist power grab, but I wonder whether you aren't looking far enough into this. Is this really a Wall Street inspired coup attempt or is the whole thing being forced on America by its creditors?

China, and other foreign governments, were sitting on the majority of Fannie and Freddie toxic waste and Paulson dutifully bailed them out. I suspect that foreign US creditors would be further seriously damaged if your big banks were to tumble, hence the proposed bailout.

In the real world, I am sure China and Japan are not sitting back wringing their hands and wondering what solution Paulson et al will arrive at -- they are surely proactively involved in the decision making process. Wouldn't you be?

The very big stick that China and Japan have, of course, is to sit out the next Treasury auction and the enormous stick they have, is to dump the greenback. With these guns pointed at his head, I am sure Paulson is focussed, first and foremost, on keeping the wobbly wheels from falling off the wagon -- a certainty if he doesn't keep his overseas creditors sweet.

Well-said, Mike, thank you. My view is: overseas holders of "agency" (Fannie and Freddie) debt and various derivatives are screwed regardless of the bailout. Look at how the market reacted to the bailout: the dollar immediately tanked. So if Chinese and Japanese banks are bailed out of their agency losses, then they will lose even more as the value of their Treasury holdings plummets along with the dollar.

You can look up the numbers via a web search, but as I recall China holds about $350 billion in mortgage-backed U.S. debt and about $1.2 trillion in Treasury bonds. The Japanese hold about $250 billion in mortgage-backed debt and about $500 billion in Treasuries. The key point is their Treasuries and thus their positions in the dollar dwarf their U.S. mortgage holdings.
I have a problem with the assumption that the Chinese and Japanese banks were too ill-informed and blind to know that bubble assets contained risk, regardless of ratings agency games. What sort of due diligence did these smart guys do?

Commentators such as myself were warning of extreme valuations in U.S. real estate in major media publications as early as 2003: Bay Area Real Estate: All Signs Point To A Top (S.F. Chronicle, 2003)

The charts were readily available, as was the history of financial bubbles; to say the Chinese and Japanese bankers had no access to evidence the bubble was dangerous and unsustainable is simply wrong. They bought the agency debt and dollars for their own self-interest, to wit, propping up the American consumer so he/she could continue to buy Chinese and Japanese exports.

So now that the bubble has burst, they're whining to U.S. officials, demanding they be made whole? Sorry, folks, you knew exactly what you were getting into, and it wasn't for charity purposes. You propped up the global shell-game for your own enrichment, and now that the bets have been lost you want a bailout? Sorry, Capitalism doesn't work like that.

So as Mike D. noted, the threat is the Chinese and Japanese central banks will no longer prop up the U.S. bond markets by buying T-bills and other dollar-denominated debt. Well, as the global recession deepens, they won't have as many dollars anyway, so that decline is inevitable.
And if Congress is spineless enough to pass the bailout, then the dollar falling will wipe out hundreds of billions of value from the $1 trillion+ Chinese and Japanese hoards of T-Bills and other debt.

As the street saying goes: "They get you coming and going." The non-U.S. holders of dollar-denominated debt have already lost, and nothing Congress or the Treasury can do will change that. If the bailout hands them $200 billion, then the dollar decline the bailout will trigger will take away the $200 billion (or even more) from the value of their Treasury holdings.
Non-U.S. players would be better off demanding "no bailout" and seeking a fundamental "clearing out" of bad debt which would eventually strengthen the dollar.

The proposed bailout makes no sense for other reasons. Longtime correspondent Nurse Dorothy points out one glaring one the MSM completely ignored/missed:

I'm firmly against the 700 Billion dollar bailout for two reasons. One, it will not work and two, I do not trust Henry Paulson or the Federal Reserve. Paulson was quoted as saying that if there are too many conditions to the bailout he is afraid that financial institutions will not participate. If that's the case, then how bad off are we really? If you are a bank and about to fold and this is your last resort, why would you not participate? Paulson will have you believe that we are days from a meltdown but yet he's afraid Wall Street won't participate! Somehow that just doesn't make sense. (CHS: emphasis added)

We use to be a country with a free market that was allowed to grow and contract as a healthy market should. Instead we we have a government that artifically props up markets so that they can completely fall apart later on. This bailout will only draw this fiasco out even further and it will be far more painful in the bitter end. Let the market filter out its own weaknesses so that it can eventually become strong once more.

Well-said, Dorothy, thank you. Next up, correspondent L.D. who files this report based on his experience within the bowels of the credit/housing bubble:

Sorry to contribute to a world of hype, but I feel I must say something. In addition to being the only Californian who refused buy an oversized mortgage to get into a wildly overpriced house during the past six years, I witnessed some part of the insanity when I worked at Countrywide for three years at the peak of the mortgage finance insanity. At that time I decided to rent and not buy another home because houses were wildly overpriced. I still rent and pay taxes. Lots of taxes. Really.

When I took the corporate training on mortgage finance at Countrywide, I asked the trainer why the whole of secondary marketing wasn't a giant Ponzi scheme. She asked what department I worked in and what I did. I said I was a business analyst working in Secondary Marketing. She tried to answer intelligently but eventually said, in so many words, that it was.

Then I went back to my desk and looked at the portfolios we were supposed to write computer programs to pool for Freddie and Fannie. When one dug into the loans, it was obvious that much of what was originated after 2002 would never be paid off. The only way they could be paid off is if housing prices rose indefinitely and the ratio of median home price to median income in my neighborhood was already in double digits, a completely unsustainable and rather severe bubble by historical standards.

I predicted systemic failure of Freddie and/or Fannie (the GSEs) and reinsurance industry and told my co-workers. They thought I was crazy. And I predicted that taxpayers would pay the price for the magical thinking upon which the mortgage finance system was based. I told my friends at Countrywide that it was a house of cards that would collapse and might even take the US economy with it. They were too busy buying bigger homes that cost 8-12 times their annual income and feeling rich, rich, rich! (I didn't buy a mortgage, I bought puts on FNMA, FRE, CFC, WM, IMB, PMIA, and others).

And Countrywide didn't care. They made profits by originating and servicing loans that were then packaged and sold to investors. I will repeat that in simpler terms. Countrywide took the profits and sold the risk to someone else. The someone else is now about to be bailed out by the taxpayers. Our job in secondary marketing was to make sure the loans were properly wrapped for sale, with a nice bow and a few blemishes removed or made less visible. The price of these mortgage backed securities was set by the rating agencies that were paid by Countrywide, the seller of the securities.

I will repeat that in simpler terms. The price of what we were selling was set by companies we paid to rate our products. After the securities were sold they were sliced up further in collatoralized debt obligations or CDOs that were sold to hedge funds, China, retired school teachers, your city and county, and everyone else. This was/is the industry standard. The ratings agencies are private and paid by the seller to rate their bonds and securities. The securities are sliced up and sold to people who have no idea what they are buying. By 2005, the majority of mortgage backed securities were sold to China and Japan.

Yes, China's economy may fall too even though, unlike us, they still make stuff and didn't base their entire economy on selling each other overpriced houses and generating a giant Ponzi scheme for the past six years. The US model, engineered by the finance industry and protected by lobbyists like Phil Graham, who was McCain's chief economic advisor until his unfortunate comment a few weeks back, is completely and wholly unsustainable.

Any system that privatizes benefits and socializes costs is unsustainable. Such systems will inevitably be mired in the kind of excesses seen in mortgage finance from 2001-2006. The finance industry didn't specifically penetrate the current white house like Enron did to craft the Bu$h approach to protect its excesses, but it does have the largest lobby on K Street.

And the finance industry is better than anybody at hiding the true state of their finances. Afterall, their entire existence is nothing more than the ability to play shell games with money. That is all they do and they have thousands of very smart people working on it day and night. Thus, I was certain they could stave off the inevitable collapse at least until after the election. Now, it is clear they cannot even do that. The situation is so bad that it is crashing right before our eyes, faster than a McCain speechwriter can update the stuff on their boy's teleprompter.

The legacy of Alan Greenspam has hit our global economy with a vengeance a mere 6 weeks before a referendum on the disasters known as Bush foreign policy, Bush environmental policy, Bush energy policy, Bush social policy, Bush anti-education fundamentalist hysteria, Bush war on science, and now Bush anti-regulation policy. Things are bad. Maybe shortly after the election, the Trillion Dollar Disaster of the biggest Ponzi scheme in history will be in the headlines. Maybe the US dollar will collapse. Maybe a cup of coffee will cost $10 and a loaf of bread will cost $15 for a while. Maybe oil will be priced in Euros if we cannot stabilize the dollar.

Long story short, study up on the 1930s. We will be living it soon. Soup kitchens will appear near you soon. In LA, I think the burn zone from the "civil unrest" will go west of the 405 this time. If you want a simple explanation of how the CDOs and Alan Greenscam and the credit default swaps destroyed the global economy and resulted in millions of foreclosures, check out "This American Life" episode 355 called "The Giant Pool of Money".

Listen to the whole thing and let the absurdity sink in. And do what Ira's listeners do. Laugh. Life is too short to worry about your life savings, your currency, your home, your national security, your health care, and your basic safety. All have been jeopardized by this basic republican behavior of privatizing profits and socializing costs (risk).

The "I got mine and screw you," or SUV mentality as I refer to this particularly American style of greed, has risen to its post Reagan pinnacle and brought us to financial ruin. Our grandchildren will be paying for this fiasco. It will cost more than the disastrous Iraq war (although the inevitable blowback from that will likely kill more of us). It will cost more in inflation adjusted dollars than WW II.

Some of the Obama people get it; they understand that the rating agencies have to be nationalized and investment banks allowed to fail, but don't expect Obama to hold forth with such strong stuff at this point in the election year. He will promote regulation of the industry, which is definitely lacking. McCain will not. Every time you hear McCain touting the wonders of "deregulation," just laugh and know that it means that taxpayers subsidize corporate profits that might trickle back down to them (if they aren't too busy snatching up oversized mortgages or whatever the next shiny thing is).

Yes, these crooks are killing our country and a large part of the world too, but the delicious foolishness of their basic philosophy is just too good not to laugh at. Just laugh. Then vote.

That raises one last key point: you cannot eliminate risk from free-market capitalism, as that is the very essence of creative destruction. This has been illustrated in great depth by mathematician Benoit Mandelbrot in his seminal book The Misbehavior of Markets

Frequent contributor Harun I. made these cogent points about the impossibility of ridding the market of risk, as the bailout proposes to do:

When I heard Bernanke say this yesterday I knew for the first time that he has no idea how markets work. His suggestion is essentially that these bonds be bought at par value regardless of market value. He wishes to disregard the risk that bond investors have to navigate every day. While I will not elucidate on this much because of the complexity let's suffice it to say that buying a bond and holding it to maturity is not a risk-less venture. The risk here is simple: buying these bonds at or close to par does not guarantee a sale at or above par.

In fact, whether intentional or not this is a foolhardy attempt at price control. The alternative of letting private investors purchase these assets at market pricing is not even being discussed.

The symptom of overcapacity and extremely inflated values will persist. This is the single reason why this bailout will fail. As long as prices are out of line with incomes (inflated) and there is overcapacity either we go back to flawed lending practices or there is no reason to expand until the inventory is cleared. The clearing of this inventory, no matter who owns it, will be done at prices the market can bear. The underlying problem is our economic philosophy that says essentially we must inflate, borrow and consume to grow.

Fractional-reserve banking renders a bank insolvent immediately. And the Federal Reserve's haphazard artificial pricing of money and printing money out of thing air while charging interest is foolish and criminal. Without changing this flawed belief system we are left trying to rebuild and re-inflate the Hindenburg. Clearing the banks balance sheets will not create velocity unless of course we reinstitute the lending practices (reckless expansion of debt) which got us in this predicament.

The paradox is (and this is what they will not say) that reckless expansion of money and credit is now required in order to expand. Stated another way, under this flawed economic model and under the current circumstances, what we need kills us but without it we die.

Note to Congress: Bailouts, regardless of their structuring, will not work. Stop debating it because it is a false solution. And just for a refresher, here is the chart of the Dow Jones, which looks poised to break support at 10,700 and head lower--much lower. It's called creative destruction, and it is the beating heart of Capitalism.

A few books of related interest:
The Long Emergency: Surviving the End of Oil, Climate Change, and Other Converging Catastrophes of the Twenty-First Century by James Howard Kunstler
The Misbehavior of Markets
The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb
Extraordinary Popular Delusions and the Madness of Crowds by Charles MacKay
Manias, Panics, and Crashes: A History of Financial Crises by Charles Kindleberger
Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein
Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor
The Great Crash 1929 by John Kenneth Galbraith
The Crowd by Gustave Le Bon
When Genius Failed: The Rise and Fall of Long-Term Capital Management
The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities Fiasco: The Inside Story of a Wall Street Trader
Web of Debt
Financial Armageddon: Protecting Your Future from Four Impending Catastrophes

Reader Essays:
A 70 Trillion Dollar Counterfeiting Ring(Zeus Y., September 23, 2008)
According to several sources the market for so-called “credit default swaps” last year alone was nearly equal to the total global GDP, around 70 trillion dollars by some estimates. Yet these derivatives have no discernible “origin” or value.

The MacRib is Back!(Chris Sullins, Septmber 23, 2008)
I want to assure you this is not a viral ad campaign. There is going to be a point to the title because it contains a small story within a much larger one. Also, the title contains a unique spelling for a reason.

Thank you, William S. ($15), for sixth generous donation to this site. I am greatly honored by your ongoing support and readership.

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