Last Resort Lending

Lots of big bank whining today as the Fed turns over the names of the banks that borrowed from its discount window during our last financial crisis.  The Fed fought tooth and nail to keep the names secret under the theory that disclosing them would somehow cause the markets to punish the banks because they'd basically be viewed as insolvent.  Which, actually, a large number of them were during the crisis.  Bloomberg has the story.

JPMorgan CEO Jamie Dimon vows that his firm won't ever borrow from the Discount Window again because of this disclosure stigmata, and generally bankers have been whining and gnashing their teeth over this ruffling of their secrecy.  To which I say, talk to me when you're actually facing the choice of either having your company go under or borrowing from the Discount Window.  I'll put money down that you'll be borrowing from that window.  Talk is cheap when you're not facing any risk.  And given the amount of money that the taxpayers had to funnel and/or guarantee to the big banks, they should just shut up on this point.

On Edge

For the moment the market has stabilized teetering on the edge.  

I am worried that Obama's economic action team is not up to the task.  Their dithering on toxic assets, the banks and AIG merely puts the solution off to another day.  This has the unpleasant effect of increasing the cost of any future solution.  Treasury is way too tentative, vague, oracular and  shockingly understaffed.    Economists are losing faith.  You know, the ones that told us the free market would set us free. 

And what's this crap about Citigroup making a profit?  Aren't they on taxpayer life support?  What kind of accounting are they doing that they're showing a profit?  Isn't that the kind of accounting that got us into this mess in the first place?

The market surge after the news that Citigroup was projected to be "profitable" in the first quarter displays the desperate psychology of a wounded beast.  Charging wildly in any direction at the slightest provocation.  This beast is far from done.  

Or Maybe Not

Hard to tell what is going on in the credit default market. Some argue that there is no significant risk of things spinning out of control because the parties that insured Lehman's bonds were forced to pony up collateral as Lehman's bonds precipitously fell in price (CDS contracts have margin call clauses activated by price drops) and that this payment of collateral has already been written down on the parties balance sheets. Sounds plausible. Others are not so sure. But what scares me about those who say this is no big deal is that they are prefacing their statements with words like "probably" or phrases like "no one really knows." Which brings us back to the central fact that no ones knows WTF is going on in the markets right now. I doubt our wild ride is over.

The Next Wave

We are truly experiencing a post modern financial crisis. Uncertainty abounds. No one knows when the next wave is going to hit, or how big it's going to be. A front runner for churning out the next financial tsunami is the turbulence in the credit default swap market caused by the Lehman Brothers bankruptcy. Credit default swaps are a form of insurance sold to protect the buyer of a fixed income product from a default. In Lehman's case a buyer of Lehman's bonds could, as many apparently did, buy credit default swaps to insure against a Lehman default. By declaring bankruptcy Lehman has essentially defaulted on its bonds and the parties that insured those bonds now have to pay up. But no one knows how big a payment those parties have to make or whether they have the money.

This unknown liability on the part of the insuring parties could in turn set off a chain reaction of defaults by the parties if the combination of their credit default swap liabilities and their other liabilities exceed their assets and they are unable to get credit to meet their obligations because the credit markets are frozen. And if those defaulting counter parties' liabilities are in turn insured by credit default swaps, the next wave is going to get bigger. Lehman's default could lead to the default of parties that insured the Lehman debt, and the default of those parties could lead to the default of additional parties who insured the debts of the Lehman parties. This is one of the reasons the government is bailing out AIG: the concern that the failure of one party in the credit default swap market would lead to a wave of defaults .

It doesn't help that you don't have to own the underlying bond to buy a credit default swap for it. This fact results in the possibility that the liabilities of the Lehman credit default swap counter parties could be greater than the actual debt that Lehman issued if more than one party bought a credit default swap on the same bond.

What makes this whole thing post modern is that no one knows the extent of the Lehman credit default swap party liability because there is no central clearinghouse for credit default swaps that can provide this information. Essentially the credit default market as a whole behaved irrationally in that it acted as if the possibility of a large scale default was non-existent, and thus the necessary market mechanisms to cope with a large scale default never emerged. This was a direct result of a lack of regulation of the derivative markets.

Hamilton v. Jefferson Redux

Pardon my disappearance, work has been hectic, to say nothing of the financial markets.  My 401(k) is down 30%.  Viva la bourgeoisie!  We will survive like cockroaches.

I digress.  My only comment for the moment is that the factions in this financial crisis have split  along the historical divide of the high finance Hamiltonians versus the Central Bank Hating Jeffersonians.  The Jeffersonians are rightfully angry at the Hamiltonians for delivering a gargantuan credit crisis.  Hamiltonian play in the field of derivatives exacerbated the  inevitable cyclical credit bust that is a given with capitalism.  The fact of this cyclical credit collapse is what justifies regulation with the aim of transparency and mitigation of leverage.  The margin requirements for the purchase of equities imposed by the securities laws of the 30's have done us well.  The current crisis is not an equity market crisis.  The traditional equity markets are certainly feeling the effects, but these effects are the result of collapses in the derivative markets, particularly securitized mortgages and mortgage backed collateral debt obligations (CDOs).  As Obama aptly said in the debate last night, we have 20th century securities laws for a 21st century market.  But I digress.

Crisis of Faith

It all comes down to what you believe.  If you believe something has value you might decide to exchange something for it.  If you're unsure if something has value, or worse, suspect that something may be garbage, you're not going to be inclined to trade for it.  Often nothing physical has changed in the object of your valuation when you or the market decides to change your valuation.  Only your mental belief as to that objects valuation-utilitarian, fiscal or otherwise- has changed.  Your belief that your bank will be able to pay you your money that you gave it.  The belief that you are sufficiently capitalized because of new and exotic asset backed securities whose value has never been tested before.  The belief that securitization has ameliorated market risk to a negligible level.  (Despite the fact that every previous  iteration of the idea that some financial innovation has effectively extinguished risk has gone down in flames.) The belief that credit ratings are accurate.  

It was defaults on securitized mortgages that heralded the ascent of our current crisis of fiscal faith.  When this happened, no one believed the valuations of the underlying assets anymore.  Arguably this is irrational as a certain amount of default in a mortgage backed security shouldn't impair the value of the security because it is still backed by real estate that can be sold to compensate the security holder.  But when it dawned on the market that securitization provided an incentive to lenders to lend recklessly because they could bundle and sell their risk to third parties, the market realized that securization also provided an incentive for false valuations.  That is because securitization removes risk from the original risk taker thereby encouraging them to play longer odds.  And when faith was lost in the original valuation, the market in securitized mortgages went belly up.  The disbelief then spread to the other derivatives markets. 

Johnny Come Lately

John McCain adds nothing to the bailout negotiations.  The Keating Five affair is reflective of his judgment in financial affairs and crises.   And his alleged campaign pause to return to Washington to save the day is a cynical move that has disrupted the deal at hand.  If the Republicans cut a deal before he shows up, he will look irrelevant.  Thus they're stalling the deal until McCain can play his role.