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. 

The Dukes of Moral Hazard

So the Federal Reserve, whose powers have been traditionally limited to the banking system, has now decided essentially to buy AIG and become the insurer of last resort for the credit default swap market.  This means that you and I, fellow taxpayer, are now on the hook for the irresponsible, irrational, and down right greedy behaviour of huge swaths of the market that wanted nothing to do with government regulation when the getting was good but who now are lined up at the governments door with cup in hand now that the risks have come home to roost.

This is a bad move, and one that it's not clear  the Fed can even afford to do, given the fact that the Treasury is now, wait for it, issuing more debt to insure that the Fed has sufficient liquidity in the days to come.  After re-establishing the moral hazard involved with trading exotic and convoluted credit derivatives by hanging Lehman Brothers out to dry, Paulson and company decide that it shouldn't apply to anyone who bought insurance for their derivative sludge.  But these weren't mom and pop investors who were buying this insurance in the form of credit default swaps, these were sophisticated investors who, if they'd paused for a moment and done their due diligence, should have realized that they were buying insurance from a speculator in the credit default swap market.  And that speculation was centered on the belief that there wouldn't be a systemic collapse in the credit markets.  Well, surprise surprise, yet another credit bubble has burst.  And the taxpayer is now footing the bill again.  

The sophisticated investors should be forced to take their losses.  The only people who should be bailed out are the mom and pop investors who stand to lose their retirement savings because of events they can't understand.  It'd be cheaper that way, and much more morally satisfying.

Whistling Past the Graveyard

Is this the final financial derivative wave crashing down on Wall Street?  Will all now be washed clean again?  Or are we on the verge of financial catastrophe?  Maybe I'm just scared because I know more about Wall Street now than when I was younger, but banks are going under right and left and major companies are struggling to shore up their capital.  It's going to be an interesting week. Adios Lehman Brothers, Merrill, we hardly knew ye.  AIG, you're not looking too good there, fella. You look like you need some more capital.  Best of luck at the Fed money spigot.  There's no consequences to the Fed extending all this credit, right?