Mortgage Cocktail and the Business of Credit by Steve Curnutte

11:29 pm | 2 recommendations | Be the first to comment

The Yearning for a Malefactor (and other failures)

The churning of the press in the last few weeks has at least been good for something. If there were any doubt before, none now should remain. Our national conversation about our economic woes is shockingly devoid of an original voice. Each new article about the state of our affairs seems little more than a recapitulation of someone else’s opinion; which itself is derivative of another’s opinion. At best, we might find a concise description of what has happened. More likely, we find a scathing tirade that devolves into political posturing. Noticeably absent are solutions.

Facts are fickle things of course, but we can say with confidence that things are not getting better. The albatross of evaporating home equity pulls us ever downward. The storm of deleveraging in the markets seems only to beget more deleveraging. The appalling loss of our collective wealth threatens to grind our consumer based economic machine into metal shards. Left standing at the edge of the squall line is the American public, baffled, confused, angry and fearful.

The ferocity of the arguments push factions further a field until one side shouts ‘affordable housing is to blame’ another ‘it was the greedy investors’ and still another ‘Wall Street sold out Main Street’ and nothing is heard over the ever greater distance of their positions. We have before us now an endless parade of pious vigilantes each blasting the other for its thuggary and greed.

In his respected book The Great Crash 1929, Galbraith calls this ‘the yearning for a malefactor.’ Remember that it was after the crash but still in the middle of a crushing depression that Roosevelt assumed the mantel of the Presidency with a promise in his inaugural address to ‘drive the money-changers from the temple.’ Perhaps the most chilling observation in Galbraith’s book is this single sentence, ‘The singular feature of the great crash of 1929 was that the worst continued to get worse.’

There is blame enough to go around of course, and in the assignment of that blame we may find clues for our reconstitution. But it takes little courage to blame for the sake of blame itself. Far harder indeed it is for us to pause, to rethink our entrenchments, and to cast a new mold.

Traditional clashes between political factions may offer a win should the cause be won. If one were to win the war on drugs for example, surely all would prosper. Or if another were to forever make solvent our entitlement programs, surely all would win too. But we must now realize this crisis is different. It is a zero sum game. The victory of one will only be at the expense of another in equal measure and neither will have made it one step closer to a solution. We are in the most proverbial of boats together. It is a mess of our own making and by our own making will we it be solved.

03:41 pm | 6 recommendations | 6 comments

The Treasury, Mosquitoes, and Unintended Consequences

The moves of our Federal Reserve and Treasury in the last few weeks are gigantic in scope. Decades from now students will study 2008 when the financial markets changed, when the relationship between the government and the private sector was forever altered, and when doggedly held beliefs were shaken from their established perches. Of course unprecedented times call for unprecedented measures, but massive actions in complex systems always create unintended consequences. What will ours be? Can the brightest minds in the world fail? How can apparently simple solutions breed terrible consequences? Easy.

Take the building of the Panama Canal. The French found the brightest among them to engage in one of the most historic engineering events of the era. They tapped their countryman Count Fedinand de Lesseps who helped build the Suez Canal to oversee the project. They tapped Gustave Eiffel (as in the Eiffel tower) to build the locks for the canal. They tapped some of the best doctors of the day to care for the thousands of workmen on the job.

And so it began. The brightest and the best all working as a team. They built huge wards with rows of beds to take care of injured or sick workers. To keep the stinging bugs and tarantulas from crawling up the legs of the hospital beds onto the patients, the brilliant French doctors had a plan. They placed each bed leg in a bowl of water. The bugs would not crawl into the bowl and swim to the legs of the beds. The solution to the problem of dangerous bugs seemed simple, even ingenious.

But the rate of Yellow Fever and Malaria among the hospital patients was soaring. Even the rate of infection of the workers in the fields was soaring. Dozens died daily. Soon hundreds died daily. The problem kept compounding until finally, more than 20,000 workers died. The French gave up. The bonds used to finance the building of the canal project were worthless. Middle class families who invested in the bonds back home in France lost everything. The smartest people, from one of the most educated countries on earth at the time, failed miserably.

Turns out, it was the law of unintended consequences writ large in the Central American jungle. As we now know, mosquitoes breed in stagnant water and transmit tropical diseases through their bites. The bowls of water meant to keep crawling bugs from reaching the sleeping patients actually served as a breeding ground for mosquitoes. The French inadvertently created an epidemic that killed people at an appalling rate. Take infected people; place them in a ward with workers who might only be injured. Place hundreds of little mosquito homes at the foot of everyone’s bed. Make sure that all mosquitoes now will carry the diseases in their blood. Make sure all patients in the ward are infected. Send the legions of infected insects out into the fields to infect more workers. Fill more wards. More bowls. More dead.

The law of unintended consequences is very real. Hard walls in a complex system force the system to find a way around. When the Treasury asked (and received) permission to bail out Fannie and Freddie, they wanted the markets to feel good about lending them money, about buying their stock, and about buying their mortgage backed securities. Instead, just the suggestion of the bailout created a crisis of confidence. If the government takes over, will it render my stock worthless? Will it make my bonds junior in importance to their bonds? The move intended to avoid a bailout, forced a bailout.

Now the government intends to buy tens of thousands of bad loans and begin a massive program of debt forgiveness and loan restructuring. What will the unintended consequences be? Will good borrowers stop paying on their loans so they can get on the gravy train? What will the unintended consequences be of the government’s move to buy preferred shares of huge banks? Instead of encouraging the banks to lend again, the move might simply delay the inevitable pain and failure of bad banks. Perhaps it will not encourage lending at all – just a round of cannibalizing consolidation.

The markets into which the Fed and the Treasury are digging their fingernails are deep, complicated, and connected globally on the lowest and the highest levels. A complex system requires us to tread with caution, to think in terms of decades not hours. Can the brightest minds in the world make mistakes? They do all the time. In the case of Panama, they killed 22,000 people without pointing a gun. Can the best laid plans fail? Of course. As the Roman playwright Titus Maccius Plautus observed a couple of thousand years ago, “things we not hope for often come to pass more than things we wish.”

10:08 pm | 5 recommendations | 5 comments

Time for True Economic Innovation...

With the speed of a thunderstorm and the force of a glacier, the massive deleveraging of global markets is reshaping the face of American finance. The venerable system of Wall Street investment banks was carved from the map in a matter of weeks. The unwinding is not over of course. But a way forward must be found.

There will be a moment in the months and years to come, when our culture will look back and realize that it is over. That we survived a very black time and that better days are finally upon us. At that moment, without a doubt, we will have an entrepreneur to thank. An innovator. A free thinker. Teams of them in fact.

Some would argue that innovation got us into the mess in the first place. They cry out - It was the derivatives! The credit default swaps! It was those complicated and new fangled financial instruments that made all of this happen!! In a way they would be right. There is little doubt these financial innovations amplified risk to an astonishing degree rather than democratized risk as they claimed. But the answer is not so easy.

Deeper problems have been building for years. Our central bank was too cozy with our politicians and too archaic in its structure. Our affordable housing mandates were pushed too far and they injected poison into the financial bloodstream. Our energy policy was tumbling headlong into dangerous addictions. The price tag of our social aspirations outstripped the income of our tax system. Our national obsession with stuff eclipsed our cultural heritage of rugged individualism.

Not surprisingly, the creation of sophisticated financial instruments coincided with the maturation of computation. Financial wizards fed data and ran programs as fast as their processors could handle it. Currency arbitrage could be tracked and bet upon. Fluid commodity markets like oil and wheat could be understood in new and different ways. By the height of the credit bubble, Wall Street was selling a piece of a piece of a piece of a debt insured by someone who was insured by someone who owned a security. The math was unfathomable. Turns out the risk was unknowable and the damage unthinkable.

The innovations were not without benefit of course. The securitization of mortgages lowered borrowing costs for millions of people for decades. The explosion of building brought an explosion of jobs. Marketers had people to pay them. Brand builders had people to brand. Web designers had sites to build. There was money to fund the tech start ups. There were customers to buy computers and pay for internet access.

But the system was still the same. The innovations were just still the playthings of the old guard. Profits were maximized and risk was forgotten. But the bones of the system could not handle the new weight that was being created. Remember, the horse drawn buggy was improved with newer wheels, better axels, and better suspension right up until the automobile relegated it to history forever.

And so it comes to you. To us. The destructive force of unwinding is clearing out a new space upon which to build a new financial model. The task to us is to build nothing short of a new cultural identity. The architects of this new model have not yet revealed themselves. But make no mistake; the new model will be as different from the old as the car is from the buggy.

Eric Hoffer observed, ‘In times of change learners inherit the earth; while the learned find themselves beautifully equipped to deal with a world that no longer exists.’ The denizens of Wall Street and the tired politicians in Washington are beautifully equipped indeed. It is time for the learners to step forth.