Bailout, Sub-prime et Al

I received a few e-mails asking if I could explain in layman’s language:

  • what this crisis is all about and
  • my stance.

I can certainly explain my stance; the first part of the question may be a little more difficult. Sure, I have my views, but like the Elliott Wave, if we put a number of practitioners in a room, they all will have different ideas about ‘what the crisis is all about”. OK, then, here comes my reply – ready or not:

This problem began with over-leveraged, poorly managed risk among some larger US financial institutions, It then very rapidly became a world wide problem. To understand why, we need to trace three factors:

  1. The bursting bubble in the housing and credit markets
  2. The role of the Internet in the creation and demise of the bubble; and its role in the world crisis
  3. Globalization of world markets.

I won’t go into why the bubbles occurred – there is little argument that they did happen. But in Wall Street’s drive to secure greater profit, they created securitization of debt. The good news about this is  it enabled successful start-ups that normally would not have a look-in at a bank loan, that could obtain financing. But the problem is this:

these loans lack transparency, few understand their intricacies and they divorce the lender from the risk of lending.

What happens in securitization is lenders placed their investment assets into a group. They then sub-divide the package into multiple income streams and sell each stream as an asset-backed security.

When the US housing boom ended, the invalid (pie-in-the- sky) assumptions underlining the sub-prime mortgages caused above normal defaults and foreclosures. This caused larger than greater normal losses firstly with hedge funds and then with banks. These institutions were not only US based but were located world-wide.

Securitized sub-prime loans have been aptly described as ‘toxic waste’. Now here’s why the problem grew exponentially – no one knew who had how much of the ‘toxic waste’ and how to value the ‘waste’.

As a result two things occurred:

  1. Investors started to withdraw from any institution that ‘smelt’ like having ‘toxic waste’ exposure. This caused the share prices to fall, thereby affecting the ability of the institution to borrow money. This was a crisis of cash.
  2. The problem grew so large that banks were reluctant to lend whether or not the counter-party was tainted. This was a crisis not of cash but of confidence.

This is where the problem stands at the moment.

The US bailout is an attempt to solve the problem of cash – but like many short-term solutions, the US authorities, like Wall Street in the bubble years, are ignoring the consequences of their actions: the spurt of growth in M3, a growth divorced from productivity, will cause massive inflation. This rise will start being reflected in the inflation numbers in the next 3 to 18 months.

At that point, the FED will ultimately be forced to raise rates or face hyperinflation. You can use your imagination what would happen to an already fragile US economy when that happens.

Here’s the sad part. It’s not clear that solving the cash problem will solve the confidence dilemma. As I write, the Asian markets have reacted positively to the bailout but I’ll reserve judgment about its effectiveness to restore confidence until end of trading today.

In any event, whether or not, the bailout will help confidence in the short-term, I take the view that in the longer-term other measures are necessary i.e. greater transparency on securitized assets and some means of valuing the ‘toxic waste’.

In ‘The World is Curved’, David Smick said (page 45):

“..securitization, even though essential to wealth creation, is so arcane that few people can understand its workings…..the industrialized world has surrendered control of its financial system to a tiny group of five thousand or so technical market specialists….These insiders are the rare few who know how the securitization process works..And even they at times are dubious that the securitized assets reflect the value stated. But you want a scarier thought? Picture the US Congress trying to effectively legislate the regulation of something as complicated as the securitization process” (without causing even more financial carnage).


3 thoughts on “Bailout, Sub-prime et Al”

  1. Ray, US stocks death spiralled Monday, with the Standard & Poor’s 500 Index tumbling the most since the 1987 crash after the House of Representatives rejected a $700B plan to rescue the financial system by
    a vote of 228 to 205.

    Fear was deep and widespread, as investors dumped stocks for government bonds. The Chicago Board
    Options Exchange Volatility Index, Wall Street’s main barometer of investor fear, jumped 39% to
    48.40, a nearly six-year high, and was at 46.72 at the close.

    CNBC videos

    Gross Weighs In
    Reaction to the defeated bailout bill, with William Gross, PIMCO and CNBC’s Erin Burnett.

    NYSE CEO Responds
    Discussing the impact for the NYSE after the House voted against bailout bill, with Duncan Niederauer, NYSE Euronext CEO and CNBC’s Maria Bartiromo & Dylan Ratigan.


    European Banking Turmoil
    Credit markets tightened further and stocks tumbled Monday as governments were forced to step in to rescue a basket of European banks. Daragh Maher from Calyon has analysis.

    RAY ON TV SESSIONS: India audience:
    Mon Sep 29 1.10pm singtime -UTVi Business news

    Tue Sep 30 1.10pm singtime – CNBC TV 18

    CNBC Awaaz-Wed Oct 1 08 @ 1PM

    By idkit on Sep 30, 2008
    cross ref

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