Friday, September 28, 2007

The End of the Beginning

"Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game. Those loans were invented so that hedge funds would have high-yield debt to buy." Satyajit Das in an interview with Jon D. Markman, The Credit Crisis Could Be Just Beginning

In what follows I revisit the theme I touched on recently, namely the way in which all the focus of the current credit crisis is being laid at the door of the subprime bubble and by implication on those Americans who entered into one or other of the less than prime mortgages. Let's not forget the hoopla around the spread of home ownership in recent years and the signal it gave that anyone who struggled to get a foot on the home ownership ladder was being a model American. Now there is a definite atmosphere being created that those unfortunate enough to have been on the lowest rung of the ladder are the ones whose 'irresponsibility' has been the cause of tipping the ladder. Let there be no doubt about it that this is a smokescreen, and one made all the easier by the shroud of hocus pocus that has been built around the technical aspects of the finance world.

Everyday life has a pretty good idea of how cause works and despite all the verbal alchemy things are no different in the case of the credit crisis. If anyone approached an auto collision by focusing on how the innocent party had invited the offending vehicle to bring it on we would rightly consider it silly. Similarly, the growth of the subprime mortgage market wasn't a result of some smart idea dreamed up by the homebuying public. It resulted from a premeditated strategy to extend the market for mortgage credit. It wasn't the ordinary homebuyer who invented this mind boggling range of products. On the contrary the various players in the market vied to outdo each other in the next esoteric product they could come up with. All of this went on with the blessings, some would say encouragement, of the FED. Listen for example to Alan Greenspan speaking at the Community Affairs Research Conference in April 2005:

“Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country. With these advance in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers.”
The question then arises of the driver for these marketing innovations. We hear lots about the world having been swimming in liquidity. Note however that not many speak of this as being awash in cash. The truth is that the creation of 'liquidity' stemmed from the development of a range of financial products by the investment community, products massively built on leverage and the off-loading of risk through instruments that to all intents are one or another variety of insurance policy. The problem is that whereas insurers have a long experience of the statistical possibility of the risks they cover actually occurring and know full well that 'runaway' risks are absolutely rare - even mass auto pile-ups or 'out of control' forest fires have a limit as to how far they will go - no such predictability comes with the markets. No one ever heard of 'unwinding' in the case of the ordinary business carried by insurers.

Everyone in the financial markets however had better have heard of the great crashes that have been a recurrent feature in the history of that world. If not they have no business being in business. In practice of course what happens is that every generation cooks up one or another 'theory' that they've got things under control and it won't happen again, "the business cycle has been mastered" and so on, only to be proven wrong each time. These theories are invariably nothing but rationalization of the foolhardy risk taking, what has become known as 'exuberance'.

When in mid-August Goldman Sachs announced that a “25 standard deviation event” had caused the value of its quantitative fund to drop 30%, the implication was that the subprime mortgage crisis had caused the market to behave in some wholly unexpected pathological manner, normally to be anticipated only two or three times in the history of the universe. In reality such “25 standard deviation events” happen two or three times a decade and are perfectly normal. The abnormality, in which the market lost its mind, was in Goldman basing its reputation and its investors’ wealth on such obviously inadequate mathematical techniques. When markets lose their mind, Martin Hutchinson

Given this it is truly outrageous that those who will suffer most in real practical terms from the operations of the credit freewheelers are now being set up as the first link in the chain of cause of the crisis. The truth is that this line is being pushed more as a move to justify the rescue of the speculators by public funds than as a real explanation. It is hoped that gushing of crocodile tears for suffering homeowners will garnish enough sympathy so that the financial world can be pulled from the fire of its own creation, while at the same time it keeps the spotlight pointed elsewhere. And make no mistake about it, it is the financial industry that will benefit from any of the measures contemplated so far. Who after all will benefit from the publicly funded rescue of the debts owed to the mortgage lenders, (even if it's only through the 'liquidity enhancing' measures of the FED or through tax breaks)?

The other aspect of this turn of events is that it acts as an impediment to the understanding of the real causes. Could it be that this is yet another convenient result for those who have gained most from the whole affair? After all, failure to unravel the system of real interconnections that have ended as this 'unwinding' leaves the door open for an equally profitable repeat in some future period.