James’s Musings

thoughts, photography, and geeky stuff
from an unrelentingly curious Silicon Valley entrepreneur

Clinton + Bush = The Perfect (Economic) Storm

by James G. Beldock on November 2, 2008

[ed­i­to­ri­al note: Some of you saw this post ear­lier this week; oth­ers were foiled by a strange Internet Explorer in­com­pat­i­bil­i­ty in­duced by Microsoft Word. Leave it to Microsoft to pro­duce a word proces­sor whose HTML out­put is in­com­pat­i­ble with their own web browser. All fixed now.]

Later this week, I’m go­ing to ar­gue that the Fed’s re­cent rate cut is at best an ex­er­cise in fu­til­i­ty and at worst a mis­take. [an­oth­er ed­i­to­ri­al note: turns out I was wrong, at least on the sec­ond part. ex­er­cise in fu­til­i­ty per­haps, mis­take, no. see my next post.] First, it’s time to lay the ground­work:


The Creation of Free Debt1

In the ear­ly days of the bail-out de­bate (way back in the first week of October), Robert Reich gave a talk at the Commonwealth Club in which he, right­ly, laid part of the blame for the ori­gins of the cur­rent eco­nom­ic cri­sis at the feet of the Clinton Administration (of which he was a part from 1993 through 1997, as Clinton’s first Secretary of Labor). Regardless of where your pol­i­tics lie, it’s pret­ty clear that the rough­ly 1998-vin­tage an­nul­ment of ven­er­a­ble Glass-Steagall (which among oth­er things cre­at­ed a sep­a­ra­tion be­tween in­vest­ment bank­ing and com­mer­cial bank­ing ac­tiv­i­ties in the US) was the first in a se­ries of ma­jor er­rors which even­tu­al­ly re­sult­ed in today’s cri­sis.

Add to this some­thing Reich didn’t touch on: the Clinton ad­min­is­tra­tion per­pe­trat­ed the sec­ond er­ror lat­er in its watch, when it agreed with nu­mer­ous Wall Street gi­ants that cred­it de­fault swaps (the “big bad” CDSs we keep hear­ing about the­se days) ought not to be reg­u­lat­ed. Why CDOs should have been (and must now be) reg­u­lat­ed will be the sub­ject of still an­oth­er post, but for now let’s stip­u­late that CDSs are opaque de­riv­a­tive in­stru­ments (i.e., not on­ly not trans­par­ent but al­so based on in­scrutable “if…then…else” risk struc­tures which, for lack of in­spec­tion, can mask huge ex­po­sure to glob­al ex­ter­nal­i­ties) and that the prac­tice of “net­ting”2 (in which an in­vestor hedges by pur­chas­ing two CDSs with op­po­site and mu­tu­al­ly-ex­clu­sive pay-off cir­cum­stances, thus “net­ting to ze­ro” his ex­po­sure re­gard­less of which of the two out­comes takes place) has ex­posed the en­tire econ­o­my to sys­temic risk of coun­ter­par­ty de­fault. Why? Because net­ting (off­set­ting hedges) don’t work if one of the two con­tracts in the hedge blows up be­cause one of the insurers—think AIG—is sud­den­ly un­able to pay. And if every­one is a coun­ter­par­ty to every­one else, well, you get the pic­ture…. (My friend Paul Sheehan, who at one time was in charge of de­riv­a­tives over­sight at mon­ey cen­ter banks as an ex­am­in­er for the NY Fed and now runs an Asian event-dri­ven hedge fund, points out that AIG wasn’t ac­tu­al­ly de­fault­ing; it was mere­ly sub­ject­ed to an avalanche of “col­lat­er­al calls” by coun­ter­par­ties who in­sist­ed that AIG set first $20 bil­lion, then $40 bil­lion and then $60 bil­lion aside as col­lat­er­al again­st their CDS oblig­a­tions.)

Enter in­to this brew­ing per­fect storm the High Priest of Economic Growth, Alan Greenspan, who, along with the Bush Administration, feared that the 2000/2001 bub­ble burst­ing and the tragedies of 9/11 might con­spire to cre­ate a Depression. Greenspan’s Fed—amid much aplomb from the neo-sup­ply-siders of the Bush administration—cut the Fed Funds rate so pre­cip­i­tous­ly and so ag­gres­sive­ly (down to 1.00% in ear­ly 2003) that, as Reich points out, re­al in­ter­est rates were neg­a­tive for per­haps a year or two. I took a look at the data and pro­duced the chart at the top of this post, and to be speci­fic, re­al in­ter­est rates were neg­a­tive for near­ly 11 quar­ters (2.75 years) be­tween 2003 and 2005. (see fig­ure above) And, as oth­ers have point­ed out, the prob­lem wasn’t just neg­a­tive re­al in­ter­est rates per se, but the fact that such low Treasury rates drove the world of in­vestors who were look­ing for “safe” fixed in­come se­cu­ri­ties to look elsewhere—to CDOs.3

Is it any won­der that every­one and his broth­er who could sup­port even a mod­er­ate cred­it rat­ing bor­rowed like there was no tomorrow?(Don’t even get me start­ed about the Ponzi scheme per­pe­trat­ed by the rat­ing agen­cies, the bond is­suers and their syn­di­ca­tors.)Of course not. If you were a pub­lic com­pa­ny CFO from 2003 to 2005, you were crazy not to bor­row: it was free! And what did you do with all that mon­ey? You couldn’t in­vest it in­to re­al op­er­a­tions be­cause you couldn’t scale that fast, and nei­ther your busi­ness nor the econ­o­my wouldn’t sup­port it any­way. (That was one of many hints: if your busi­ness can’t con­sume more debt with­out do­ing some­thing off the reser­va­tion, per­haps you have no busi­ness draw­ing down that debt in the first place!) And so you gam­ble with it. You cre­ate de­mand for new and in­ter­est­ing se­cu­ri­ties with which to sate your de­mand for re­turns on debt you have no busi­ness gen­er­at­ing in the first place. So you over­heat de­mand for CDOs, and you cre­ate an ir­re­sistible temp­ta­tion for the bankers to cre­ate more and more of them. Commercial banks did it. Investment banks did it. Even in­sur­ance com­pa­nies did it.

Thus Clinton Administration poli­cies and Bush Administration poli­cies cre­at­ed the per­fect storm:


If you have been think­ing about the ram­i­fi­ca­tions of what the Fed did ear­lier this week, you can see where this is go­ing. But that will have to wait for the next post(s)….

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  1. Inflation data from http://inflationdata.com/inflation/Inflation_Rate/HistoricalInflation.aspx, Fed Funds data from http://www.the-privateer.com/rates.html. Graph by the au­thor. []
  2. The best ex­pla­na­tion of both the sys­tem risk from net­ting and CDSs in gen­er­al I’ve come across comes from the ab­solute­ly su­per This American Life/NPR News col­lab­o­ra­tion “Another Frightening Show About the Economy”, it­self a fol­low-up to an ear­lier and equal­ly ex­cel­lent col­lab­o­ra­tion clev­er­ly ti­tled “The Giant Pool of Money” []
  3. cred­it to “The Giant Pool of Money” for ex­plain­ing this so clear­ly. []

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