Subprime fallout: Save Our Souls - By Julian Delasantellis

Posted by ProjectC 
"Finance is the lifeblood of commerce; to expect the general economy to prosper if the internal malfunctions of the finance sector are rendering it unable to fulfill its traditional function as an intermediary between lender and borrower is about as realistic as assuming a body can survive without a circulatory system. In contrast, using the prosperity of America's overpriced, gold-plated employment-based health care system as a proxy for the wellbeing of the general economy is similar to saying that a community is prospering because all of its local vampires are healthy."

Subprime fallout: Save Our Souls

By Julian Delasantellis
Oct 23, 2007

Call it karma, Karl Jung's synchronicity, serendipity, or just plain old bad dumb luck, but it is interesting that the US stock market chose to throw in a 5% price decline in the week that Rupert Murdoch's Fox Business cable channel, the unabashedly rightwing rah rah towel-snapping boobs over bonds alternative to General Electric's CNBC and Bloomberg TV, debuted in 30 million US homes.

In contrast to the rest of the financial media, which correctly placed the blame for this latest market falloff, culminating in Friday's 367-point, 2.6% fall in the US Dow Jones Industrial Average, on continuing and ever-deepening concern over the credit quality effects of the US subprime crisis, Fox Business rounded up the usual keffiyeh-clad suspects and was alone among the financial media in placing at least part of the blame for the selloff on market nervousness over the terror bombings that greeted former premier Benazir Bhutto's return to Pakistan the previous day.

In a time of significant crisis in the markets, when investors are in desperate need of real, unbiased actionable information, Fox Business will probably keep its viewers from changing the channel to CNBC or Bloomberg with the usual Murdoch media strategy of increasing the diaphanousness quotient of their female on-air talent's attire. (Surely, Fox Business' Liz Claman and Nicole Petallides must have by now discerned the purpose of the bowls of ice cubes on their dressing room tables.)

For the rest of us, dealing with the challenges posed by the current financial markets' travails may prove somewhat more problematic.

To paraphrase Henry II, "subprimes, subprimes; will no one rid me of these damned subprimes?" That's proving to be much easier said than done. For the third time since March, we are in the midst of a significant market selloff, a sharp and painful expansion of what the markets call "risk aversion".

The first time was in early March, followed soon by HSBC bank's reporting that its earnings would be negatively affected by problems at its American Household Finance mortgage unit, the signature event that brought the subprime mortgage crisis front and center to the market's attention. That caused a 7% decline in the US Dow Jones Index, 8.5% in Germany's XETRA DAX index and a 9.7% decline in Japan's Nikkei 225 index.

Strong world economic growth drove the subprimes from the market's concern in spring and early summer, but by mid-July, growing realization of just how extensive, and how widespread the subprime losses were going to be led to the big equity market calamities of August, with both the Dow Jones and the DAX falling over 11%, the Nikkei 16.5%. (I wrote about the internal market dynamics of the August selloffs in my October 2 ATol article, No such thing as a sure thing.)

August's market carnage and investor losses had the US Federal Reserve and other world central banks saddling up and riding to the rescue of their large investment banks and other speculative interests, with market interventions and, in the case of the Fed, interest rate cuts.

This settled things down a while; the Dow Jones and the S&P 500 reached all-time record highs in the first week in October, the DAX nearly so. Until last week the markets seemed to be confident that the world's economic regulators could, with more rate cuts and prudent oversight of the institutions endangered by the crisis, stay at least somewhat ahead of the whole subprime mess.

Last week the sentiment turned; it no longer seemed that the central banks were staying ahead of the crisis; the fear was that the crisis was going to catch up, run over and flatten them.

In a fitting upbraid to those who think that by the sheer force of their intellect or will they are able to tame markets, the proximate cause of last week's turmoil was an attempt to save them. I've written before that one of the biggest problems in the current subprime crisis is the fact that those investors outside of the financial institutions that waded into the subprime swamp have no real idea just how bad things are, just how much subprime and subprime-related exposure that those now caught in the swamp are hiding under water and away from view. (The Economist magazine reports that banks suspected of having the most exposure to the specific subprime-related debt called "structured investment vehicles" (SIVs), are now being termed by the markets as being "SIV positive", as if the SIVs were deadly communicable viruses, which, in actuality, may be closer to the truth than the wags either realized or intended.)

Three of the most bounteous of American finance capital's heavy hitters, Citigroup, JP Morgan/Chase and Bank of America, floated an idea over the weekend of October 13-14 to establish, within the neighborhood of US$100 billion (a very nice neighborhood indeed) of these banks' funds, something called "the Master-Liquidity Enhancement Conduit", or M-LEC - commonly called "the superfund".

In simplest terms, what the big hitters were hoping was that when investors dealt with these institutions after the establishment of the M-LEC, no longer would the big institutions be tinged with the pervading aroma of feculent subprime carrion that currently permeates much of American finance. The idea was that the M-LEC would buy the questionable (although not the worst) of the subprime SIVs, taking them off the bank's balance sheets, and, in so doing, restoring confidence in the big banks.

But if it was going to be this easy to solve the subprime mess it probably would have been done by now, and, as the markets realized this, the selling of last week set in. (This selling was matched in Asia on Monday, where stocks plunged, led by Japan's benchmark Nikkei 225 stock index losing 3.20% and the Korea Composite Stock Price Index shedding 3.8% in early trade. Stocks were also down in Australia, Hong Kong, Indonesia, the Philippines and Taiwan.)

If the big banks really wanted to get the SIVs off their books, they would not have needed to set up a $100 billion M-LEC to do it; all they would have to do is exactly the same thing that widows and orphans do when they want to sell 100 shares of AT&T; call up their brokers and have them put in a sell order.

But this is exactly what the big banks do not want to do, for they do not want to accept the fire-sale or worse prices for the distressed SIVs that the market is now willing to give them. Since the SIVs trade in the secondary market so infrequently, the big banks had been valuing them on their books not in relation to their recent sales, their "comps" in real-estate lingo, but instead according to a series of complicated proprietary mathematical model formulations that allowed the banks to carry them on their books at valuations far higher than what today's nervous markets are willing to pay for them. (I wrote about the inherent dishonesties involved in marked-to-model pricing in my July 3 ATol article, Of termites and index mania.)

So, if the M-LEC is going to take the bad SIVs off the big banks' hands, at what price will these transactions be made? The big banks don't want to take the market prices; they'd be overjoyed to get the marked-to-model prices. The free market won't give them the latter; it was the sneaking suspicion that the banks were going to force marked-to-model pricing down the throats of the M-LEC, which after all would be the big banks' creation, that turned the markets against the M-LEC concept by late last week.

Inherent in the idea of the M-LEC is the hope that, eventually, the big banks which created it would be able to take off its training wheels and let it stand alone as a profit-making entity. The market sees this as unlikely; if at birth the M-LEC is to be saddled with the dead weight of its creators' previous greed-soaked imprudence and impropriety, then it's not surprising that, by the end of the week, the market looked around and saw that the general situation was far worse than it previously thought.

As far as the markets are concerned, it's best to not have any problems, it's somewhat worse but acceptable to have a problem but then to come up with a workable solution. If you have a problem and it is then seen that your solution is nothing more than blather-sodden balderdash, then, in terms of inspiring and maintaining confidence, that's the worst situation of all. No wonder that, by Friday afternoon, investors were crowding the stock market's exits, having sold out and heading for the hills.

Many right-wing pundits, in their ever-more difficult effort to maintain the George W Bush-economy-triumphant-over-all talking point, continue to attempt to play down the seriousness of the subprime crisis, noting that, even amid all the bad news regarding the US real estate sector being proclaimed all across the non-Murdoch media, over 90% of US homeowners are still continuing to meet their mortgage obligations on or near on time.

This is true, but meaningless. As I have written many times, it may be called the subprime crisis, but the real problems lie not with the poor subprime borrowers awaiting their upcoming and inevitable foreclosure, it's what happened to that subprime mortgage paper as it got packaged and repackaged, leveraged up, collateralized, borrowed upon, and then leveraged up again, while it moved further and further up into finance capital's elite addresses. A $1 loss on a $100 stock should not be a problem, unless you've used your $100 investment to buy $100,000 of that stock on margin. In that case, you are wiped out.

It is true that the general market is still only around 5% off its recent highs, but it is in looking at the market's internal dynamics that you can see just how serious things are becoming.

It was in the March selloff that the market basically decided to throw the pure subprime lenders, such as New Century Financial and Novastar, onto the refuse heap of finance history; as we move ever deeper into the dark cellars of this crisis the market is moving to target a far pricier prey. Far and away, the biggest losers in this month's selloff are the general banking and finance sectors, as the market now accepts and prices into stock values the fact that subprime contagion can now be found behind the regal polished doors of Wall Street's best addresses.

The entire banking and finance sector is trading at or near its lows for the past year, and much of that decline has occurred in the past two weeks. The S&P banking sector is down over 12% in that period; mortgage leader Washington Mutual is down 22%, Countrywide Financial is down 26% as news reports spread that the US government is now investigating its chief executive officer, Angelo Mozilo (last year's media darling for his supposed role in bringing home ownership to the masses) for his previous selling of $130 million of his personal stock in the company; a fairly sagacious move with a stock whose price has declined 67% since February.

As surely as night follows day and autumn follows summer, in the financial markets the fuzz follows the froth, the cops follow the carousal. Market cheerleaders counter that other stock sectors, especially export-orientated and health care, are holding up better as finance falls away, but as an argument for the continued general health of the market that is very misleading.

Finance is the lifeblood of commerce; to expect the general economy to prosper if the internal malfunctions of the finance sector are rendering it unable to fulfill its traditional function as an intermediary between lender and borrower is about as realistic as assuming a body can survive without a circulatory system. In contrast, using the prosperity of America's overpriced, gold-plated employment-based health care system as a proxy for the wellbeing of the general economy is similar to saying that a community is prospering because all of its local vampires are healthy.

The relatively bullish US employment report of October 5 made some market observers wonder whether another Federal Reserve interest rate cut would be needed at the Fed's next meeting on October 31, but the market turmoil has settled that question. As I wrote in my September 19 ATol article, A rate cut with a shoeshine and a smile, Fed chief Ben Bernanke's actions during the summer have proven that he is more than willing to step into Alan Greenspan's big shoes as supporter of stock prices of last resort.

At least in the short term, how much good that will really do is questionable; the previous rate cuts of August 17 and September 18 have seemed to have had an effect most analogous to that of the newly popular energy drinks, a quick buzz of buying that rather rapidly wears off.

What more rate cuts will certainly do is give another kick to the US dollar while it's already down; since the commencement of interest rate cuts on August 17, the greenback has fallen over 6% against the euro, reaching record lows of over 1.43 euro/US$. One thing that this will do is continue to drive crude oil prices further up towards $100 a barrel. As I wrote in my September 20 ATol piece, US rate cuts: Like a blow to the head, the relationship between a falling dollar and higher crude oil prices is one of finance's most reliable tautologies. This will drive home heating oil prices up now, and gasoline prices up after the New Year; if you've got people who heat their homes with oil on your holiday list, big thick warm wooly sweaters (very much unlike those worn by the Fox Business anchorwomen) might this year be the gift that keeps on giving and giving and giving.

Is it possible that America might be facing an extended period of a declining standard of living, maybe even of living within its means? Heavens, what a terrible concept, you can hear political opinion and posturings from all across the ideological spectrum from the 17 or so odd (and, yes, some are very odd) candidates currently competing for the Democratic and Republican parties' presidential nominations. It's important to support the troops; it's a lot more important to support the credit cards.

In much the same way that in 2000 candidate George W Bush promised the US military that "help was on the way" and then threw it into the abattoir that is Iraq, for the beleaguered American shoppers till they droppers, a rescue from the country's current economic difficulties may soon be on the horizon.

Over the past week the financial press reported rumors that China's state-owned commercial bank, CITIC, the country's eighth-biggest lender, was looking to buy a good sized stake in the US investment brokerage house Bear Stearns, the bare-knuckle Wall Street brawler whose default on two in-house subprime hedge funds was essentially the starter's pistol for the midsummer crisis.

I wrote about this concept, the large pools of Asian and oil exporter state managed capital, called Sovereign Wealth Funds, (SWFs) in my August 21 ATol article, When the big guns fail, call in China. CITIC is not technically an SWF, but the principle is the same; it's 21st century state capitalism coming in to solve and benefit from the problems caused by the excesses of unregulated 20th century market capitalism.

The Economist magazine estimates that worldwide SWFs have over $3 trillion at their disposal; that represents about 5% of the world's total base of investment capital. The SWF horde is far and away the only source of funds big enough to dig America out of its subprime mess, but the inherent drawback of allowing foreign state capital to bail America out of the difficulties created by its long-standing desire to live beyond its means would be that the nation would in effect be selling the ownership of its very profitable banking and finance industries to other nations.

Like selling yourself out of your own house so that you can then pay a monthly rent to the new owners, generations of economic servitude would be the price of yet another all too brief period of illusionary prosperity.

No wonder those in the SWF home countries don't have to watch Fox Business to get that perky feeling.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.

(Copyright 2007 Asia Times Online Ltd. All rights reserved.)