“Where’s Waldo?”--in the Information Age?

Or it has to be hidden?
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From Bill Gross:






Duringtimes of market turmoil it helps to simplify and get basic – explainthings to a public and even yourself in terms of what can be easilyunderstood. Goodness knows it’s not a piece of cake for anyone over 40these days to understand the maze of financial structures that nowappear to be unwinding. They were created by youthful financialengineers trained to exploit cheap money and leverage who showed nofear and who have, until the last few weeks, never known the sting ofthe market’s lash. They are wizards of complexity. I, however, havingjust turned 63, am a professor of simplicity.

 

Soforgive my perhaps unsophisticated explanation to follow of how thesubprime crisis crossed the borders of mortgage finance to swiftlyinfect global capital markets. What Citigroup’s Chuck Prince, the Fed’sBen Bernanke, Treasury Secretary Hank Paulson, and a host of othersophisticates should have known is that the bond and stock marketproblem is the same one puzzle players confront during a game of“Where’s Waldo?” – Waldo in this case being the bad loans anddefaulting subprime paper of the U.S.mortgage market. While market analysts can guesstimate how many Waldosmight actually show their face over the next few years – 100 to 200billion dollars worth is a reasonable estimate – no one really knowswhere they are hidden. First believed to be confined to Bear Stearnshedge funds and their proxies, Waldos have been popping up withregularity in seemingly staid institutions such as German and FrenchBanks that have necessitated state-sanctioned bailouts reminiscent ofthe Long Term Capital Management Crisis of 1998. IKB, a German bank,and BNP Paribas, its French counterpart, both encountered subprimemeltdowns on either their own balance sheet or investment fundssponsored by them. Their combined assets total billions although theirWaldos are yet to be computed or even found.

 

Thoselooking for clues to the extent of the spreading fungus shouldunderstand that there really is no comprehensive data to allow anyoneto know how many subprimes actually rest in individual institutionalportfolios. Regulators have been absent from the game, and informationrelease has been left in the hands of individual institutions, some ofwhom have compounded the uncertainty with comments about volatilemarket conditions unequaled during the lifetime of their careers. Andtoo, many institutions including pension funds and insurance companies,argue that accounting rules allow them to mark subprime derivatives atcost. Defaulting exposure therefore, can hibernate for many monthsbefore its true value is revealed to investors and importantly, toother lenders.

 

Thesignificance of proper disclosure is, in effect, the key to the currentcrisis. Financial institutions lend trillions of dollars, euros,pounds, and yen to and amongst each other. In the U.S.,for instance, the Fed lends to banks, which lend to prime brokers suchas Goldman Sachs and Morgan Stanley which lend to hedge funds, and soon. The food chain in this case is not one of predator feasting onprey, but a symbiotic credit extension, always for profit, but neverwithout trust and belief that their money will be repaid uponcontractual demand. When no one really knows where and how many Waldosthere are, the trust breaks down, and money is figuratively stuffed inWall Street and London mattresses as opposed to extended into theincreasingly desperate hands of hedge funds and similarly leveredfinancial conduits. These structures in turn are experiencing runs fromdepositors and lenders exposed to asset price declines of unexpectedproportions. In such an environment, markets become incredibly volatileas more and more financial institutions reach their risk limits at thesame time. Waldo morphs and becomes a man with a thousand faces. Allassets with the exception of U.S. Treasuries look suspiciously likeevery other. They’re all Waldos now.

 

Thepast few weeks have exposed a giant crack in modern financialarchitecture, created by youthful wizards and endorsed as adiversifying positive by central bankers present and past. While thenewborn derivatives may hedge individual institutional and sector risk,they cannot eliminate the Waldos. In fact, the inherent leverage thataccompanies derivative creation may foster systemic risk wheninformation is unavailable or delayed in its release. Nothing withinthe current marketplace allows for the hedging of liquidityrisk and that is the problem at the moment. Only the central banks cansolve this puzzle with their own liquidity infusions and perhaps aseries of rate cuts. The markets stand by with apprehension.

 

Butshould markets be stabilized, the fundamental question facing policymakers becomes, “what to do about the housing market?” Granted acertain dose of market discipline in the form of lower prices might behealthy, but market forecasters currently project over two milliondefaults before this current cycle is complete. The resultant impact onhousing prices is likely to be close to -10%, an asset deflation in theU.S.never seen since the Great Depression. Granted, stock markets haveperiodically retreated by significantly more, but stocks have neverbeen the savings nest egg for a majority of Americans. 70% of Americanhouseholds are homeowners, and now many of those that bought homes in2005-2007 stand a good chance of resembling passengers on the Poseidon– upside down with negative equity. A 10% “hook” in national homeprices is serious business indeed. It’s little wonder that Fed,Treasury, and Congressional leaders are shifting into high gear.

 

Housingprices could probably be supported by substantial cuts in short-terminterest rates, but even cuts of 200-300 basis points by the Fed wouldnot avert a built-in upward adjustment of ARM interest rates, nor wouldit guarantee that the private mortgage market – flush with fears ofdepreciating collateral – would follow the Fed down in terms of 15-30year mortgage yields and relaxed lending standards.Additionally, cuts of such magnitude would almost guarantee aresurgence of speculative investment via hedge funds and leveredconduits which have proved to be the Achilles heel of the currentcrisis. Secretary Paulson might also have a bone to pick with this“Bernanke housing put” since it more than likely would weaken thedollar – even produce a run – which would threaten the long-termreserve status of greenbacks and the ongoing prosperity of the U.S. hegemon.

 

The ultimate solution, it seems to me, must not emanate from the bowels of Fed headquarters on Constitution Avenue, but from the West Wing of 1600 Pennsylvania Avenue. Fiscal, not monetary policy should be the preferred remedy...