Sunday, September 28, 2008

Then the Gods of the Market tumbled...

Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew,
And the hearts of the meanest were humbled and began to believe it was true
That All is not God that Glitters, and Two and Two make Four...

From Rudyard Kipling's
The Gods of the Copybook Headings

A copybook was an exercise book used to practice one's handwriting in. The pages were blank except for horizontal rulings and a printed specimen of perfect handwriting at the top. You were supposed to copy this specimen all down the page. The specimens were proverbs or quotations, or little commonplace hortatory or admonitory sayings—the ones in the poem illustrate the kind of thing. These were the copybook headings.

This poem was written by Kipling later in his life. He had lost his dearly loved son in World War 1, and a precious daughter some years earlier. He was a drained man in 1919, and England, with which he identified intensely, was a drained nation. Though he was no atheist, (he) was in fact a Christian of an eccentric sort, Kipling seems to have found little consolation in religion. Kipling was embarked on his two-volume history of the Irish Guards—his son's regiment—in WW1. The project took him three years, and was, he remarked, "done with agony and bloody sweat."With all this as background, it is hard to disagree with the general opinion that "The Gods of the Copybook Headings" is a clinging to old-fashioned common sense by a man deeply in need of something to cling to.(source)

This blog is a copybook of sorts for me. And this poem spoke to me because the longer I live and the more I see, the more it seems that there are certain basic truths about the human condition that transcend time and space. You know what I'm talking about - all those things your mother told you, every cliche-riddled, hackneyed phrase that you can think of. I'm here to tell you, you ignore them at your own peril. Remember moderation in all things? Which brings us to today's particular peril: The Financial Market meltdown.

Like Kipling, when he wrote about the Gods of the Copybook, Wall Street and life in general had left me fried like bacon. My brother was fighting a life threatening illness, I was having seizures of unknown origin. It was a crazy time. But it was a glamorous life and had become who I was. It was a little ballsy to turn my back on it, I guess. I'm sure there were acquaintances that thought I should have had my head examined at the time. (I probably should.) But it's always hard to explain the relief I felt upon leaving the high pressure demands of Wall Street and how I've changed since then. I've been gone for a long time from it and the markets have evolved and changed too. Have I missed it? Yes. But I looked at it is the closing of a chapter in my life and moved on, completely stepping out of that world with gratitude and thanks to God for giving me the experience.

But it was the experience of another era, so while I have been watching the developments of this week unfold with great interest, I have also been watching them with a sense of great detachment. (Which is weird because I do have capital and my retirement $ at risk.)

Please know that I am in no way holding myself out to be an expert, but it's starting to seem silly to be talking to you about pole dancing Muslimas with boob jobs, Islamopirates and hijackings and such, all the while ignoring the 800 lb gorilla in the US living room. So here goes...

The good news: there's some kind of deal. That will satisfy those who believe in that kind of thing and buy some time. The bad news: IMO, it's not going to do much to stanch the bleeding.

Everyone is standing around watching the gyrations in the stock market and real estate market like that is where the true problem lies. No, in a heading that could have been written by the Gods of the Copybook Headings themselves.

"Curst greed of gold, what crimes thy tyrant power has caused." Virgil

Good old greed. Starting back in 1995, the masters of the bond and credit market universe got too cute by half and structured a new and exciting financial instrument, the credit default swap and it's these credit default swaps that are the crux of the problem. The magnitude of the fallout from this hairy piece of "financial engineering" is staggering. Believe me, when I tell you that these things are so wrapped around the axle I don't think anyone knows who's got what.

Under a CDS, a bank originates loan to a company. A second bank (or other financial institution) can agree to cover the credit risk for the loan, by agreeing to make payment to originating bank if the company defaults on the original loan. The originating bank pays a small insurance premium to the second bank for assuming the risk of the loan.

Typically, payments under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong (CDS being a new market, it is by no means "recession-proof").

Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.

But they didn't work out that way...the real estate bubble burst and the mortgage market melted down, factors of life their models didn't take into account. Which brings us to another Gods of the Copybook Heading meets Gordon Gecko Greed is Good moment...the moment when "Wall Street" took over and expanded the volume far beyond what was required for hedging risk. The traders at commercial banks and insurance companies, freed from the constraints of Glass-Steagall by Bill Clinton era deregulation, jumped in with both feet.

After all, bonuses depend on the volume of business. Therefore, bank traders sold the credit risk of a loan not just once, but as many as 10 times. And they sold it not to solid banks and insurance companies, but to three solid banks, one solid insurance company, three dodgy brokers and three hedge funds. Then the traders went out and sold other CDS products that were not even related to actual loans on the books, but to imaginary indices of credit quality in the "widget" industry.

The credit risk of the system was hugely multiplied.

Instead of one $10 million credit risk loan, there are now ten $10 million credit risks on just one loan.

See what I mean about being wrapped around the axle?

Because of this axle, banks around the world are under tremendous pressure. They've even stopped loaning to each other which tells you how bad it is. Bond traders have been standing around with their hands in their pockets - no one is making trades. LIBOR is quaking under the weight of the stress and the short term paper market has pretty much seized up. Commercial paper is how companies finance their day to day operations and make payroll. September 30 is the day when positions unwind and this is where the pain on Main Street will really start. A flood of redemptions is preparing to swamp Hedge Funds. The US Mint has stopped production of gold coins due to soaring demand. Tonight's Asian market open will indeed be interesting. The only bright spot I could find? (and that even has a downside.) Issuance of Islamic bonds falls 54% in the first half of the year. The bad news: "The drop confirms that Islamic finance has become intertwined with global financial markets and is in no way an isolated market". This is confirmed by the following headline: Chicago Muslims devastated by investment scam.

This isn't over by a long shot. Unless this can get things moving quickly (and have you ever known anything to happen quickly when the US govt is involved?) havoc will continue to wreak the credit markets, the relief rally in the stock market will be brief. Will smart money continue to stay on the sidelines? Will there be any smart money left? At heart, financial markets are about confidence in the system and confidence has been gravely shaken.

In other words, the jig is up.

How bad it will be is anybody's guess. But!

As it will be in the future, it was at the birth of Man-
There are only four things certain since Social Progress began:-
That the Dog returns to his Vomit and the Sow returns to her Mire,
And the burnt Fool's bandaged finger goes wabbling back to the Fire;

And that after this is accomplished, and the brave new world begins
When all men are paid for existing and no man must pay for his sins,
As surely as Water will wet us, as surely as Fire will bum,
The Gods of the Copybook Headings with terror and slaughter return!

Unlike Kipling, I'm an optimist who finds consolation in faith, and I believe we will all muddle through somehow.

I'm also a free market trader and believe that the market has to work this out. These type of bailout programs just tend to delay the pain and there is going to be some pain, my friends. I oppose the structure of this bailout on principle, so watching these government types preening and posturing in front of the cameras this weekend was like watching a train wreck in slow motion. They are beyond clueless. And infuriating.
For Nancy Pelosi to call the House Republicans unpatriotic for not attending negotiations that they weren't invited to attend is an outrage. To see these Democrats stand up in front of the cameras and outright lie their a$$e$ off just shows you what we're dealing with.

"Fleece in our times."

Our friend GW at Wolf Howling is doing yeoman's work hoisting these bastards on their own petard for creating the climate that allowed the real estate bubble to flourish and burst. I recommend his blog to you.

(The first credit default swap was after Dinah left the street so she's been having to get up to speed on them herself. If you are interested in learning more, this piece (and source for much of the info here) is a good place to start and this will provide you a window into what's been going on with the banking side of the equation. If you want to laugh and learn as you get up to speed on these magillas go here and check out this horse race analogy.)

The full text of
The Gods of the Copybook Headings

Some of Dinah's other Wall Street copybooks can be found here.

And please be reminded that the fasten seat belt sign is still illuminated. It's gonna be a bumpy one.