We’re all familiar, I hope, with the reason we had an arms race with the Soviets for three decades. It certainly cost us enough, but the payoff was that we never had a third World War.
To me, this phrase also summarizes the reality behind “Too Big to Pay,” my personal version of the very similar phrase (Too Big To Fail) attached to the world’s largest financial institutions.
I call them TBTP because they managed to keep every major government from extracting a small transaction fee or insurance premium to build up a fund that would actually pay for the clean-up when one of them becomes insolvent. We can all rest easy knowing their customers won’t be paying an extra thousandth of a cent on each trade. After all, it’s much better policy to charge all the non-customers and the next couple of generations for the cost when it happens again.
If you read Alan Greenspan’s testimony around the time some of those “anti-business” legislators and regulators were suggesting new rules to handle all the new derivatives, you’ll see that he believed in a mathematical impossibility:
That every counterparty to every derivatives trade would successfully protect themselves from failure by their counterparties. That all participants in a complex and opaque business would know enough to see, for their own protection, that they had sufficient collateral for every trade. He didn’t even think the failure of Long Term Capital with its coterie of Nobel economists was sufficient warning that even the biggest banks and dealers didn’t know enough or see enough to get it right every single time. Even with the lesson of tiny Herstatt Bank to guide him, he insisted no oversight, disclosure, regulation or capital requirements needed to exist.
Even if the odds were a million to one that any one party to a private swaps contract might fail, by the time there were $60 trillion of CDS (synthetic bond obligations) outstanding in literally hundreds of thousands of transactions, the odds were beginning to tilt in favor of failure.
Having been inside several of the largest and most competent banks that did that business, I can state unequivocally that the individual odds of getting it wrong were higher than a million to one.
In other words, it was bound to happen that a cascading failure event would occur, and without additional capital held aside to address the cost of failure, the entire institutions were poised at the edge, even if no one knew it.
Sir Alan and the Free Market acolytes merrily worshiped their infallible god of market forces, never even thinking about what an interconnected system of hidden obligations might do if it unraveled.
When Bear Stearns was vivisected by its former trading partners, the Treasury Department under Paulsen and the Fed was able to force a shotgun marriage over the weekend. Unfortunately for us taxpayers, JP Morgan got to “buy” $30 billion worth of Bear Stearns illiquid structured paper with $29 billion of ten-year non-call, non-recourse debt. They also got to step into Bear’s shoes on literally trillions of dollars of over-the-counter CDS deals with enormous bid/offer spreads which came with the portfolio of hedge fund Prime Broker accounts. Nice for them.
Then the crisis gradually built up steam over the summer, so that by the time Lehman was ready for one last push into insolvency, everybody knew it was coming. The Powers That Be thought it wouldn’t be too terrible to let it fail, since we had forewarning, and Lehman wasn’t as big as the others. That’s when they found out about Mutual Assured Destruction.
Within 48 hours of Lehman becoming a spot on the sidewalk, the largest and oldest Money Market fund “broke the buck” because it held Lehman Commercial Paper.
Once Commercial Paper funds couldn’t be trusted, almost nothing could. I saw my employer, a large asset manager, hit its limits for overnight exposure for every major bank in the world. After all, we couldn’t afford to put more than $50 or $100 million in any single private company, could we? We ended up putting some of our money with the Fed and buying T-Bills for negative yield. I know some people thought it was impossible to have negative yields — that no one would put their money somewhere with the guaranty to get less money back a week or month later. The thing was, we knew exactly how much less, and we knew we would get the rest back. We obviously weren’t alone in our concern.
Soon everyone in our shop who could access and run the system that calculated and entered swap clearing instructions was re-calculating every exposure to Lehman, both as a creditor and debtor. They were busy 24/7.
On a worldwide basis, everyone in the swaps business was doing the same thing. Naturally, none of us knew how much exposure anyone else had to Lehman, so we couldn’t be sure whether anyone other than Central Banks was solvent.
Everything stopped. Commodity shipments, debt being rolled over, Letters of Credit, the repo market, CD’s. All of it.
It turned out that even a somewhat smaller member of the Club (Lehman) was large enough that anyone who forced them out of business was taking a very real chance that they would put themselves out of business by the same action. They should have known from tiny Herstatt way back in 1974.
That’s how I’m looking at the put-back lawsuits. If Bank of America truly had to buy back every questionable loan that Countrywide wrote all at once right now, then the big name plaintiffs like Pimco, Blackrock, the Fed, Fannie and Freddie might find themselves trapped by the liquidity drain themselves.
I see the likely outcome to be one that takes at least a year or two to come to a payment amount, and for that payment amount to be small enough that BAC can pay it without collapsing. Nobody in the Club wants to trigger failure of the entire Club, after all, so they’ll take what BAC can afford, in the time frame they can afford to pay it. I figure 15% or so, or maybe $5 to $7 billion. Same story at the other mortgage monsters.
So that’s what I say whenever I get one of those breathless calls about the collapse of the entire system because of failures in Gold deliveries, or the broad statement that all MBS are “worthless,” or the call for hyperinflation of the Dollar. I say that it won’t happen the way the Apocalypse folks see it. It will be a controlled crash, with most of the pain somehow getting spread across the populace that never got any of the upside.
The big banks and insurance companies and fund management complexes have gotten so big that they know they can’t kill one of their fellow Club members without suffering from the poison themselves.
Mutually Assured Destruction.
The really silly part of this whole story was the “fix” we undertook in America. Instead of breaking them up, we decided to merge them. Nothing like taking a problem that’s too big to face and making it bigger, after all.