Mutually Assured Destruction

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.



11 Responses to Mutually Assured Destruction

  1. Larry says:

    “It will be a controlled crash, with most of the pain somehow getting spread across the populace that never got any of the upside.”

    What will happen if that populace (or a significant portion of it) wised up to what was being done to them? What if they got REALLY angry about it?

  2. William Kinsolving says:

    This is a great essay, Howard. In answer to Larry’s question above, I sink in cynicism, believing that the problem is too complex to be understood and stimulate a rebellion. Also, a leader is not pointing to it and labeling the villain, a la Teddy Roosevelt and the “trusts,” or Milyukov and Kerensky (not to mention Lenin) able to load the whole Russian economic mess onto the feckless Nicholas II. What the populace needs is a villain, not an amorphous derivatives confusion, and I’m afraid Alan Greenspan just can’t fill the role. The danger is that Obama, unless he identifies a villain and comes up with a solution, risks becoming the villain himself.

    • hhill51 says:

      I agree. To truly repeat the past, we’d have needed to elect McCain to be the modern Hoover. Then the excesses of Bush2 would parallel Coolidge’s Roaring 20’s, and McCain could have used the same policies to deal with the problem that Hoover tried, and today’s Tea Party wants.

      • Larry says:

        Today’s Tea Party doesn’t even know what it wants. You definitely don’t know what it wants. Roughly half of them want a xenophobic theocracy led by an Alaskan cheerleader. The other half has actually read the constitution and think it might be worth actually giving a try for once.

        But you are right about one thing… McCain would have done the same half-assed Keynesian stimulus that Hoover did.

        If you meant allowing the market to self-adjust, you need to take a closer look at what Hoover actually did. And you can be sure that McCain would NOT have done that. He would have done whatever the bankers told him to do – just like Obama.

        The only real difference would have been which groups of parasites would have got a bigger share of the loot.

  3. hhill51 says:

    Larry –
    You really shouldn’t talk about history without checking. Your assumption that Hoover reacted to the 1929 market crash and financial crisis with Keynesian action is just plain false. He did what the Tea Partiers want. He cut the Federal budget by an enormous percentage, and let the banks and businesses fail. Just what you want too, I think. Suggest you read up on Andrew Mellon, who was Treasury Secretary under Harding, Coolidge and Hoover that said “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.”
    The result of those policies (which we would call Austrian school) was a decline of nearly 75% in the value of farmland, 30% unemployment, and roughly 50% foreclosures. It was nearly a generation before the deflationary hole created was filled by demand from (yes) deficit government spending for infrastructure, the WPA and conservation corps, and military buildup. Really hard to imagine how bad the same policies could be today with no open land to move to, and supply chains for all the necessities of life so intertwined with finance.
    But let’s do it as homage to the quasi-religious beliefs of the newly reborn fiscal conservatives. The beauty of religion is that it allows you to deny reality, even religion masquerading as political or economic theory.

    • Larry says:

      You’ve removed my entire responses now, but left your insult intact. Will you edit it, or shall I tell you what I REALLY think?

      • hhill51 says:

        You are being banned for inappropriate behavior. You should have gotten the hint when I removed the offensive language the first time. You persisted, and continued to use gutter language.

  4. r3fman says:

    Great post, and a good response to Larry. Unfortunately, too many people substitute ‘freedom of speech’ for rational thought, and then demonstrate that just because they can speak, doesn’t mean they should.

  5. Edwardo says:

    “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.”

    Given the nature of the LTCM debacle, a calamity that Greenspan presided over, your assertion, namely that such an idea never occurred to them, seems highly questionable. I think we would do much better to credit their errant behavior not to a lack of imagination, but, rather, to an absence of moral integrity.

    • hhill51 says:

      It’s so hard to express sarcasm in writing. I know that Alan knew, but his adherence to free market orthodoxy was so strong that he could participate in the virtual lynching of Brooksley Born when she suggested regulatory oversight for derivatives. After all, the LTCM affair and the Born slapdown occurred almost simultaneously — Born’s working paper was May of 1998 and LTCM was that October. Then we got the Commodity Futures Modernization Act spliced onto the Lame Duck Federal Budget in late 2000.

  6. Edwardo says:

    Pardon me for missing the intended sarcasm. Yes, poor Brooksley Born. It’s so hard to be honest amidst those who aren’t.

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