The Shoes Yet to Drop

Flooding the banks (both commercial and investment) with cash by the Federal Reserve had the intended purpose of dodging the 1929 bullet of insolvency due to a lack of available currency. Both Alan Greenspan and Ben Bernanke attribute that lack of will on the part of the Fed at the time as a central reason the Great Depression was so severe. We have yet to see how that will work out, but injecting some $16 trillion that essentially came from nowhere but the printing presses is sure to have a major negative impact on the value of our currency.

I am reminded of the story of the truck driver who repeatedly stopped every half-mile or so to run around to the rear of his vehicle and pound on the doors. He then drove on. Frustrated and tied up, a driver behind him finally got out of his car and asked,

“Why the hell do you keep stopping to beat on the back doors of your truck?”

“Buddy, I got ten tons of pigeons in there and only a five ton license. I gotta keep half of ‘em in the air.”

It remains to be seen if Bernanke can keep half his pigeons in the air.

Is Bernanke whistling past the graveyard or truly dodging the bullet of 1929? The larger question may be, considering where the combining of commercial and ‘investment banking’ has brought us, is the system worth saving?

Combining commercial with investment banks was strictly prohibited after the Great Depression by The Banking Act of 1933.1 That law established the Federal Deposit Insurance Corporation (FDIC) in the United States and imposed banking reforms, several of which were intended to control speculation. It is often referred to as the Glass–Steagall Act.

Glass-Steagall was repealed by President Bill Clinton in 1999 and banking was once again off and running.

Credit Cards

Let’s be clear about the fact that credit card debt is entirely unsecured. That means that although lenders can annoy you and add late charges till the cows come home, essentially they have no recourse but to report you to credit agencies and boost your interest rate by nearly double. They can file legal charges and take you through the courts to collect their debt and interest accrued, but can’t go after other assets.

Thus credit card debt, should a nationwide tsunami of default occur, is a very real and delicate liability to the banking system.

Just Master Card, Visa and American Express account for a little over a billion credit and debit cards currently in use in America, just over three each for every man, woman and child in the country. Average credit card debt per household totals approximately $16,000. Total American credit card debt hovers near $1 trillion and the trigger, should there be a national meltdown, is escalating interest percentages for late payment. The individual or family that cannot make their current payment at 12.5% can hardly be expected to pay it off at twice that percentage, hence the possible tsunami as the economy deteriorates.

That said, I suppose Bernanke will simply print off another $trillion and claim it’s necessary to the health and welfare of the banking system. The health and welfare of we poor taxpayers who keep bailing them out isn’t of importance. What is important is providing us with new buckets, as both those we’ve been using continue to leak and our arms wear out.

Here’s an interesting middle part of an article2 from that presages disaster by the very nature of consumer gullibility and bank usurious tendencies:

At that same time, First Premier Bank launched a new credit card with the sky-high 79.9% rate.

The card proved popular with consumers, said First Premier Bankcard CEO Miles Beacom, but the performance was bad: “A lot of the people ran up the card, defaulted and went directly to charge off.”

As a result, they dropped the rate to 59.9%. “We also tested it at 23%, 33%, 45%, but 59.9% is the one that shows the best performance and where the organization can market the product,” he said.

Since then, nearly 700,000 people have signed up for the 59.9% card — and more than half of them carry a monthly balance, Beacom said. (The company later clarified that 280,000 people have an active 59.9% card — 700,000 have applied for First Premier prodcuts since late 2009.)

And yes, that rate is completely legal. The Card Act, which was passed in late 2009 to protect consumers from predatory lenders, only prevents issuers from raising rates retroactively. Credit card issuers are free to charge whatever rate they want at the front end.

The liability is out there when 700,000 people will grab at a straw like a 60% rate. They were once against the law, but no more. Presumably, when the roof falls, First Premier Bank expects the Fed to bail them out.

Bloomberg reports,

3The household balance sheet is in worse condition than at any other point in history since the Great Depression. From 2001 to 2007, debt for U.S. households increased to $14 trillion from $7 trillion, and the ratio of household debt to gross domestic product was higher in 2007 than at any time since 1929 (and we know how that turned out).

With household debt doubling in the six years prior to financial meltdown and three quarters of a million people hoping to be approved for a 60% finance rate credit card, you can argue about the nuts and bolts, but hardly that the wheels are about to come off.

Student Loans

Student loans are supposed to bridge the gap between what it once cost to attend college and what the nut has become. They help pay for tuition, books and enough to feed and house an increasingly hungry student population. The great proportion of those loans are federal. Student loans are now so ubiquitous that it’s the rare kid walking across campus that isn’t slumping a bit under the load.

4Federal Student loans are generally less expensive than private student loans. However, the federal student lending program still generates billions of dollars in profit for the government each year, because the interest payments exceed the government’s own borrowing costs, loan losses, and administrative costs.

So, it’s a profit-center for the government. Okay, why not (I leave you to fill in your own reasoning)? But the education tail now seems to be wagging the dog. It’s difficult these days to get a decent job without a college education and yet getting that degree grabs 10% of a new hire’s income for up to 25 years. That is, if either the student or the economy can hold out that long, which is the thrust of my argument. Employment statistics are pretty rough today and likely to get rougher.

5A weak labor market already has left half of young college graduates either jobless or underemployed in positions that don’t fully use their skills and knowledge.

Young adults with bachelor’s degrees are increasingly scraping by in lower-wage jobs — waiter or waitress, bartender, retail clerk or receptionist, for example — and that’s confounding their hopes a degree would pay off despite higher tuition and mounting student loans.

These are the bright young minds we keep reminding ourselves will pull us out of the morass into which the past generation of weak old minds has buried us. Just as Baby Boomers sneak off into retirement with all the loot, these are the kids to whom we hand over the reins.

6The amount of student loans taken out last year crossed the $100 billion mark for the first time and total loans outstanding will exceed $1 trillion for the first time this year. Americans now owe more on student loans than on credit cards, reports the Federal Reserve Bank of New York, the U.S. Department of Education and private sources.

Students are borrowing twice what they did a decade ago after adjusting for inflation, the College Board reports. Total outstanding debt has doubled in the past five years — a sharp contrast to consumers reducing what’s owed on home loans and credit cards.

Twice what they were borrowing a decade ago and outstanding student loans now essentially equal total American credit-card debt. When I went to college in the late fifties, there was no student loan debt, because it wasn’t necessary. The lucky kids’ parents sent them and the rest of us toughed it out with a combination of parental help, summer jobs and working during the school year.

But it was possible then. Even tuition at Harvard was $1,000 in 1957 , compared to 2012’s $36, 305. And it isn’t only Harvard that’s expensive today. Listen to a grandparent’s concern over essentially a trade-school debt7:

Our grandson attended a national automotive school for one year in 2007 at a cost of about $40,000. He graduated third in his class.

Today, he earns $13.50 per hour with no benefits as an auto mechanic for a private company. He was led to believe by his parents and the school that he could make three times this much in a year or two after graduation. Now, five years later, with two young children, he works 55 to 60 hours a week and picks up side jobs to survive and pay his student loans.

And still, most months he has to borrow money for rent and gas. How long can he keep doing this? I don’t see an end to this when he is saddled with so much debt.

A person with other financial problems can use the bankruptcy courts to forgive and/or restructure debt, but if you have student loans you cannot receive this help.

That’s a pretty rough row to hoe on $13.50 an hour and just starting out in life.

Auto Loans

Hot off the newswire as I write this. We are apparently saved and you can toss this book, heave a long sigh of relief and take your loved one out to dinner. Barack will no doubt be reelected and the economy take off like a drone missile.

8Auto Sector Indicator Signals US Recovery: New auto finance company loans originated between January-March 2012 totaled $52.5 billion, which is 49% higher than the recession low in March 2009 ($26.9 billion) according to Equifax’s May National Consumer Credit Trends Report. The most current data also shows that new auto bank loans amounts originated between January-March 2012 totaled $47.5 billion, a seven-year high and 25% higher than the recession-era low in March 2010 ($35.9 billion).

The total number of outstanding auto loans continues to climb, surpassing 57 million for the first time since February 2010 and balances among existing auto loans are also increasing, with the May 2012 total of $740 billion representing a 34-month high.

That certainly has put my mind at rest. Another $47 billion added to the three quarters of a trillion dollars out there whizzing up and down our highways. Certainly sounds like an indicator-signal of recovery to me. Live Trading News must be smoking some pretty good stuff.

Walk in, drive away used to be the pitch. But while automobiles are most people’s largest investment after their home, the loan is among the easiest to default. Simply take it back where you bought it, throw the keys on the desk and the dealer gets a car that’s depreciated to less than the outstanding loan and very little incentive to chase a voluntary default. The shoe that could drop for lenders is the new paradigm, drive in, walk away.

Mortgage Foreclosures

I guess the mortgage loan debacle is pretty much front and center on everyone’s radar today. The common opinion is that these stories of illegal aliens buying half-million dollar homes deserve to lose them and that point of view is absolutely correct. But that’s not the whole story.

Wall Street single handedly created this housing bubble in cahoots with lenders by the invention of mortgage based securities that essentially took all risk off the hands of the banks and ‘bundled’ these mortgages, offloading them to investors. Which might have been okay, were it not for the fact that the banks no longer gave a damn about default, because they were no longer directly on the hook. The loan, as well as the security, was elsewhere. So that’s the lender side, a fee based income with limited risk and a prescription for disaster.

Had the banks been prevented from gambling in investment markets (as they were under law)9 until 1999, we might have at least didged the housing bubble and the mayhem that ensued. The Clinton administration’s Federal Reserve Chairman, Paul Volker encouraged congress to “provide clear and decisive leadership that reflects not parochial pleadings but the national interest.” Well, sometimes parochial pleadings have a purpose, but they were overturned and the snowball began to roll. The banks wanted badly to get in to the investment banking arena and the Wall Street crowd wanted badly to get in to banking. A marriage for sure, but one destined for divorce and we taxpayers were elected to pick up the alimony payments.

On the investment bank side, Wall Street had the hots to tap into what they saw as a huge profit opportunity in the mortgage markets and access to the banks securitized mortgage holdings amounted to the camel’s head in the tent. Once inside, the possibilities were endless and the horizon was as far as their ability to invent investor vehicles. Of course those ‘vehicles’ were mostly getaway cars, but what the hell.

  • There were Structured Investment Vehicles (invented in 1988, hit a high in 2007 and none remain today)

  • Asset-backed commercial paper was collateralized by ‘other financial assets’ a good many of which turned out to be ‘liar loans’ offered as triple-A by paid off credit raters such as Moody.

  • Residential mortgage-backed securities (RMBS) began pretty much as government backed agencies (Fannie Mae, Freddy Mac) but the morphed into what were termed private-label entities, which grew like their pants were on fire from 2001 to 2007, and then fell into their own flames in 2008 when real estate staggered.

There were almost endless ways to skin this cat, but it still ended up as cat skin.

The rest of what is not the whole story lies on the consumer side. As the housing market heated up, formerly conservative middle class homeowners began to feel left behind when the conversation at the canasta table turned to which friend of a friend was cleaning up ‘flipping’ real estate. Thus conservative homeowners began to dip their toe in a second or vacation home to hold for a while and re-sell. And it worked, as long as you had a chair when the music stopped. Not everyone did.

The second bunch of solid, middle-class homeowners to burn their fingers were those who stayed out of the frenzy, but mistakenly believed their home was actually worth a lot more. This was encouraged by a blitz of refinance now and home equity loan advertisements. Why not finally take that extended vacation, build the new garage or buy a second BMW?

Why not indeed? Those who took loans against their home equity are now stuck with the vacation, garage or new car and all of them are depreciating, while their house now has a mortgage for more than it’s actually worth. These home equity loan victims will probably weather the storm, but their future has suddenly been mortgaged as well.

It’ll be a rocky road if the housing market tips further and for sale signs start popping up in what used to be stable neighborhoods.

Opaque Financial Instruments

Credit default swaps (CDSs) are a new fangled kind of insurance on bonds issued by companies and countries as well, look at the current mess in Greece, Spain, Portugal, Italy and Ireland. They can be bought and sold, which makes them and the assets they cover extremely volatile. When I say new fangled, I mean they didn’t even exist until the late 1990s and because they are so complicated, most investors don’t understand them very well. Warren Buffett famously compared them to weapons of mass destruction way back in 2003 and their destructive force didn’t really hit home until the 2008 meltdown.

But they were big-time contributors, melt-down wise. Investment bank sales people in far-flung offices were trading them like crazy and the bean-counters back home really had no idea what was going on. What was going on wasn’t subject to much scrutiny as long as the profits kept pouring in—and pour they did. The market for what no one understood very well soared from less than $1 trillion in 2000 to over $30 trillion when the walls came a tumbling down in 2008.

It’s somewhat comparable to life insurance. Suppose I have a million dollar policy on my life. The premium is based on statistics that show how likely I am to die or be killed and the underwriters are so skilled that life insurance is a profitable business. But suppose anybody could but that same policy. A couple thousand people invest in my policy by paying a very small short-term bet on my death. It’s all okay until one morning I’m found slumped over my Cheerios and a thousand people try to cash in. Suddenly a $1 million dollar policy is expected to pay $1 billion in claims and there’s no billion there. My wife gets a mil and all the CDS investors are caught with a startled look on their faces. It’s estimated that, in one form or another, there are $60 trillion out there in unfunded credit default swaps.

Essentially, that’s why everyone, including Ben Bernanke, is so nervous about what’s going on in Europe and how its outcome will affect America. International finance is so intertwined today that a financial tsunami in Europe could wet a lot of feet in New York on Wall Street. CDS trades are rumored to be behind the recent $2bn loss at JP Morgan that so surprised its chairman, Jamie Diamond, as he sputtered before Congress.

That’s a very short-course in investment-speak that informs us on investment trajectories and why some things are now underwritten at 700 times what they’re worth. Hang on, maybe we can learn something:

10The current financial crisis has been caused by a ‘credit crunch’ in inter-bank lending that has been brought about because financial institutions no longer trust traditional ways of rating the risks and value of loans and assets. This has been caused by concerns that highly leveraged derivatives, such as credit default swaps and collateralized debt obligations, are not properly valued which has made the financial obligations of lending parties increasingly opaque and difficult to understand. When banks are not sure of the stability of the other institutions they are lending to and borrowing from because of concerns about their financial exposures to complex derivative positions, they lend less which has produced the current crisis.

Aha, so now we’re down to this matter of trust in the banking community. They no longer trust each other because they allowed the building of computer modeling financial derivatives no one understands. Which was all well and good while the money rolled in, but has them eyeing one another with suspicion when the shit hit the fan.

It’s interesting to me that the traditional means of rating risks and values doesn’t have a very long tradition. Does less than twenty years of spellbinding give the spellbinder traditional status? Essentially, it sounds as if the banks followed their own bread-crumbs into a labyrinth and are now startled to realize they don’t know the way out.

The financial innovations that have generated this crisis have evolved along a cumulative trajectory related to a series of improvements in how the risk of lenders defaulting on their loans is framed, standardised, analysed, and re-engineered. This has produced a huge increase in the use of technology (to measure and hedge exposures), the use of derivatives (that are now approximately 700 times the value of their underlying assets), and the use of leveraged business models (i.e. hedge funds and private equity). The current crisis reflects how a technological trajectory based on using financial engineering techniques to analyse and repackage credit risk has complicated the financial system and increased the importance of liquidity risk.

Complicated the financial system, you say. Sounds to me more like innovation in a sausage factory, the only difference being we are no longer getting sausage and no one knows where the hell to find the Braunschweiger and hotdogs.

The Investment Banks have Chopped us and now no one, including them, wants to Shop.

1 Wikipedia, Glass–Steagall Act

2 CNNMoney, Mastering Your Money, Blake Ellis, Feb 14, 2011

3 Bloomberg, Jul 8, 2011, Household Debt Is at Heart of Weak U.S. Economy: Business Class

4 Wikipedia, Student Loan

5 USA Today, 4/23/2012, Half of new graduates are jobless or underemployed

6 Dennis Cauchon, 10/25/2011, USA TODAY; Student loans outstanding will exceed $1 trillion this year

7 The Denver, Opinion, 06/10/2012, Student loan horror stories from our readers

8 Ebeling Heffernam, Live Trading News, June 29, 2012

9 The 1933 Glass–Steagall Act

10 FINNOV research in the context of the current international financial crisis

published: 14. 9. 2014