Preventing a Panic

It is the first time house prices had fallen year over year since the Great Depression.

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The fireworks of the primary season, climaxing on February 5, are like having a carnival on a beach while a tsunami gathers force offshore. "Hope" and "Change" as slogans may make people feel good, but they have the same relevance to the financial complexities threatening us as the clueless castaways on Lost, the quirky ABC melodrama.

The castaways are truly lost because they don't understand their new world. Understanding our new world should be the first requirement of all the White House hopefuls because what we are facing is a credit crisis so severe that it threatens the working of the economy. And so deep that it may take as long as two years to unwind—even assuming the top policymakers understand how the new world works. The problem is so complex that nobody can give the right answers before knowing the right questions and gathering the right information. This is a much tougher task than Congress applying band-aids of tax and investment relief. The financial community itself is bewildered, unsure of its risks and liabilities and taken by surprise almost daily. The story of the 31-year-old trader at Société Générale, one of France's largest banks, reads like the script of a movie thriller. He bet $73 billion of the bank's money that European and German stock indexes would go up. When they turned down, the bank discovered the unauthorized trades and unraveled them—at the stupefying cost of $7.2 billion.

Questions: How could one junior trader have bet so much without senior management knowing? How could the bank fail to monitor properly the sophisticated trading techniques and the computerized analyses that underscored the bets? How could it not be aware of the risks inherent in the incredible leverage by which banks borrow 80 to 90 percent of every $1 they invest?

Oversight failure. These failures are shared by many American investment and commercial banks. Merrill Lynch held subprime mortgages exceeding the net worth of the firm. Citigroup had $80 billion of sub-prime mortgages held off its balance sheet in so-called structured investment vehicles. In effect, this meant Citibank had guaranteed the financing to support a massive investment literally unknown to the financial community and much of its management. This at the same time it was holding an additional $50 billion of subprime paper on its balance sheet.

These and other banks invested heavily in all this paper because big profits come from borrowing inexpensively in the short term and reaping higher returns from longer-term securities (many of which earned AAA and AA from the rating agencies). Nice, but just as profits are magnified by leverage, the 1-to-9 ratio of cash equity to borrowing, so are the losses. If the price of the longer-term securities grew by 5 percent when the security had been financed to the tune of 90 percent credit, the result was a 50 percent return on the equity. But if the prices fell by 5 percent, there was a loss 10 times greater in the value of the equity. Your original dollar was worth 50 cents. In many cases, the equity was wiped out. The way up is also the way down.

The markets provided easy, almost unlimited financing to buy securities. But this bubble depended primarily on another bubble—the one in housing. The assumption had been that house prices would continue to rise, enabling overextended borrowers to refinance the growing equity value in their homes. But when prices began to fall in 2007, mortgagees went into default. Bad enough—it was the first time house prices had fallen year over year since the Great Depression. But worse, the defaulters, like falling dominoes, took down with them the institutions that had invested in subprime mortgages bundled into bondlike securities (collateralized debt obligations or CDOs).

The risk in these securities was supposed to be reduced and dispersed by a variety of bond insurance mechanisms (credit default swaps or CDS)—but the rising tide of defaults in CDOs and corporate bonds has imposed heavy burdens on the insurers. The insurers can get the bond they guaranteed, but it is now worth much less than its face value. If the insurer can't afford these losses or goes bust, the bond bounces back to the "original" holders of the CDOs, who bear the losses they thought were guaranteed not to happen. The result can be a fire sale of billions of dollars or securities.