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Notes on the crisis, pt. II

The Wall Street Journal featured a fine piece of reporting some days ago aptly headlined, “Anatomy of the Morgan Stanley Panic.” It is well worth reading for anyone seeking insight into how the crisis was precipitated, with specific emphasis on the interaction of short-selling and derivatives.

The article details the panic of mid-September. Back then, like many banks, Morgan Stanley careened toward ruin, propelled by plunging stock value, rapid credit derivative inflation, and a flight of capital by hedge funds. It nearly fell off the cliff, and in the end required state assistance to survive.

Morgan Stanley can probably function as a metonym for investment banking in late modern America. The sector no longer exists on Wall Street, strictly speaking. It fell to the vicissitudes of human psychology, exaggerated and accelerated by the web of abstraction which had been its bread and butter for a decade.

It would be idle to attempt to attempt to summarize the tale told in the Journal. The writers have already done that masterfully. Instead I’ll offer a few snippets, organized briskly.

On Sept. 16, Morgan Stanley's stock fell sharply during the day, although it rebounded late. Some hedge funds yanked assets from the firm, worried that Morgan might follow Lehman into bankruptcy court, potentially tying up client assets. [. . .] Protection for $10 million of Morgan Stanley debt [that is, credit-default swaps] had risen to $727,900 a year, from $221,000 on September 10. [. . .] It’s impossible to know for sure what was motivating buyers of Morgan Stanley credit-default swaps. The swap buyers stood to receive payments if Morgan Stanley defaulted on bonds and loans. Some buyers, no doubt, owned the firm's debt and were simply trying to protect themselves against defaults. But swaps were also a good way to speculate for traders who didn't own the debt. Swap values rise on the fear of default. So traders who believed that fears about Morgan Stanley were likely to intensify could use swaps to try to turn a fast profit.

Amid the uncertainty that Sept. 16, Millennium Partners LP, a hedge fund with $13.5 billion in assets, asked to pull out $800 million of the more than $1 billion of assets it kept at Morgan Stanley, according to people familiar with the withdrawals. Separately, Millennium had also shorted Morgan Stanley's stock, part of a series of bearish bets on financial firms, said one of these people. In addition, the hedge fund bought “puts,” which gave it the right to sell Morgan shares at a set price in the future.

That same day, Sept. 16, Third Point LLC, a $5 billion hedge-fund firm run by Daniel Loeb, began to move $500 million in assets out of Morgan Stanley. [. . .] Around the same time, hedge fund Owl Creek began asking to withdraw its assets, and ultimately took out more than $1 billion. [. . .] Before noon [on Sept. 17], swaps dealers began quoting the cost of insurance on Morgan in “points upfront” — Wall Street lingo for transactions where buyers must pay at least $1 million upfront, plus an annual premium, to insure $10 million of debt. In Morgan Stanley's case, some dealers were demanding more than $2 million upfront.

During the day, Merrill bought swaps covering $106.2 million in Morgan Stanley debt, according to the trading documents. King Street bought swaps covering $79.3 million; Deutsche Bank, $50.6 million; Swiss Re, $40 million; Owl Creek, $35.5 million; UBS and Citigroup, $35 million each; Royal Bank of Canada, $33 million; and ACM Global Credit, an investment fund operated by AllianceBernstein Holding, $28 million, according to the documents.

The following day, Sept. 18, some of those same names were back in the market. Merrill bought protection on another $43 million of Morgan Stanley debt; Royal Bank of Canada, $36 million; King Street, $30.7 million; and Citigroup, $20.7 million, the trading records indicate.

And on and on. Keep in mind that (supposing, as always, my understanding of this stuff is accurate) in most of these transactions, no property was changing hands. Short-selling involves borrowing stock and selling it lower, and credit-default swaps involve trading abstracted risk on a company’s failure.

What do I take away from the article? Mostly a kind of staccato of intuitions which I am trying to organize into coherent thoughts.

(1) All this high-finance engineering leaves me adrift, ideologically. Doctrinally speaking, what does Capitalist theory have to say about the possibility that a company may be driven to ruin and disgrace in a matter of days based on panicked hedging and derivatives sales? Does Capitalist doctrine require that Treasury and the Federal Reserve sit idly by and watch the degringolade? Was the SEC wrong to ban short-selling financial stocks on September 18? Was the Fed wrong to backstop money market accounts? I find the answers to these questions, if they issue from doctrinal propositions, rather unsatisfying. My instinct is to favor prudence and pragmatism.

(2) Our subjection to these engineered financial abstractions, so painfully obvious now, will be a long time in unwinding. There is no doubt in my mind that it needs to happen — the brutal deleveraging, the retreat from credit at all levels, the return of real savings — and that in the end the economy will be healthier for it. But the bitter truth is that even these healthy developments will in all likelihood exacerbate our current agony, for they amount to almost irresistible deflationary pressures.

(3) Right now almost everyone, from consumers to the biggest private bank, is hoarding cash. The Treasury and the Fed have together added to the markets a truly extraordinary sum of money. Bloomberg News came up with a figure of nearly $8 trillion, inclusively of everything since the Bear Stearns bailout in March. This was before last week’s announcement of a new lending facility for various securitized consumer debt, along with the huge purchase of Fannie/Freddie debt.

(4) It could hardly be plainer that Paulson, Bernanke and Geithner regard the deflation fears as all too real. They’re hoping to inflate our way out of it. As a friend puts it, the helicopters are in the air, dropping money from the sky. We’re even hearing the phrase, “quantitative easing,” which is a rather curious euphemism for directly expanding the money supply. Whether even the enormous resources of these men, and the institutions they lead, can correct the kind of contraction in demand we’re experiencing is an open question.

(5) On the other hand, if the deflation fears are overwrought, then we’ve got a serious inflation problem on the horizon. That is to say, if the contraction in aggregate demand proves temporary — never matures into a deflationary spiral like the Great Depression — then there are literally trillions of extra US dollars floating around out there; and when they begin to flood world markets whenever economic activity resumes, the strength of the dollar will plunge. This will be true even without the expected expenditure of Obama’s Keynesian fiscal measures.

(6) I said above the crisis will be a long time in unwinding. There I meant financially, but it will be even longer for the social effects to be felt. Indeed, there are still plenty of people who think the whole business is a bunch of hooey. The panic is media-driven or something. This, I’m afraid, is a sadly myopic illusion. We might as well say that Hurricane Katrina was media-driven.

In truth the wealth of an entire generation and more of Americans has been laid to waste, and shall not soon be recovered. The lifestyle of philosophical ennui enjoyed over the last decade and more shall whither. It will be many, many years before standards of living will be restored. An entire generational mentality about equity investment will similarly perish.

To round out this formless sketch I’ll tell a little story or parable. This year’s Wake Forest University basketball team, it turns out, shows real potential for the future, boasting a host of agile big men (five guys over 6'9") with enormous range and talent, along with several subtle, tough guards. They are very young, and need to shoot the ball better to really compete against the powers of the Atlantic Coast Conference, but there is certainly potential in this team.

Ten years ago on this day, when your humble correspondent was a student at Wake Forest, there was also a good basketball team. But more importantly there was an extraordinary boom of wealth generation in the stock market, felt even down to the stunted mind of the rowdy and reckless boy your humble correspondent was back then. The image of this wealth filled the American imagination.

But then the tech bubble bursting gave way to the mortgage bubble, which burst in time to fuel the commodities bubble. Until this very fall, the whole mentality begun in around 1994 (or even earlier if you consider Clinton the consolidator of Reagan), the notion that the stock market (or, later, housing values) would gain infinitely and enrich everyone, was operating in force.

I doubt it will survive this, that mentality. It will be long in coming, but come it will. And one day the historians will say that in the Autumn of 2008 a world died.

Comments (3)

The impression one gets is that derivatives are not only useless but dangerous in a one-way market. But if that is the case what is the point of it in the first place. The quants are noticeably silent on the damage caused by their inept financial engineering. A civil or marine engineer will be held accountable if his model fails catastrophically, the quants though will hide behind higher mathematics and blame the markets. They in their turn were used by their malevolent higher-ups who needed the mathematical opacity to cover their scams. The sheer scale of the corruption and mendacity involved is mind-boggling involving the rating-agencies, programmers and salesmen right up to the CFOs, CEOs and the SEC. Wall Street is like Sodom, not one good man is left. And we haven't seen the end of it since some the sorcerers have decamped to the Obama administration.

A civil or marine engineer will be held accountable if his model fails catastrophically, the quants though will hide behind higher mathematics and blame the markets. They in their turn were used by their malevolent higher-ups who needed the mathematical opacity to cover their scams. The sheer scale of the corruption and mendacity involved is mind-boggling involving the rating-agencies, programmers and salesmen right up to the CFOs, CEOs and the SEC. Wall Street is like Sodom, not one good man is left.

This is one possibility. Another is that everyone (Wall Street, Main Street, politicians, brokers, quants, everyone) was operating under a false assumption, namely that there wasn't going to be a significant and generalized drop in housing prices. One can ask why everyone was making this assumption, but once it is granted that everyone was making it one needn't posit universal malevolence to explain what happened next.

Ok, granted that the government with its Freddie Mac guarantees led to moral hazard. But this is not the first housing bubble in the history of the world. Only a decade ago in 1997 at the time of the Asian Crash, the Americans were full of advice for the poor Asians who had a similarly inflated sense of worth due to their astronomical housing prices. Even so not many Asian trading houses fell in the ensuing rout. Yet the Americans, whose entire brain trust seemed to be working the computers in Wall Street instead of doing something useful like growing corn were caught unawares. Which is of course not completely true, since a little thought would have shown that shorn of the technical verbiage they just had another Ponzi scheme going. Charlie Prince caught it best - as long as the music played one had to dance - the only problem being that they had danced right off the cliff. In describing this as malevolent I was using cheap rhetoric but quite a lot of the Wall Street guys would have known what was going on.

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