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Generational Dynamics Web Log for 6-Apr-07
The financial mania continues with "CDOs Squared"

Web Log - April, 2007

The financial mania continues with "CDOs Squared"

And suddenly, Moody's is worrying that derivatives may be riskier than they had thought.

I thank an entry in the SuddenDebt blog for calling my attention to a new investment craze: CDOs Squared!

CDOs (collateralized debt obligations) are credit derivatives that are a kind of loan insurance. If you loan someone some money, or purchase a corporation's bonds, which is similar, then there's a chance the loan won't be repaid. CDOs provide the mechanism whereby you can pay a third party an upfront amount plus an annual fee. The holder of the CDO just has to sit back and collect money unless, of course, the company you loaned money to defaults on the loan, and then the third party has to make good on the loan.

Banks will take thousands of mortgage loans or credit card loans and package them up together and split them up into pieces based on levels of risk. CDOs then can then be bought and sold the same as a stock certificate. Stock certificates are based on a company's assets, and the CDOs are based on the underlying collection of loans.

Well, thanks to the subprime mortgage loan debacle, a lot of people who had just expected to sit back and collect fees are suddenly discovering that they're responsible to make good on a lot of other people's mortgage loans. This is leading the holders to take desperation measure.

This brings us to the magic of "CDO squared" or "CDO^2" -- CDOs based on other CDOs. Now, if I have this straight, it works this way: Financial managers holding a lot of these CDOs suddenly have a lot of money to pay, so it's as if they have to repay a loan. So you can put together large bunches of CDOs, just as earlier you could put together large bunches of mortgage or credit card loans. Then you can break up the large bunches of CDOs into pieces, based on levels of risk, and CDO^2s become another money-making scheme.

When you get down to the heart of it, what all this does is recycle pieces of paper, CDOs in this case, so that they can be sold and resold, each time at a higher price.

It's getting to the point where even Moody's Investors Service is getting worried. They're discovering that CDOs are riskier than people ever realized because of "overlapping subprime exposure." Duh!

Last December, I explained how this works with hedge funds, how it's possible for a good salesman to start up a new hedge fund, based on underlying assets of any kind whatsoever, and then bid up the price of the hedge fund shares so that they're worth many times more than the value of the underlying assets. In essence, the hedge fund manager is "making money" -- literally, as if he had a printing press. The hedge fund shares can now be traded at their inflated values, so in some circles they're as good as money.

It all resulted in this table, as of last year:

    Item                          Value ($ trillion)
    ----------------------------- ------------------
    All public firms-"real value"   30
    All stock market shares         65
    All hedge fund shares          370 (June, up from 300 in Jan)

[[Correction: "All hedge fund shares" should have read "all credit derivative securities."]] (Correction made on 13-Nov)

My guess is that the $370 trillion figure reached at $500 trillion by January of this year, but I haven't seen those figures.

And when you have hedge fund shares that are worth 10-15 times as much as the underlying assets, then you can bet that there must an awful lot of "overlapping" going on. Moody's might have figured that out long ago.

The point I'm making with all of this is the hyper-manic nature of investing, just before a major financial crisis.

Last week, I described in great detail how this mania worked in the case of the Tulipomania bubble:

"By the later stages of the mania [at the end of 1636] the fusion of the windhandel with paper credit created a perfect symmetry of insubstantiality: most transactions were for tulip bulbs that could never be delivered because they didn't exist and were paid for with credit notes that could never be honoured because the money wasn't there."

A web site reader has referred me to a book that describes what happened in the Panic of 1857. This information is from a 1950 book by Allan Nevins, The Emergence of Lincoln: Prologue to Civil War 1859-1861, Volume II.

The book has a lengthy chapter on the panic of 1857, and we're going to quote excerpts.

The New York Stock Exchange had been in existence for more than 60 years at that time, and had always been a staid, sedate institution, until the 1850s.

"No feature of the boom had excited more comment than the novel vogue of speculation in securities. Stock-gambling, scolded the National Intelligencer, has grown to "an incredible extent" in the chief cities. ... While numerous journals printed sharp exposures of nefarious operations of brokers, the New York Observer defended them. The public, it argued, had an incorrect estimate of the New York Stock Exchange. "It is not a gambling-house; and although many desperately risk their all on the rise and fall of the market, yet a large part of the business is as legitimate as any other commercial transactions. ... Transactions in bank and insurance stocks were usually sedate, but railroad shares often produced a wild hubbub." (p. 180-1)

It's worthwhile remembering that railroads were the high-tech innovation of the day, just as the Model T Ford was the high tech innovation of the 1920s bubble, and the internet is the high-tec innovation of today. (Incidentally, the tulip was a very high-tech item in the early 1600s, as botanists were able to produce tulips with spectacular colors by means of breeding experiments.)

"To John Bigelow, the sale of more than $22,000,000 worth of stock in one fortnight of 1857 seemed ample basis for an Evening Post editorial denouncing "A Growing Evil" -- overspeculation. The mania for playing the market had attacked every body, he wrote; lawyers, merchants, doctors, and even clergy were abandoning a safe seven percent to gamble for twenty. If the speculation was deplorable, the secret manipulation of stocks by insiders was far more reprehensible. (p. 181)

This raises a point that I've made several times before, and is worth repeating: There is a lot of crime going on today, committed by desperate people who are in over their heads in investments or subprime mortgages. Crimes like embezzlement are ticking time bombs. No one worries about embezzlement when everyone's making money, but when times get tough, every past transaction is gone over with a fine tooth comb. It happens in every generational panic. It's happening already, as even bankers are now being subjected to criminal investigations because of "predatory lending" on mortage loans.

What we're now going to see is how bubbles feed into each other. A bubble in one are creates money that can be used to drive up prices in another area.

"Commodity speculation was equally reckless. The press in 1856 and 1856 was studded with items on fortunes quickly conquered by bold Napoleons of the market. Chicago wheat brokers who bought at $1.40 and sold at $1.85, pork dealers who secured prime mess at $16 a barrel and parted with it at $20 -- these men were objects of admiration so long as prices rose. ... By midsummer of 1857, declared the New York Herald, commodity prices had increased forty percent in four years. ... [T]he Herald laid this disastrous rise to speculation. It made a particular point of cotton. Despite an estimated American crop in 1856-57 of about three million bails, with a large carry-over in European warehouses, raw cotton had gone so high that textile interests were being crushed between excessive costs and an overladen market. Within a year, declared the Herald, speculators had forced it up nearly forty percent. (p. 182)

Now we'll see how different bubbles tied in to one another. And for those of you who are interested in the causes of the Civil War, including slavery, the bubble economy even had it's effect on that:

"Speculative ventures in lands, railroad building, and slaves kept and were closely interrelated; the rise in grain, meats, and cotton, and the westward movement of the population, maintaining all three. The "negro fever" was now rife in the South. Cotton planters found that the cost of hands soared out of all proportion even to rising prices for their staple. Prices in the Lower South were rising to $1,800 and even $2,000 for prime field workers. The two possible remedies were a reopening of the African slave trade, and a utilization of cheap lands. Since the former could not be attained except after prolonged agitation, if at all, planters bought lands in Arkansas, Texas, and unsettled parts of the older States with avidity. If they could only get the labor, they might pay for their holdings with one or two crops. Similarly in the Northwest, where McCormick's reaper and other machinery made labor a minor problem, high prices for foodstuffs and meat turned prosperous famrers and immigrants into land buyers, while speculators crowded in early upon their heels. The Graduation Act of 1854, reducing the price of public land in proportion to the lengh of time it had been fruitlessly offered for sale, played into the hands of would-be monopolists; for it placed no limit on the amount of land one purchaser might take. Some bought large areas." (p. 183)

This is all very similar to the last few years. We've had a high-tech bubble, a real estate bubble, a commodities bubble, a stock market bubble, and even the price of food has gone up substantially.

It's a purely generational attitude that comes about at the height of the bubble mania, just before a crash, as I discussed in my article based on research by Harvard economist Robert J. Barro. Tying all the bubbles together is a credit bubble, which allows ordinary people to go more and more deeply into debt in order to get money to put into commodities or real estate or the stock market. It's a giant worldwide pyramid scheme (or Ponzi scheme), and every pyramid scheme must come to an end.

The mania continued to get worse and worse. As you read the following paragraph, keep in mind that hedge funds today are almost completely unregulated. Therefore, they play the same role today that unincorporated banks played in the 1850s:

"Most incorporated banks were prohibited by law from engaging in any business other than banking. Unincorporated banks, however, were free to employ part of their capital in outside operations, and frequently did so. They sometimes made prodigious temporary gains at the sacrifice of safety. Banks of large capital were likely to have a more prudent management than lesser institutions, for they could employ more skillful and experienced officers, and command better means of credit investigation. Yet even large, incorporated banks were sometimes grossly misconducted. Much indignation was aroused in New York when in 1855 the cashier of the Mechanics' Bank, who had been forced to resign after a quarrel with the president, published a pamphlet containing amazing disclosures. It showed that the bank had contributed to political parties out of a secret drawer, that it had paid "assessments" by the City Chamberlain without keeping any account of them or making any report to the directors, and that it had permitted other shocking laxities in expenditure and bookkeeping." (p. 185)

Once again, you can see that criminal activities became exposed.

Now, as you read the following paragraph, remember what I said above about how hedge fund managers "make money" literally -- as if they had a printing press. The same thing happened in the 1850s:

"Viewing the banking system of the country as a whole, men could see that it contained too many new and immature units; in the ten years preceding 1857, no fewer than six hundred and seventy-eight new banks had been set up. They could see that ready assets wee much too small in proportion to liabilities; in 1856, deposits and circulation came to $407,000,000, while specie was only $53,000,000. They could see that bank management was sometimes dishonest, often incompetent, and still more often reckless. The ablest bankers of New York, Boston, and Philadelphia, eager to increase their deposits, fell in with an unfortunate trend. Not content with being mere passive recipients of funds from country banks, they actively solicited deposits, even sending out circulars. On the floating capital thus obtained, they paid as much as four percent for sums up to $5,000 and as much as five percent for sums beyond that amount. These funds they then lent to brokers and others, often on dubious security, at profits of one to three percent a year. The brokers then used the money inventures of a more or less speculative hue. As the nation's load of debt from railway construction, the expansion of mills, factories, and stores, town promotion, and speculation in commodities rose, the sums owed to banks, brokerage houses, and private lenders became more and more disproportionate to the supporting assets." (p. 187-88)

It never ceases to amaze me how blind people, even supposedly intelligent people, are to what's going on. People would rather think of almost anything else besides what's really going on.

This "global warming" frenzy is an example of how incredibly crazy all this is. Everyone's getting all upset because the temperature of the earth may go up by 1-2 degrees by the end of the century, and some species of animals will go extinct.

Well, how many species of animal will go extinct when we have a world war? Why don't people worry about a financial crisis leading to a world war?

And it's easy to prove that there's going to be a world war. Just extrapolate the population growth forward, and extrapolate the amount of food we'll have, and it's easy to see that there won't be enough food to feed everyone.

Why wasn't that in Al Gore's movie? Isn't that an environmental disaster too? I guess some "inconvenient truths" are more inconvenient than others, and some truths are just too darned inconvenient even for Al Gore. Better to worry about the earth's temperature in 2080 than in what might happen in the next year.

From the point of view of Generational Dynamics, a generational stock market crash is overdue. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: Tulipomania bubble (1637), South Sea Bubble (1721), French Monarchy bankruptcy (1789), Hamburg Crisis of 1857, and 1929 Wall Street crash. We're now overdue for the next one.

It could happen next week, next month or next year. But when it happens, massive numbers of people will become unemployed, bankrupt and homeless. Many ordinary people will go to jail because of crimes they committed out of desperation.

As I've said before, it's possible that some people reading this have committed crimes, such as embezzlement, thinking that no one would check and they wouldn't be caught. It's true that no one checks as long as everyone's making money, but when things go wrong, everything is checked and double-checked, and criminals are caught.

If you've committed a crime out of desperation, then you should try to find a solution immediately; even if you're going to be bankrupt and homeless, you don't want to be a criminal as well. Don't tell a friend or family member of your crime, because you'll make that person an accessory after the fact. Go talk to a lawyer immediately, and examine the choices available to you.

As the crisis approaches, remember what I always say: No one can prevent the crisis, but you can prepare for it. Treasure the time you have left, and use it to prepare yourself, your family, your community and your nation. (6-Apr-07) Permanent Link
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Generational Dynamics Web Log for 6-Apr-07 The financial mania continues with "CDOs Squared"

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Generational Dynamics Web Log for 6-Apr-07
The financial mania continues with "CDOs Squared"