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Generational Dynamics Web Log for 27-Apr-08
Brilliant Nobel Prize winners in Economics blame credit bubble on "the news"

Web Log - April, 2008

Brilliant Nobel Prize winners in Economics blame credit bubble on "the news"

Meanwhile, the deflationary spiral is in progress, but hyperinflation is not.

On Friday morning, I listened on CNBC to a discussion with two Nobel Prize winners in Economics give their explanations of what went wrong with financial instruments that led to the credit bubble that's now bursting.

Robert Engle and Joseph Stiglitz, Nobel Prize winners in Economics <font face=Arial size=-2>(Source: CNBC)</font>
Robert Engle and Joseph Stiglitz, Nobel Prize winners in Economics (Source: CNBC)

The two were Robert Engle, 2003 Nobel Prize Winner in Economics, and Joseph Stiglitz, 2001 Nobel Prize Winner in Economics.

According to the program discussion, it was Engle who developed the mathematical models that were used by the financial engineers to develop the CDOs and related instruments that created the credit bubble.

The credit bubble created tens of trillions of dollars of securities (CDOs or collateralized debt obligations), backed by mortgage-based securities, on the assumption that the housing bubble would continue forever. The math behind these CDOs was based on numerous false assumptions, as I explained in "A primer on financial engineering and structured finance." (In addition, the same mindset that created the fraudulent CDOs also invented the hare-brained auction rate securities scheme, which has created in more trillions of dollars in worthless securities.)

And so, the issue under discussion was whether it was Engle's model that's to blame for the credit bubble and the current financial crisis.

This question was addressed to Stiglitz: "Is it a case of financial innovation gone awry? Is it a matter that regulators couldn't keep up with it fast enough? Was the model a force for good, and just misused?" Stiglitz' reply:

"I think part of the problem is that when they studied these models in business schools, they only got part of the message. ... They got some of the message, but not the whole story.

One of the things that's really quite striking is that they believed that they were creating new financial instruments, these new financial instruments were going to change the world, and yet, in estimating the risk, they had to use previous data, data from the world before they changed it.

So there was inherently a logical inconsistency in what they were doing."

This is a point that I've made numerous times, and discussed at length two years ago in "System Dynamics and the Failure of Macroeconomics Theory."

Stiglitz is saying that in this one case, economists tried to apply old financial models to new financial instruments, and the assumptions in the old models failed.

When I discuss this concept, however, I state it differently: In EVERY case, economists' macroeconomics models are always wrong, because they're ALWAYS based on old data, and the models don't take into account generational changes. By modifying the models to incorporate System Dynamics as applied to generational flow, the models would be much more accurate.

Stiglitz went on to discuss the issue of "correlative risk." This is also an issue that I touched on in "A primer on financial engineering and structured finance." The problem, in a nutshell, is that if everyone is using exactly the same model, doing exactly the same things, then one person making a mistake means that EVERYONE is making the same mistakes. In that case, mistakes correlate with one another, rather than occurring randomly:

"One of the problems of that was that they were all using similar models, that was creating systemic correlative risk, and they underestimated the degree of the correlation.

So for example, big events like housing prices going down -- they felt you had to diversify, because you only own -- you had a portfolio of 1000 houses. How could 1000 houses all have problems?

Well, the answer is, if the housing market collapsed, if unemployment increases, if interest rates rise, a very large fraction of all of these are going to have problems.

They simply didn't take into account these kinds of correlative risk, and the extent to which these correlations might actually be increased by the fact that they were all using similar models."

Now what does this guy think -- that we're all idiots - which is what we'd have to be to believe this drivel.

He's saying that these brilliant Gen-X financial engineers all went to business school, all learned these complex mathematical models, then went into the financial industry and applied these models, creating CDOs and other complex financial instruments.

But ohhhhh, they forgot that unemployment might increase!! Duh!!

And ohhhhh, they forgot that interest rates might rise!! Duh!!

And ohhhhh, they forgot that the housing bubble might burst!! Duh!!

Does Nobel Prize winner Stiglitz really believe this? Does he really think the rest of us believe it?

At that point, the following question was posed to Professor Engle: "If everyone is using the same model, does that make it a less effective model? What do you think to that?" Here's his response:

"I think the main driver of volatility and correlation is actually the news. It's not the way we use the instruments - I think that's important, but it's a secondary effect -- and what really happened in this case to make the correlation so high across the regions of the country, as Joe just described, is that it was a macroeconomic event. That is, the economy slowed down."

Ohhh, now I get it. It's "the news" that's the problem. These financial geniuses created these CDOs and other financial instruments.

But ohhhhh, they forgot that the economy might slow down!! Duh!!

This is the kind of airheaded discussion that's become the norm among today's economists, even Nobel Prize winning economics. It's total gibberish, but that's OK by today's standards.

It's easy to see why Stiglitz and Engle are puzzled. It's the unspoken question in all of these discussions: How could massive, pervasive credit fraud have occurred throughout the entire financial and real estate industry? How could EVERYBODY in these industries, from top to bottom, all be so willing to practice such corruption and fraud, screwing investors and the general public for their own gain?

This is the question that they don't even try to answer.

Just as they never try to answer why the dot-com bubble occurred in the late 1990s. Why did the dot-com bubble occur at all, and why did it begin in 1995 rather than some other year, say 1985 or 2005? They don't try to answer that, even though the answer is completely obvious: 1995 was the time when all the survivors of the Great Depression were replaced, in senior management positions, with people who were born after the Great Depression. It's as simple as that, but none of the great geniuses even think of it.

And now, what about the credit bubble? Stiglitz and Engle are trying to figure out how the corruption and fraud could have been so pervasive, and why no regulators stopped it. So they had to grasp at something that affects everything, and they picked interest rates and unemployment. Well then, why didn't the same thing happen the last time interest rates rose and unemployment rose?

It makes no sense at all, but they never consider the obvious solution: There is one thing that's changed for every company of every type to people at every level, and that's generational changes. That's the one and only explanation that even makes sense, and yet it's never even suggested or discussed. Apparently it's too abstract for even Nobel Prize winners to grasp.

Surging defaults in CDOs

Also on Friday, CNBC economist Steve Lieseman presented some data about the surging default rate for CDOs. In addition to be very significant by itself, this data refutes the claims of Stiglitz and Engle.

If you've been following the financial news or this web site for the last year, then you know that many financial institutions -- Merrill Lynch, Citibank, Bear Stearns, etc. -- have been "writing down" assets in their portfolio. This means that these securities were on the books at an inflated estimated nominal value computed by a computer model. It had to be done this way because there was no market in which to buy and sell these assets. As the housing bubble began to burst, financial institutions -- completely against their will -- were forced to re-value or "write down" these securities more realistically.

The original inflated values were set by computer models that assumed that the CDOs were AAA rated, meaning that the probability of default is much higher than assumed. As the probability of default rose, the CDOs become worth less.

However, the writedowns were made without the CDOs actually defaulting. The re-valuing was done based on new assumptions that the CDOs had a much greater chance of defaulting than previously assumed.

Well now the CDOs are starting to default -- in high volume.

According to the data presented by Lieseman:

Lieseman somehow concluded that this was "good news" (everything is always "good news" on CNBC), but in fact these figures not only show that Stiglitz and Engle are wrong, they also show that the most cynical explanation is the correct one.

The innocence explanation that banks are giving for creating worthless CDOs and selling them to people is that they didn't understand that they were going to be worthless. Stiglitz and Engle supported this innocence explanation by saying that these poor financial engineers couldn't possibly have foreseen such things as the bursting of the housing bubble or a rise in interest rates.

But by 2007, it was perfectly clear that the housing bubble had burst, and that interest rates were rising. So by Stiglitz' and Engle's reasoning, the financial engineers should immediately have realized that their models were wrong, and the banks should have immediately stopped creating and selling CDOs.

But that's not what happened. What happened, as I've said before and has been confirmed by these new figures, is that the banks continued to create these faulty CDOs and sell them to investors.

In other words, putting Stiglitz' and Engle's reasoning together with Lieseman's figures, the only possible explanation is massive fraud by the banks.

And that doesn't surprise me at all, and shouldn't surprise any regular reader of this web site.

Recently, in the article "FBI joins SEC into wide-ranging investigation into mortgage-lending industry." we provided a lengthy list of all the actors in the housing and credit bubbles, and the kinds of fraud they perpetrated at all levels. It ran from homeowners who lied on their applications to brokers who lied about home values to lenders who adopted "predatory" lending practices to investment banks that created fraudulent CDOs and other mortgage-backed securities to ratings agencies that gave them AAA ratings in return for fat fees to "monoline" bond insurers that insured them for fat fees. The list is almost endless.

What Lieseman's figures show is that all these forms of fraud actually INCREASED as time went on. I've said this before, but Lieseman's figures prove it.

Economists like Stiglitz and Engle look at this massive, pervasive fraud, and have NO IDEA what's going on. How could so many people been involved? They have no explanation, and they grasp at straws.

I've given a complete explanation of the credit bubble in generational terms, showing how the Boomers first caused the dot-com bubble, and then how the Boomer/Gen-X interaction caused the credit bubble and the massive fraud. That's the only explanation that actually makes sense, unlike the ones given by Stiglitz and Engle.

And what I've also said before is that the stench is sickening. We're talking about huge numbers of people who defrauded poor people, investors and the general public for their own personal gain. We're talking about a financial industry culture, led by Boomers who were willing to overlook fraud for personal gain, and perpetrated by nihilistic, destructive, and self-destructive Generation-Xers who were willing to perpetrate any fraud, screw any person or group of people, for their own personal gain.

It's no wonder that Stiglitz and Engle and other mainstream economists are spouting nonsense to explain what happened. Even if they know what happened, they can't admit it because they'd be admitting their own complicity.

Credibility and earnings

The current financial crisis has gone through several stages. First it was the finance and real estate industries defrauding investors and the public, with analysts and journalists saying that we're in a new modern world where prosperity would last forever.

Then, when the credit crisis began in August, there was a swing to risk aversion, as asset writedowns showed that financial institutions had been consistently lying to investors and the public.

Since then, we've had commercial banks, investment banks, ratings agencies, "monoline" insurers, analysts, journalists and government officials and regulators lying about what was coming.

The cycle has repeated over and over: Someone would say that everything was all right, and then the next day some earnings figures or other data would prove they'd been lying. Then they'd say that everything was all right, and the data would get even worse. And the cycle would repeat.

What's happened in the last couple of months is really ugly: The lying gets worse each time the news gets worse. Even worse than that is that investors are adopting the attitude that the news is so bad that it can't get any worse, and so it has to get better.

These people should have no credibility left at all, after everything they've said has turned out to be wrong, time after time. And yet, they seem to believe and support one another until the data proves them wrong. It's a variation of "honor among thieves."

An obvious example is the table of corporate earnings estimates that I've been posting, based on figures from CNBC Earnings Central supplied by Thomson Reuters. Here's the latest version:

  Date    1Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct 23:             +10.0%
  Jan  1:              +5.7%
  Feb  6:              +2.6%
  Feb 29:              -1.1%
  Mar  7:              -4.3%
  Mar 14:              -7.8%
  Mar 21:              -7.9%
  Mar 28:              -9.3%
  Apr  4:             -12.2%
  Apr 11:             -14.1%
  Apr 18:             -14.6%
  Apr 25:             -14.1%

On January 1, the beginning of the first quarter, analysts estimate earnings growth of 5.7%. Those estimates have fallen almost every week since then, apparently leveling off around -14-15%. Don't be surprised if this estimate falls even further.

How can anyone possibly believe anything that analysts at Thomson Reuters, or ANY analysts, say at this point? And yet, investors appear to be mesmerized by estimates that earnings will grow 25-50% in the third and fourth quarters. How dumb do they have to be to believe that?

The situation that we have today is that the same financial managers, financial engineers, analysts, regulators and journalists who created and supported the housing and credit bubbles, through either their own stupidity or their own dishonesty or their own corruption or their own criminality are now continuing with exactly the same stupidity, dishonesty, corruption and criminality, because to do otherwise would be to admit to their own part in the growing financial crisis.

Amid all this stench of corruption, these people should have no credibility left whatsoever. Instead, they cling to credibility by supporting one another's corruption, watching as the news gets worse and worse, hoping for the day when they'll find someone besides themselves to take all the blame.

Credibility and asset writedowns

Are asset writedowns almost at an end? The banks, analysts and journalists are saying that they are, but they haven't gotten this right since the beginning, so we have to assume that they're being stupid, dishonest or corrupt, as they have been all along.

In fact, some figures published this week indicate that there's still a long way to go.

Let's begin with a table of all the asset writedowns so far (as of April 1) -- and keep in mind that in each case, the institution had said just a few days earlier that everything was perfectly fine:

    Firm                    Writedown     Credit Loss      Total
    ----------------------- ---------     -----------      -----
    UBS                       38                            38
    Merrill Lynch             25.1                          25.1
    Citigroup                 21.4            2.5           23.9
    HSBC                       3              9.4           12.4
    Morgan Stanley            11.7                          11.7
    IKB Deutsche               9                             9
    Bank of America            7.3            0.9            8.2
    Deutsche Bank              7.4                           7.4
    Credit Agricole            6.5                           6.5
    Credit Suisse              6.3                           6.3
    Washington Mutual          0.3            5.5            5.8
    JPMorgan Chase             2.9            2.1            5
    Wachovia                   2.9            2              4.9
    Canadian Imperial (CIBC)   4                             4
    Societe Generale           3.8                           3.8
    Mizuho Financial Group     3.4                           3.4
    Lehman Brothers            3.3                           3.3
    Barclays                   3.2                           3.2
    Royal Bank of Scotland     3.1                           3.1
    Goldman Sachs              3                             3
    Dresdner                   2.7                           2.7
    Bear Stearns               2.6                           2.6
    ABN Amro                   2.4                           2.4
    Fortis                     2.3                           2.3
    Natixis                    1.9                           1.9
    HSH Nordbank               1.7                           1.7
    Wells Fargo                0.3            1.4            1.7
    BNP Paribas                1.3            0.3            1.6
    DZ Bank                    1.5                           1.5
    National City              0.4            1              1.4
    Bank of China              1.3                           1.3
    Bayerische Landesbank      1.3                           1.3
    Caisse d'Epargne           1.3                           1.3
    LB Baden-Wuerttemberg      1.3                           1.3
    Nomura Holdings            1                             1
    Sumitomo Mitsui            1                             1
    Gulf International         1                             1
    European banks not         8.4                           8.4
    listed above
    Asian banks not            4              0.7            4.7
    listed above
    Canadian banks             2.4            0.1            2.5
    excluding CIBC
    ----------------------- ---------     -----------      -----
    TOTALS                    206            25.8          231.8

And so, that's a total of $232 billion in asset writedowns, as of April 1.

What should we make of this list? Is this the end of the writedowns? Are institutions finally being honest, and confessing to everything, as investors seem to believe?

Actually, there's every reason to believe the opposite:

And so there's no motivation whatsoever to hurry up and write down assets, and there are HUGE motivations NOT to do so unless absolutely forced to. So there's ABSOLUTELY NO REASON to believe that the asset writedowns are anywhere close to completion.

Also, notice the following peculiarity: Recall from the figures above the Steve Lieseman provided that $179 billion in CDOs have ALREADY DEFAULTED. As Lieseman discussed when he presented these figures on CNBC, there's absolutely no way to correlate the defaulted CDOs with the writedowns in the list above. The banks are simply keeping all that information top secret. If $179 billion have already defaulted, you can be sure that there will be a lot more than $232 billion in writedowns to come.

One question that we might ask ourselves is this: How much are the assets in institution portfolios that MIGHT have to be written down in the future? It turns out that we know at least some of the answer to that question, thanks to new data that was posted last week.

But first we have to review some definitions. Last October, I described a new accounting rule, FASB Statement 157. This rule describes three categories of assets that an institution might have in its portfolios, and three different methods for determining their market values. Here are the three categories:

Most CDOs and asset-backed securities are in the Level-2 category, and some are Level-3.

What's been happening since August is that as Level-2 assets either default or get written down, a chain reaction is created. These writedowns and defaults become "observable market data," and so by the "mark-to-matrix" rules, similar securities held by the same institution or other institutions must be written to comparable prices.

The new FASB Statement 157 accounting rules became effective on November 15, and now, five months later, the size of the assets in these categories has become public for some major institutions.

Bennet Sedacca on the Minyanville web site posted the following table of Level-2 and Level-3 assets for the eight largest holders in the U.S.:

    Institution                   Level 2         Level 3
    and ticker                    Assets          Assets
    -------------------------   --------------   ------------
    1) JP Morgan (JPM)          1,093,059,020     71,290,000
    2) Citibank (C)               933,639,030    133,435,000
    3) Bank of America (BAC)      781,805,030     31,470,000
    4) Merrill Lynch (MER)        768,073,010     41,449,000
    5) Goldman Sachs (GS)         620,985,970     96,386,000
    6) Bear Stearns (BSC)         332,979,010     37,350,000
    7) Morgan Stanley (MS)        304,052,010     78,168,000
    8) Lehman Brothers (LEH)      199,830,990     42,508,000
    -------------------------   --------------   ------------
    Totals                      5,034,424,070    460,766,000

Putting all this together, here's what we know:

You can make your own judgment, but my judgment is that hundreds of billions of dollars or trillions of dollars of additional writedowns are being hidden by financial institutions, either inadvertently, or purposely, in order to mislead investors and the public.

And judging from the reactions of investors and the financial press, who are saying that the worst is over, the financial institutions' mendacity is being rewarded.

Credit default swaps (CDSs) and counterparty risk

Little is known by anybody about the real structure of all of the the $700 trillion worth of credit derivatives in financial portfolios of institutions around the world, since they're totally unregulated.

One segment of those credit derivatives, the credit default swaps (CDSs) segment, totalling $45 trillion, is becoming better understood.

In particular, it's becoming clearer that the marketplace is creating long "chains" of CDSs that pose serious systemic risk to the global economy.

In general terms, here's how these chains are created:

Now you may think that the above example is fanciful, but as I understand what's going on, it is not fanciful. In fact, it's become standard practice among investment banks and hedge funds to offload risk in exactly this way. Hedge funds in particular have created tens of trillions of dollars of CDSs in order to offload risk with one another. The "monoline" bond insurers have acted as counterparties to many of these CDSs, in return for fat fees.

Now you can see the meaning of the phrase "counterparty risk." I've signed a CDS with you, and if my CDOs default, I'll expect you to pay me $1 million.

You think you're OK, even if you don't have $1 million to spare, because you've signed a CDS with another counterparty, B, who'll have to pay you the $1 million that you have to pay me. The counterparty chain goes through C, D, E, and so forth and, like any chain, it's only as strong as its weakest link.

With tens of trillions of dollars CDSs intertwined through investment funds and hedge funds, there is a great deal of fear that any large bankruptcy will cause a chain reaction that will cause multiple bankruptcies.

It was exactly this kind of CDS counterparty chain reaction risk that Fed Chairman Ben Bernanke was talking about when he testified before Congress to explain why the Fed saved Bear Steans from bankruptcy in March. Bear Stearns was going to go bankrupt within 24 hours, which would have caused a systemic calamity to the global economy.

At the end of the most interesting part of the testimony, Senator Bunning asked, "What's going to happen if a Merrill or a Lehman or someone like that is next?" He never got an answer to that question, but there's no doubt that the correct answer is a financial calamity.

Inflation or deflation?

I'm getting one or two questions each week from web site readers either asking about or disagreeing with my discussion of deflation and the deflationary spiral we're headed for.

Here's a recent message from a web site reader:

"I do read a lot of other blogs and sites regarding economic news. One that I just read was discussing the 'deflation or inflation' question. It basically forcasts inflation.

Now... I think that you are of the opinion that a deflationary cycle is coming. The article above suggests that inflation will happen becasue currencies are no longer tied to gold and so governments can just print more and more money.

There certainly seems to be two camps of thought on this issue, both camps having there fair share of people without vested or biased interests. I'm confused as to how these two camps could have such different views."

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So I'll summarize the discussion again here, and leave anyone wanting more to read the "related articles" in the sidebar. Also, although mainstream economists talk about nothing but inflation, I would point out that I've been right a lot more often than mainstream economists in the last six years.

First, let's discuss the "gold standard" which, until 1971, pegged the value of gold at $35 per ounce. The argument being made by some (but not by Bernanke and other policy makers) is that the government could not "print money" in the 1930s because the dollar was pegged to gold, but could "print money" as much as it wanted today, making the dollar worthless, and pushing the economy into hyperinflation. Supporters of this view also use the term "fiat currency" to describe the dollar today, not pegged to gold, as opposed to the dollar before 1971.

This argument about the gold standard is completely irrelevant to the discussion in just about every possible way:

With regard to gold, I'm going to repeat a warning that I've posted several times before: The price of gold has been in the $300-500 per ounce range since the 1970s, except for the bubble in the early 1980s and the bubble going on today. The price of gold will almost certainly fall to the $300-500 range again, once the bubble bursts, even if it spikes briefly upward again. Gold is way overpriced today, and represents a very poor investment for most people.

As for the potential of hyperinflation, just consider the figures that have been given in this article: Hundreds of trillions of dollars in credit derivatives in institutional portfolios around the world; tens of trillions in credit default swaps (CDSs); over $5 trillion in CDOs and other "Level-2/3" assets. Add in at least $5 trillion as the size of the housing bubble, and additional trillions of dollars for bubbles in consumer debt.

All of that money is disappearing, as the credit bubble implodes. Are CDSs "real" money? Yes they are, in a very real sense. It's true that you can't go into the grocery story and purchase a quart of milk with a CDS, but you CAN (or at least COULD until last August) use those CDSs to purchase stock shares or other marketable securities.

When the Fed saved Bear Stearns from bankruptcy, it was not by "printing money." In fact, all the various actions taken by the Fed in recent weeks have been to permit commercial and investment banks to exchange their worthless CDOs for Treasury bills.

When a bank thus gets rid of its CDOs, it no longer has to write them down according to mark-to-market rules. Those worthless CDOs are then in the Fed's portfolio, where they will sit until either the bank has to take them back, or until the Fed can find another way to get rid of them.

So the real danger is not hyperinflation. The real danger is that the Fed itself will go bankrupt, when it becomes evident that those CDOs really are near-worthless.

And that's certain to happen, according to an analysis by Oppenheimer analyst Meredith Whitney. Here's what she said, describing the actions of commercial banks:

"[T]hese banks have got themselves into trouble, are going to get themselves into trouble prospectively, because they refuse to sell these assets, because they think the market is bid too low.

Well the problem is that each month that they wait, the asset values go lower, and then when the ratings agencies downgrade these assets, they're required to carry even more capital against those assets. ...

There are a couple of things that go on. So you have people that refuse to sell assets.... So if banks don't want to sell these assets, the longer they wait to sell these assets, the values decline.

But then when, all of a sudden, banks decide TO sell all these assets, there'll be a supply jam on the market driving prices down even lower, so there'll be more write downs. And ultimately, I think these financials will sell assets at well below today's market prices."

Whitney said that a month ago, and we can see that her predictions about falling asset prices have been coming true. This is indicated by the surging defaults in CDOs that we discussed earlier.

But now many of those near-worthless assets are in the Fed's portfolio, rather than in the banks' portfolios. So the real danger is not some kind of hyperinflation. The real danger is the total collapse and bankruptcy of the Federal Reserve, as the value of its assets become worthless. This will create a massive chain reaction, resulting in the collapse of tens of trillions of dollars worth of CDOs, CDSs, auction rate securities, and other near-worthless securities, the detritus of the burst credit bubble.

As I've been saying for years, the credit bubble has to burst. It's already leaking, and it's leaking faster and faster. At some point, the chain reaction just described will begin. This won't cause hyperinflation, because the Fed has only a tiny amount of money available to it, compared to the massive money losses that will occur. Those massive losses will create the deflationary spiral that I've described.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (27-Apr-08) Permanent Link
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