Oh almighty Schumpeter, what ye say is wrong with our markets?

by Christopher Bounds

To find an answer to the roller coaster ride the major indices gave us this week, we will look to the writings of Joseph Schumpeter (pictured) and the other Austrian School economist.

First, this week a long awaited announcement was made by the S&P Credit Rating analysts that over $1 TRILLION of AAA-rated outstanding debt may not be AAA-rated. This mishap will spell problems for all of us. Friday's news release of new home sales being down "substantially" is nothing new to anyone. Yet little is understood regarding the implication of this fact, at least as reported in the media.

What I call "The Greenspan Push", names the most profound series of events this century will endure. While Chairman of the Federal Reserve, Mr. Greenspan set the financial markets on a new course of action. Historically when banks make loans they have to protect themselves against the risk of loss those loans bring. This was done by holding sufficient reserves of gold, then when the gold standard was dropped in the early 1970's, it was accomplished by holding sufficient reserves of cash and "risk free" U.S. Treasury bonds. Then came Mr. Greenspan's Push. Under his regime, the banking industry changed in the way that they account for that risk of loss. By "Pushing" the risk out of the banking industry and into the Investment market, the banks were be able to substantial lower their liabilities...as they issued the loan and sold (or bought against) the risk of loss. By creating derivative instruments, what you may have heard in the news as "Mortgage-Backed Securities (MBS)", "Collateralized-Debt Obligations (CDOs)", "Default Swaps", "Credit Swaps", etc, all of which are essentially insurance policies against loan losses. The same as when you buy a car and purchase auto insurance coverage to "Push" the risk of loss away from you and to the insurance company. And in freeing up the reserve ratio required by banks to hold...a percentage of assets to liabilities...the banks are able to write more loans, because they "Eliminated" the prior liability while holding the asset.

No way, how is that possible? Why would the investment industry cooperate? Well as you know it is not legal to use borrowed money to invest in the stock market. Because the markets are to risky for the use of bank funds, you must use margin to accomplish leverage and that level is limited to $0.50 on the $1, allotted to certain types of securities. When added to all of your marginable assets, your leverage ratio is 1.5 to 1. Meaning you can buy $150 of something per $100 of marginable assets. When banks create derivatives they are rarely "pure" instruments, meaning that if a bank writes a $10 million loan to GE, which would typically be syndicated meaning that the bank would put up $4 million, another bank $4 million, $1 million from another bank, and $500,000 from two others. The GE loan would rarely be sold in full, the bank would "strip" the GE loan into 1000 equal parts ($10,000 each) and add each part with other "stripped" loans made to other clients. Typically the basket of loan strips would contain a high level of high grade debt...such as U.S. Treasury bonds...by combining T-Bonds with loans to customers with good credit and to those with bad credit the rating on the basket would be relatively high. When a basket of this type, a MBS or CDO, is marketed to the investment industry, typically to hedge funds and Mortgage Real Estate Investment Trusts, the leverage ratio is sky high so long as the basket credit rating is high. It is standard to borrow 15 to 1 when buying AAA-rate derivatives, meaning a fund can borrow $15,000,000 per $1,000,000 of assets. And because the basket holds a large number of U.S. Treasury bonds, the risk of default is artificially low, as the ratings are dependent on the "odds" of default and not the odds of partial default. An average spread on a loan might be 3%, the difference between the Fed Funds Rate (5.25%), which banks borrow from the Federal Reserve, and the Prime Rate (8.25%) at which banks lend to their best customers. When you strip down, combine, and sell the risk of losing that 3% spread to a fund borrowing 15 to 1 to buy it, they (the funds) earn 15 times 3% = 45% on their money.

Where does the 15 to 1 money come from? The banks. By originally writing risky loans to sub prime borrowers, then stripping and combining them with enough low risk debt that the total earns a AAA-rating, the bank sells the original loans to the investment funds by writing them (the funds) new loans secured by the basket of loans. Since the basket is of a good credit rating, the banks can write bigger loans for these instruments as they are rated higher even though, collectively, they are the same (baskets containing) good and bad loans. Plus, since banks make much higher fee's underwriting loans than just collecting the interest on them, they have a great incentive to quickly get ride of low risk loans and sit on the high risk, high interest rate ones, while selling enough stripped loans to lower their risk, and getting back the higher rated basket as collateral to keep the process going. All of this possible because of the never ending printing press of money at the Federal Reserve. It also brings up political questions as to whether the government should continue manipulating the economy, by printing money at will and adjusting interest rates artificially. As the loan market starts to overheat, the bad loans begin to default, and all of those baskets start "leaking" value, as their streams of income drop due to the defaults, their ratings will drop. And when a system so dependent on the process of fluidity...lots cash transferring hands rapidly...the banks will realize that they have far too many risky loans, either as assets or as collateral, even to the point of their obligations to depositors outnumbering their dependable assets. At this time a shiver will be sent through the world in the sense of the nineteenth century bank run. As people realize that their money in banks, and their retirement (because pension funds are the largest investors in hedge funds) have been recklessly managed, they will demand withdraw. At that point people will learn of the fact that, by definition, the bankrupt banking industry's use of fractional reserves...only holding a small percent of assets to liabilities...will be unable to pay the people's due money, unless the Federal Reserve prints that much more, diluting to value of all the cash already present...and raising our costs as most commodity markets are priced in US dollars...giving great discounts to foreigners.

This should serve as a wake up call to our political and economic leaders. Because, of the fact that the Greenspan Push was likely not intended to be deceitful, it was more likely a symptom of "elitism". The old argument of does higher income bring prosperity or does prosperity bring higher income, is in full effect. As Schumpeter wisely stated that Capitalism will serve as the source of its own demise, entrepreneurship is the only element to prevent the destruction of capitalism and the onset of socialism. This is proved by virtually all of the gains and new money printed by the push, being retained by the wealthiest or most productive individuals. The "creative destruction" of the economy, as required by Schumpeter, evidenced by new industry creating new services and employing new groups of people...destroying old industrial lines and employment sectors...has not been effectively present. Blockades in the economy in terms of minimum quotas (labor unions, government spending, minimum wages, etc) and preferential treatment (government spending, taxes, licensing, government printing money, etc) adds difficulty to entrepreneurship.

What elitist would believe, that a retailer could earn more money by focusing on the poorest of consumers? Well look at Wal-Mart. That is the focus politicians should have, eliminating political blockades. Because once again the belief of money creating its own demand fails, only the use of money will determine the demand. As the economy moves away from productive use...giving too much to those who waste it or wont pay it back...it will not create a sustainable appreciating demand. Resulting in the process needing to correct. No matter if its in the form of loans to sub prime borrows, taxes paid to wasteful elitists, or whatever...I say that the people earning the money should have the decision to waste it or not, rather than the banks and politicians doing it for us. Leave the economy with as little centralization as possible, so parts of it can respond to the parts with ailments, while earning reasonable profits...Adam Smith's "Invisible Hand". Otherwise, socialist Hillary Clinton-type economic centralization will continue to build momentum in effort of solving the problems associated with socialist economic centralization.