Saturday, June 13, 2009

"Therefore It Will Happen"

From a Charles Hugh Smith correspondent:

Oddly enough, given the fatal metaphysical error I have mentioned (debt = asset), almost all the concoctions stemming from that error have been "rationally consistent" with the irrational premise. Too bad logical consistency with false premises will virtually guarantee disastrous conclusions. Let us spell out in detail this "rational" behavior stemming from irrational assumptions.

First let us recast traditional debt in tune with the new, false assumptions mentioned above. In traditional economics, "good" debt would be a loan extended to someone with sterling credit, with a healthy income or revenue stream, and collateral that far exceeds the value of the loan. Collection is fairly simple. Risk is transparently low. The interest rate charged would be correspondingly relatively low. "Bad" debt would be someone with a low to middling credit rating, with borderline income or revenue, and with collateral that flirted with being equivalent to the loan. Risk is transparently higher. The interest rate charged would be correspondingly higher to offset the greater risk of default and failure to recoup the full value of the loan. "Insane" debt, would be someone with an incredibly low or no credit rating, whose income or revenue is well below what is necessary to pay off the loan, and whose collateral property has no, or even negative, equity in it (think of houses bought with liar loans, balloon loans, negative amortization loans).

In a traditional system, people with "insane credit" would never get a loan, because they have no way of paying it, and they do not have collateral worth anything near value of the loan. In the new system, debt is "equivalized" so that what I have called "insane" debtors actually become the most sought after market! Why? Think about it: No distinction is being made between debts that can be paid and those that cannot possibly be paid (at least without completely fantastical projections of increasing value in the property, commodity, stock, etc. upon which the loan is being drawn). All debt is seen as asset. Insane debt = bad debt = good debt = asset. This is confirmed empirically in Moody’s rating of absolute junk as secure AAA investment.

The lousier and more untenable the loan, the greater the "risk", therefore the greater interest and fees one can charge on it, and therefore the greater the ostensible return and/or profit! Combine this with the ability to externalize or pass on the liability by selling the insane loan or insuring it against default, a lender or servicer has every incentive to hand out the worst possible loans because they generate the highest fees and interest rates. "But," you may protest, "there are no foundations or fundamentals underneath these deals. They are completely irrational." In this new system, there don’t need to be fundamentals because mathematical models can now simply create and assign present value based on theoretical projections of future values accepted as if those future values were fact.

So all the incentive is toward expanding the market for heavy, pervasive debt that is impossible to pay, and then to further spawn lucrative financial derivatives (including servicing and guaranteeing loans) from that market. Add consumer industries to this balloon, like housing and automobile manufacturing that benefit from this false creation of equity based on future value, and you have a juggernaut. This house of cards is perpetuated by its own "new era" mythology ("values will always go up," "deficits don’t matter") and the fact that everyone seems to be getting richer from the loan originator to the lendee/investor—the brokers, the servicers, the appraisers, the realtors, the county property tax assessments, the furniture store owner, the homeowner.

If this situation weren’t bad enough, a new hyper-catalyst enters the picture--leveraging. Two major problems emerged here to magnify many thousand or millions fold the damage already levied by fraudulent and fantastical lending. First, unregulated private companies (equity firms, hedge funds, etc.) were able to fabricate wealth and inflate their holdings and net worth to either further invest or buy outright real companies, as Cerberus did with Chrysler. Their unregulated "money" was based in "equity" based on "marked to model" theoretical value.

Second, unregulated financial instruments like credit default swaps had no effectively no reserve requirement at all, because their reserve "money" was also based on "assets" based on "marked to model" theoretical value. Furthermore, this unregulated, self-assigned value could be, if they so desired, leveraged into investments in ratios that could defy infinity. As we know, zero multiplied by a million is still zero. Imagine if you or I could assign a 200 billion dollar asset value to our dog’s house, and use this assigned value to buy a major international conglomerate.

When people say that this is "unthinkable," what they are really saying is, "I don’t want to think about it. I don’t want to acknowledge this happened or can happen." However, just connect the dots. It’s simple. Is there anything preventing this from happening. No. Applicable regulations have been removed, and those still on the books have not been enforced. Is there any reason not to do it given the incentives and principles at play? No. Therefore, it will happen.

What we have is essentially private, unregulated money creation prompting hyperinflation in certain markets. We have an intensely large, and at this time, unknown amount of counterfeit money and value mixed in with the real. Apparently we cannot tell real money apart from counterfeit money very easily, and/or we are trying to hide the counterfeit cash through deficit bailouts from the taxpayers.

We also know that we cannot keep these fraudulence-based markets (i.e. housing) artificially inflated because they are so out of line with reality-based fundamentals and facts. However, we also largely do not have the grit to face the consequences of this rip off. So our interim strategy appears to be to try to ease into austerity by hiding the deficits, allowing companies to continue to mark to model, holding foreclosed houses off the market, etc. It is a common and understandable (but not excusable) human response. It won’t work, and it will both deepen and elongate the painful coming to terms.

Even money markets fell below 100% of principal. Think about that. That’s unprecedented in its scale and severity. You don’t need a canary to tell you what is going on. There has been a massive liquidity drain. Money has disappeared and been replaced with fraudulent substitutes of value. I’ve mentioned in other essays that this situation will eventually require massive debt forgiveness. Fraudulent or concocted wealth begets fraudulent debt. So we should come to terms with the necessity of debt erasure for larger swathes of the globe. The instigators have unfortunately, not only already been forgiven, but been rewarded with hundreds of billions of dollars of bailout money. Accountability, if it ever happens would demand these instigators go bankrupt, face criminal prosecution, and supply restitution, including returning their private, ill-gotten gains.

The Micro View:

How does this profoundly twisted macro mentality play itself out on the micro level? Let’s look at some examples...


Credit default swaps (CDS’s)

I’ve already written many essays on this subject, so I will only summarize the transparent fraud perpetrated under these "vehicles." CDS’s are unregulated insurance against defaults on loans. Though the mechanisms have not been officially investigated and audited, it does not take a genius to conclude that AIG and others could "guarantee" loans and receives premiums for nothing, that is, without actually possessing any reserve capital or exchange service at all. Using their once respected reputation as collateral, and dubious investments conveniently and generously assigned value by their own accountants, these institutions could create cash flow without providing anything in return except assurances. No wonder these vehicles were so attractive.

This would be like you or me receiving nice batches of money from our neighbors to insure against their houses being destroyed by fire, using our own house as collateral, with all of us living in the middle of a tinder-dry pine forest. The fire simply is going happen sooner rather than later with these conditions (akin to the poor fundamentals in the economy), and you and I won’t have anything left with which to pay others. However, we will have a huge private stash created by the fees and premiums we have charged and the bonuses we’ve given ourselves. This, at least, could help us rebuild our own mansions.

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