"Not a Crisis, But a Negotiation"

Not a Crisis, But a Negotiation
July 21st, 2011
By David Goldman

The financial punditeska had no clue what was about to befall them in the Spring of 2008. From July 2007 through August 2008, I told anyone who cared to ask me that their world was about to come to an end — for example, Bloomberg Radio’s Tom Keene (transcript in this old post). There were cash flows that were effectively levered 1,000 to one (when Structured Investment Vehicles with a paper-thin sliver of capital bought levered securities mendaciously rated AAA by Moody’s or S&P). And there were cross-guarantees (for example, derivative protection written on CDO’s by the large insurance companies) that no-one knew about or understood. I know for certain that Lehman management had no idea of the depth of contingent liability of their structured trading desk.

It was Enron writ large. Everyone was occulting the amount of leverage and risk in the system from their superiors and risk managers, such that the holes in balance sheets could burn clear through to China. THAT was a crisis, and to understand its depth, one had to take the trouble to follow the trail of leverage through all the alphabet-soup of new structured products. Very few financial market participants bother to do this kind of work, which is why few of them understood how bad things were.

More drivel has been written about the probability of financial crisis during the past month than at any time during my lifetime. There’s no crisis–not when all of the problems are transparent, on the table, and subject to negotiation. Instead, there is a change in lifestyle underway for Greek railway conductors, Minnesota firemen, New York City teachers, and a great many other people. Folk who only a few years ago expected to retire at sixty and spend their golden years on cruises will work until seventy and be thankful for a roof over their heads. Persuading so many people to accept this sort of change in lifestyle is not easy. It requires a bit of drama and the display (and occasional use) of instruments of torture. But there is no mystery, no surprise, no blind side.

Most of all, there’s no leverage, or rather, far less leverage than a few years ago. The regulators have seen to that. You have crashes when market participants are compelled to sell levered positions. No-one has big positions any more. They can’t get the financing. There’s no structuring activity underway, and the old bonds lie moldering in the grave of buy-and-hold portfolios.

I doubt America will lose its AAA rating; that would mean the same geniuses at the ratings agencies who declared most of the subprime universe to be AAA would have the temerity to rate the world’s most powerful economy. If the rating goes, the Fed will simply change rules to allow Treasuries to be used for collateral in the $5 trillion repo market just as they are now. Remember that Japan lost its AAA rating in 2002, but its 10-year government bonds yield barely over 1%. The fact is that ratings are important only because central banks say they are, because they are too lazy to evaluate risk themselves.

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