High speed trading, the foreclosure mess, derivatives and deleveraging
Will we all walk away this time? A deleveraged Airbus in the Hudson.
In a business transaction, which is more important; selling your deal, or delivering on what the deal promised? Wall Street has made its position clear. Hundreds of millions of dollars are being spent on computers for high speed trading platforms capable of doing deals that directly access markets electronically rather than through brokers, capable of executing thousands of trades in milliseconds without human intervention. You can’t indulge in this type of trading from Kansas, because even communicating at the speed of light, you’re behind the market. Think this isn’t important? High frequency statistical arbitrage by the few firms capable of this type of trading earns them over $21 billion per year. These, and similar organizations represent less than 2% of all trading firms, yet account for 73% of the market volume. (Advanced Trading, 10 July 2009)
To see Wall Street’s utter contempt for their customers, just compare all this cutting edge trading technology with what they have done to track their obligations to mortgagees and the bond holders such as the foreign banks who purchased what they thought were Triple A rated mortgage backed securities. They outsourced their responsibilities to a few servicing firms in the deeply troubled mortgage servicing industry. It’s not just the mortgagees who are being deprived of due legal process, but the banks that created the mortgage securities are on the hook. If they can’t prove that they delivered what they promised when they sold the securities, they will be forced to buy them back. It will be no surprise if the foreign investors and others who were treated by Wall Street as the suckers in the sub-prime game are lining up to jam the deals back down the banks throats.
The whole outcome will depend on how well the banks mortgage servicers, who employed part time Wal-Mart clerks, hairdressers, ‘limited signing officers’ and other robosigners, did their job. It is doubly ironic that one of the companies that is largely responsible for failure to follow the foreclosure laws is essentially owned by the taxpayers. To see how well GMAC, (now named Ally) recipient of $17 billion in taxpayer bailout, is handling matters, see: http://www.nytimes.com/2010/10/15/business/15maine.html Back in 2008, I compared the toxic debt situation to one of those 100 plus vehicle chain collisions that occur in the dense fog of California’s central valley, with semi-trailer loads of toxic debt hurtling through the mist. See ‘From Too Big to Fail to Too Large to Care’ at http://somewhatlogically.com/?p=51 and how we’re trying to bail it out at ‘Will Rogers, Dead Mules, Scandinavian Banks’ at http://somewhatlogically.com/?p=38
The foreclosure/mortgage backed security crisis is one of those semi-trailers that nobody seems to have recognized, and its about to plow into the fog shrouded wreckage. Every quarter, the Office of the Comptroller of Currency publishes a report on bank trading and derivatives activity. In the most recent report, they comment, as they have in the past, on the concentration of trading and derivative activities, “ Five large commercial banks represent 96% of the total banking industry notional amounts (of derivatives) and 85% of industry net current credit exposure”. They note that such concentrations are normally a concern for bank supervisors but not to worry, “…because the highly specialized business of structuring, trading, and managing derivatives transactions requires sophisticated tools and expertise, derivatives activity is concentrated in those banking companies that have the resources needed to be able to operate this business in a safe and sound manner.” Quarterly reports are available at: http://www.occ.gov/publications/index-publications.html, source of the following graphic.
This raises the question as to how does the Comptroller of Currency account for the interlinking of complex systems, where one tiny lawsuit in Maine (see NY Times article referenced above) can upset a vast body of transactions that underlay many of the financial instruments held by the banks, much like the famed butterfly in Lorenz work on chaos theory. (See Lorenz’ 1972 talk to the American Association for the Advancement of Science, “Does the flap of a butterfly’s wing in Brazil set off a tornado in Texas?”) Current understanding of the nature of complex systems simply does not allow us to predict the effects of the current mortgage/foreclosure crisis on the incredibly complex international linkage of financial institutions. Will it be “contained”, much as Treasury Secretary Paulson stated in an April 2007 speech in New York to the Committee of 100; “I don’t see (subprime mortgage market troubles) imposing a serious problem. I think it’s going to be largely contained.” Or is it the harbinger of a further solvency crisis in the banking system? Nobody knows.
The main point is that we are going to have to de-leverage all the credit instruments based on the approximately 34% decline in U.S. housing value from the peak of the housing bubble as shown by the Case-Shiller home price index. At the start of the sub-prime crisis, the Feds pegged the total value of US residential real estate at $20 trillion, and the mortgage market at $ 10 trillion. You do the math. For an interesting foreign snapshot at the time of the 2007 crisis, see the Asia Times of Nov 16, 2007. http://www.atimes.com/atimes/Global_Economy/IK16Dj02.html
Right now, Wall Street seems to be whistling through the graveyard of the sub-prime debacle, hoping that the problem will be solved on the backs of the taxpayers, the legal rights of mortgagees, and the sub-prime investors, many of them foreign banks and pension funds, who fell for the AAA rated securities that were created with securitized mortgages. It is unlikely, given what has been exposed in the mortgage servicing industry, that the investors will passively buy the Wall Street contempt for the necessity to legally document their transactions and the belief that they avoid liability by passing their responsibilities off to the mortgage servicing industry. Sort of “the dog ate my mortgage paperwork”.
The situation is a lot like the Airbus crash into the Hudson River. Imagine that we’re all on board an economic airliner that has just taken a flock of birds through the engines, representing the impact of the mortgage crisis. (maybe the Black Swans, from Nassim Taleb’s synonymously titled book on uncertainty) In the case of Captain Sullenberger, he realized that his Airbus could no longer stay in the air, let alone climb, with virtually no thrust from the damaged engines. He also immediately recognized the extreme difficulty of his position; that he couldn’t make it back an airport with the altitude (the prime asset for a pilot in trouble) available. Instead, in a brilliant piece of flying, he carefully allocated the resources of altitude and airspeed to guide the aircraft to a safe landing in the Hudson. Everyone walked away from the crash. In the case of Wall Street and the banks, they are behaving as if the economic engines are still putting out near maximum thrust, and flying us right through another flock of black swans. Will the swans be something in the value of all those derivatives listed by the Commissioner of Currency, a currency war, or perhaps the combination of securitized student loans, impossible to repay when graduates can’t get a job? Some fatal flap of a financial butterfly wing of which we are as yet unaware?
Wall Street has almost totally abandoned its supposed function of efficiently allocating capital. The sophisticated technologies of high speed trading are in reality nothing more than flashing lights in the financial casino and do nothing to invest in a productive society. The real problem is that, like the uncertainty created by the mortgage documentation, no one really knows what all the paper is really worth, nor the real strength of the financial entities behind it. We have not completely lost thrust in the economic engines, but there is certainly not enough to maintain the sky-high value of all the debt instruments created during the bubble. Wall Street shows no signs of piloting its Main Street passengers out of the crisis. Who will walk away from the crash this time?
Contempt? In Chapter 11 of her excellent book, Fools Gold, Gillian Tett of the Financial Times writes about the 11 June 2007 European Securitization Forum, held in Barcelona, celebrating the investment banking industry’s most profitable year ever. “And as the light faded, a rock band struck up, playing cheesy covers. The band called itself “D’Leverage” and was composed of bankers from Barclay Capital, Credit Suisse, and others. The name was a joke. (“It’s meant to be funny – it’s da leverage, not de-leverage,” one of those watching explained).” The very next day, she notes that the Wall Street Journal reported that a large hedge fund with broad exposure from mortgage securities and leverage, High Grade Structured Credit Enhanced Leverage Fund, had lost 23% of its value almost overnight. And the band plays on.
Update: Just when you thought Wall Street couldn’t become more contemptible.
(Please pardon the length, but it’s important to include the whole story in one post)
Just after I wrote the above post, the Huffington Post came out with a great piece of investigative journalism showing how banks and hedge funds are buying up the right to collect taxes from financially strapped counties and cities. According to the article, they’re already securitizing some of these investments, just as they did in the sub-prime market.
The article identifies several banks participating in these schemes that have been the recipient of bail-out money and continue to profit from Federal interest rates that are effectively zero. Included are: Bank of America, JPMorgan Chase as direct participants, while Wells Fargo has made loans to lien buyers. The unregulated nature of the industry, with corporations whose owners can’t be traced beyond post office boxes, has already attracted Federal investigation for bid rigging in two states, and the article documents other legal and financial issues that are already arising from this new national “industry”.
In a broader perspective, it is hard to imagine anything worse for the housing market and the overall economy than accelerating foreclosures, (as HuffPost claims) and putting more properties on the market where the return to the investors will still be substantial even if the houses acquired are later re-sold at a fraction of the actual value. It is questionable if the paperwork will be handled any more responsibly than the current foreclosure scandal.
More importantly, Wall Street has created a financial opportunity for itself from the very carnage that it precipitated, and is now preying on cash strapped local agencies whose income has been gutted by the decline in real estate tax revenues. The correct solution is to make sure that local tax agencies have the resources to handle the issues at the local level, as has always been done in the past, not by largely unregulated national commercial interests. Unfortunately, this is just part of the ongoing privatization of local functions that benefit only the financial community. For example, witness the latest trend that is emerging sell “services” to local agencies recover the cost of emergency services from accident victims.
An example of such a company is Fire Recovery USA, located in Roseville, California. They’re part of a growing number of companies ‘helping’ strapped communities bill for emergency services. This is a particularly insidious way of creating a private ‘business’ opportunity to extract funds from a public service as someone has to pay the @20%-plus fees typically charged by such companies. Note that these schemes are essentially a direct give-away of public property or data, (sometimes in response to campaign donations as in the attempts to privatize reporting of Federal weather reporting by NOAA) as none of them require any investment by the private party in the underlying existing infrastructure and its maintenance. E.g. Building maintaining and staffing fire and police stations, providing police cars and fire trucks, training staff, etc.
Here’s a couple of quotes from the Fire Recovery USA website apparently inviting communities to circumvent regulations to gain extra cash.
“We bill on your behalf, for the services you provide during a Motor Vehicle Incident, Vehicle Fire, Structure Fire, Hazmat Clean-up, False Alarms, Gas Pipeline and Power Line Incidents, Water Incidents, and Special Rescues.
We have developed a proprietary method to allow a local department/government to bill to recovery the costs of mitigating an emergency. These “incident response mitigation rates” allow some departments to bill within a regulated environment that discourages service cost recovery.”
No wonder it’s a jobless non-recovery.
Airbus Photo credit: GregL/Wikipedia Commons/Creative Commons Attribution License