We have had to endure two toxic scares in recent weeks: melamine in milk products emanating from China and the subprime mortgage fallout in the United States.
In the former case, tens of thousands of people became ill this year and four infants reportedly died. In the latter case, subprime toxicity has poisoned the entire financial market, threatening a total system collapse and a 1930s-style global depression.
The suspicion is that melamine is added to milk after it has been fraudulently diluted with water to fool government protein tests.
A sourced Wikipedia entry says officials estimate that 20% of the dairy companies in China sell products tainted with melamine.
Government regulation, it appears, has been unsuccessful in preventing melamine from finding its way into Chinese milk products.
In contrast, in the case of subprime mortgages in the US, the government has sought to both actively encourage lower and lower credit standards and facilitated the spread of the toxins by encouraging the development of an entirely unregulated shadow financial system.
It has declined to regulate these shadow markets, according to a recent Fortune article, to “guarantee that the US will maintain its global dominance of financial markets”.
Successive US governments have supported subprime loans to facilitate home ownership, dropping credit standards over the years so that eventually all comers were given loans irrespective of their ability to repay them.
The subprime loans were parcelled up by investment banks that are not subject to the rigorous regulation applied to conventional banks, and sold to investors. They used what are known as CDOs, collaterised debt obligations, for this purpose.
While investors thought they were buying packages of housing bonds, investments that were as safe as houses or as good as money, they were actually getting the equivalent of a melamine surprise.
But no one was to know this as housing prices were rising during the first part of the decade. Everyone was smiling. Even people in default could refinance their homes at the newer, higher property value.
But then, beginning in 2006, the economy slowed and homeowners began defaulting.
By some estimates as many as 16% of homes in the US are underÂwater, meaning that the mortgage is worth more than the home. The subprime portion of the housing market is reportedly about $1-trillion, the total being about $10-trillion.
But the subprime portion, somewhat like melamine in Chinese milk products, has been enough to poison the entire financial system.
You would not, for instance, want to buy those tasty White Rabbit sweets if you thought they contained milk powder and, possibly, melamine. But houses are not like milk powder. You usually can easily sort out the good stuff from the toxic.
Except in this case the investment banks have cut, spliced and packaged these loans so no two packages are the same.
A chat group I monitored came up with the great idea of finding and buying their own mortgages at, say, 20% of the face value. This would be cheap at the price. The toxic loan could be taken off the bank’s books and if this happened in enough cases there would be no need for a $700-billion taxpayer bail-out.
But the problem soon emerged that the smarty pants investment bankers had not simply put together a pile of these bonds so that you could track down your own. Rather, the CDOs cut the income stream from each mortgage into three, with three levels of risk.
The idea is to share and spread the risk in the event of default to make the whole system as safe as houses.
But now you have no hope of finding out who really owns your mortgage and even if you could find it, or bits of it, you’d not find any bank prepared to finance you to buy it at a fire-sale price.
Note that this piece of genius, the CDO, may make sense when prices are on the up. When they are going down they make it hard for the market to self-correct at lower prices. There now seems to be only one likely buyer: the taxpayer.
Issuers of these bonds also made use of the unregulated CDS (credit default swap) market. Fortune reported this is the fastest growing type of financial derivative. Privately traded, the CDS market has ballooned in just more than a decade to $54-trillion.
“By ostensibly providing insurance on risky mortgage bonds, they encouraged and enabled reckless behaviour during the housing bubble,” said Fortune. It explained that the CDS market tied together companies such as Bear Stearns and AIG.
Fortune says there is at least one key difference between casino gambling and CDS trading: gambling has strict government regulation.
It says that in 2000 Congress, with the support of former Fed chairman Alan Greenspan and former Treasury secretary Lawrence Summers, passed a law prohibiting all federal and most state regulation of CDS and other derivatives.
“There’s another big difference between trading CDS and casino gambling,” says Fortune. “When you put $10 on black 22, you’re pretty sure the casino will pay off if you win. The CDS market offers no such assurance.”
The New York Times has detailed how a small unit in AIG, employing fewer than 400 people, became a leading player in the CDS market.
During the housing boom the unit virtually printed profits for AIG, but when the market turned it notched up $25-billion in losses, enough to bring the insurance behemoth, which once had $1-trillion in assets, to its knees.
After the failure of Lehman Brothers there was the real possibility of the giants of finance falling like skittles. There is only one thing the authorities can do in this case: reach for the taxpayer.
Treasury secretary Hank Paulson and Federal Reserve chairperson Ben Bernanke came up with what was dubbed Hanke Panke, a $700-billion buy-out of toxic assets. A key part of Paulson’s original proposal was that he would have the powers of a financial tsar, not subject to review of any kind.
The inference must be that he was looking for a huge pile of money (the $700-billion is more than the International Monetary Fund, or IMF, has loaned in its 64-year history) without being subject to any oversight. He could clear up the mess created by his political pals and no one would need be really any the wiser.
Paulson, depending on your perspective, could be a great choice for the job. A former chairperson of Goldman Sachs, with a reputed wealth of $700-million, could be great in the “takes one to know one” sense.
One account is that Paulson never intended spending the $700-billion. He was to use this big number, combined with sweeping powers as financial shock and awe, to spook the markets back into line.
The $700-billion is by most accounts inadequate for the job. The IMF has estimated that $2-trillion is needed to stop the credit crunch from adversely affecting private sector growth.
By early this week markets seemed to be in freefall as the crisis on Wall Street firmly moved to Main Street. The $700-billion bail-out had been signed into law by George Bush, but immediately discounted by Wall Street, which by mid-week was down 35% on its highs a year ago. Asian markets, led by a 10% fall in Japan, were sharply down at mid-week.
The British government announced a $90-billion support package and part nationalisation, but the FTSE shrugged off the news, immediately falling by 6%.
When markets cease up, we are used to seeing central banks intervene by cutting rates to lubricate them. Governments have, in recent days, also been announcing deposit protection to prevent runs on banks.
But this has just exacerbated things with depositors instantly moving money where there is the best protection, further increasing the problems for the entire system.
Likewise, it is of no use, under these circumstances, for Bernanke to cut rates unilaterally as this will just lead to a massive move to higher interest rate jurisdictions. At mid-week the major central banks of the US, Europe and England, as well as four smaller ones, cut rates in an unprecedented joint move by 0,5%. The FTSE recovered somewhat, but still closed 5,4% down on the day.
In the meantime, the Fed has been busy. It has upped the amount of money it provides short-term to banks to more than $800-billion as banks stopped lending to one another.
It has also said it will buy unsecured debt from corporates so that they can meet their short-term funding requirements. It has not disclosed the amount it will buy, but this market is also in excess of $800-billion.
Some states, notably California and Massachusetts, have said they will also approach the Fed to meet short-term financial needs.
If it seems the Treasury and Fed can magically create money as needed, this is not so. The bill will ultimately be sent to the taxpayer or consumer in the form of higher taxes or inflation.
There have been enough bubbles, stretching at least back to the South Sea bubble of the 1720s, for policymakers to know that the absence of prudent regulation will sooner or later bite you on the backside.
This is why most markets internationally, including in the US, are tightly regulated in terms of norms that have been developed over decades.
Inexplicably, in the case of subprime and the associated CDSs, the US chose not to have any systems in place to test the milk for melamine.