Editore"s Note
Tilting at Windmills

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November 5, 2007
By: Kevin Drum

TROUBLE IN RIVER CITI....Atrios comments on the latest estimate of "Level 3" assets owned by Citigroup. That is, assets that no one really knows how to value:

I guess the point is that the inability to put reasonable estimates on the value of this stuff isn't simply due to an inability to account for them accurately due to the fact that they don't trade enough to have a genuine market price. Whoever loaded up on these piles of shit should have some knowledge of just what is contained in them....Unless, of course, no one has any clue what these pieces of paper represent. And that seems to be where we are.

Speaking (as usual) from a position of profound ignorance about this stuff, this still doesn't make sense. I assume these Level 3 assets are primarily the equity tranches of the various CDOs and SIVs put together by Citi over the past few years — and, yes, these are close to impossible to value because so much of their value is based on computer-driven modeling of how all the underlying assets interact with each other.

But the whole point of CDOs and SIVs in the first place is that some portfolio manager collects a bunch of assets together into a single vehicle and then puts the entire vehicle on the market. So if push comes to shove, the CDO can always be unbundled and the underlying assets put back on the market individually. It might not be pretty, but it would give us a pretty firm idea of what they were really worth.

And that seems to be the problem: not that this stuff can't be valued, but the almost dead certainty that, in fact, the underlying assets aren't worth much at all. And if the CDOs and SIVs were unraveled, and marked to market, Citi would be close to bankrupt. Maybe a few other banks as well.

Or so I'd guess. Certainly one thing that makes me even more nervous about all this than I otherwise would be is that even people who are genuine experts don't really seem to understand this much better than me. They're all mystified too. How can that be?

Kevin Drum 1:45 PM Permalink | Trackbacks | Comments (51)

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Kevin Drum: "if the CDOs and SIVs were unraveled, and marked to market, Citi would be close to bankrupt. Maybe a few other banks as well.

Bye, bye, Citibank, and IIRC Bank of India (oops, I mean America) and Wachovia.

Tough, it's called a market. Sometimes people screw up. Bailing out the rich (remember LTCM?) creates a 1000x greater moral hazard than UHC. Yet which do the wingnuts bloviate about?

Posted by: alex on November 5, 2007 at 1:57 PM | PERMALINK

Two points:

Unraveling a set of financial assets isn't that simple. If you have CDOs backed by more CDOs backed by CMBS (commercial mortgage backed securities) which are backed by mortgages on real estate, there's a lot to unravel.

Not everyone agrees that the proper value for an asset is its liquidation value at any given instant. As we have seen with tech companies, sometimes the stock of the company can sell for a lot more than the underlying assets. Correlatively, Jeff Bezos is lucky that he wasn't forced to sell of Amazon in pieces when its stock was at its low point.

Posted by: y81 on November 5, 2007 at 2:01 PM | PERMALINK

There are two points. First, as another commenter mentioned, an asset's worth not totally clear at liquidation.

Second, and perhaps most importantly, we're not just talking about constructs based on such assets; we're talking about a lot of DERIVATIVES of constructs based on such assets. If you can't value the underlying paper, valuing the derivative is even harder.

Posted by: kay on November 5, 2007 at 2:08 PM | PERMALINK

y81: Not everyone agrees that the proper value for an asset is its liquidation value at any given instant.

Of course not, but comparing tech companies to CDO's is ludicrous. Almost the entire value of such companies is in "good will" - the established and potential future value of the organization working as a whole. CDO's are simply "financially engineered" combinations of mortgages and what not. They only work together as a whole in the sense that somebody claimed that they represent a good risk/reward combo. Otherwise the underlying assets have nothing particular in common.

Posted by: alex on November 5, 2007 at 2:15 PM | PERMALINK

Time for a good old fashioned bank run.

Posted by: Old Hat on November 5, 2007 at 2:18 PM | PERMALINK

Sigh.....those who ignore history are doomed to repeat it. The home savings and loan debacle and the failures of SEC oversight to name just a couple, never seem to teach these guys any lessons.

They just keep coming back with ever more complicated and inventive investment schemes....ideas so convoluted even THEY can't really explain how they work, and when they eventually explode, as they are once again, they wriggle around looking for ways to get the feds to bail them out.

Of course the big boys don't really need "bailing out." Regardless of the chaos they cause, the system makes sure they get golden parachutes and giant salaries to weather the vagaries of "free market forces."

I only hope there is a special place in hell for the folks at Citi...they have routinely issued credit cards and used a variety of gimmicks which enable them to charge monthly rates of over thirty percent for the unwary. This might be considered usury at the state level, but Citi and their pals got Congress to supercede such limits at the federal level, then used their powers to limit bankruptcy and bombard those who are ensnared with a waterfall of new offers.

I paid off a Citi card two years ago and keep it idle, but still receive, at least twice a month, a set of blank checks from them. All I need to do is "cash them" for card transfers or purchases. It is all so handy and efficient. Unfortunately for them, I haven't been tempted.

Posted by: dweb on November 5, 2007 at 2:19 PM | PERMALINK

Alex, I mostly agree: a pool of mortgages is not like an operating business in most respects. I was just looking for an analogy that the audience here might appreciate. However, if your comment is taken to mean that the value of, say all the securities representing interests in a pool of mortgages is simply the sum of what each mortgage would fetch on the whole loan market, then you go too far. First, the pooling of mortgages achieves diversification. Additionally, putting the riskier tranches in the hands of experienced players in the distressed real estate market allows more capital to be invested in the safer tranches by people without that expertise.

Posted by: y81 on November 5, 2007 at 2:21 PM | PERMALINK

dweb, what on earth do Citibank's credit card practices have to do CDOs? I don't like Word anywhere near as much as WordPerfect, but that doesn't prove that Microsoft's accounting for stock options is wrong.

Posted by: y81 on November 5, 2007 at 2:24 PM | PERMALINK

They just keep coming back with ever more complicated and inventive investment schemes....ideas so convoluted even THEY can't really explain how they work, and when they eventually explode, as they are once again, they wriggle around looking for ways to get the feds to bail them out.

The products aren't that convoluted at all, they're just pieces of paper backed by shitty mortgage-bonds. Here's a funny explanation of how they work:

http://calculatedrisk.blogspot.com/2007/10/sivs-explained.html

Posted by: Old Hat on November 5, 2007 at 2:24 PM | PERMALINK

dweb - If you call and ask them to stop sending those checks, they will comply.

Posted by: Former Conservative on November 5, 2007 at 2:31 PM | PERMALINK

All those bassids that cram our mailboxes with credit card solicitations with trick rates and death-trap rate escalations....and end up charging 25-35-40% interest should fry in Hell....if Old Nick would have them. What does this have to do with CDOs? It's all part of the immensely clever and destructive practices that allow the financial empires to strip mine people; of course, they've been doing this for years in the poorer parts of the world and this nation, but now they're going after what's left of the middle class. Mining the pillars.

Posted by: Stewart Dean on November 5, 2007 at 2:35 PM | PERMALINK

y81: if your comment is taken to mean that the value of, say all the securities representing interests in a pool of mortgages is simply the sum of what each mortgage would fetch on the whole loan market, then you go too far

No, I'm not suggesting that. However I strongly suspect that the value of such financial engineering has been oversold. In other words, the ratio of the bundled to unbundled value of CDO's would be far less than the ratio of bundled to unbundled assets of most tech companies (or most companies period).

I suspect that a lot of the problem here is old fashioned hype and a bubble, not just of such financial instruments as CDO's, but the real estate market in general.

Posted by: alex on November 5, 2007 at 2:38 PM | PERMALINK

even people who are genuine experts don't really seem to understand this much better than me. They're all mystified too. How can that be?
Kevin,
They're mystified because they can't afford not to be. Admitting the value of the derivative means taking a loss, sometimes a complete writeoff, and careers are made and lost on such things.
At least America is not Japan, the denial can only last so long.

Posted by: Northern Observer on November 5, 2007 at 2:51 PM | PERMALINK

The experts are mystified because they did not ask any questions when the mortgages were making money. Simple as that. What's that internet stock REALLY worth? It doesn't matter as long as it's going up. You get the idea, it has happened before.

Posted by: American Citizen on November 5, 2007 at 2:53 PM | PERMALINK

"And if the CDOs and SIVs were unraveled, and marked to market, Citi would be close to bankrupt."

Is there a factual basis for this conclusion? I understand that we do not know the value of these instruments, but I presume some know how much the rough value of Citi is even if you value these instruments at zero and that it would not leave Citi bankrupt albeit bloodied.

Do these instruments have the potential to create huge liabities beyond being worthless that would literally leave Citi bankrupt?

Posted by: Catch22 on November 5, 2007 at 2:58 PM | PERMALINK

"... It's all part of the immensely clever and destructive practices that allow the financial empires to strip mine people; of course, they've been doing this for years in the poorer parts of the world and this nation, but now they're going after what's left of the middle class. Mining the pillars."
Posted by: Stewart Dean on November 5, 2007

-------------

I love the way you expressed this...
"mining the pillars".

We Americans have a duty to ourselves and the world to find some way to put a stop to this crazy form of capitalism. We must protect ourselves from the Crazies in politics AND commerce.

You can bet the people who put this process in motion will benefit, regardless of whether government bails out Citi or any other financial "institution" (perhaps called that because of the Crazies inside).

Wanna bet they were people who gave campaign donations to the Bush Crazies?

How do we determine who created this scam?

What would be an appropriate punishment for them?

Posted by: MarkH on November 5, 2007 at 3:04 PM | PERMALINK

Old Hat:
That bit you linked to is hilarious.

I highly recomend it.

http://calculatedrisk.blogspot.com/2007/10/sivs-explained.html

Posted by: mirror on November 5, 2007 at 3:05 PM | PERMALINK

The banks would have liked to unload these Level 3 investments before anyone knew what they are really worth. Mystification simply means they cannot find any new suckers to sell these 'investments' to.

Posted by: Brojo on November 5, 2007 at 3:42 PM | PERMALINK

In response to catch22's question:

Do these instruments have the potential to create huge liabilities beyond being worthless that would literally leave Citi bankrupt?

The short answer is maybe.

Citicorp is huge, holding paper assets of $2.35 trillion, according to Reuters. But the market capitalization of the company itself is considerably smaller, maybe $175 billion. If there's a asset shortfall, that's where the loss happens.

Ignoring CDO's and other dubious investments for the moment and just focusing on SIV's, Citicorp is sitting on about $100 billion in paper SIV assets that have an actual value...but nobody will come out and say what that value might be. If that value is a large and reliable number, it is in Citicorp's interest to say so now. But they aren't. If, at the end of the day, that value is a small number, then Citicorp is toast. And SIV's aren't Citicorp's only problem.

The last two rounds of writedowns are already on the scale of Citicorp's net annual income, and there's more to come. I think the newly announced $8-$11 billion writedown (a pretty big low-high spread for something you are actually intending to write down), following on the heels of its $6.5 billion writedown last month and the current frantic round of short-term refinancing, signals a new strategy of stretching the bad news out over a period of months, hoping that nobody adds up the writedowns and correctly concludes that Citicorp is having a slow-motion Wile E Coyote moment.

Posted by: Kevin Bell on November 5, 2007 at 3:49 PM | PERMALINK

You can't stitch these securities back together. The owners of the tranches that are actually backed by an asset are not going to be willing to unilaterally absorb the risk that they paid to avoid.

That applies across the board. Since these tranches are all divided by degree of risk, the people who paid a premium (accepted a lower interest rate) to avoid the risk are not going to agree to take it back again. The whole point of this exercise was to expose the riskiest components of a loan to willing speculators.

No, they can't be valued at this point--which, of course, was part of the risk, that the marketplace for these securities would be illiquid.

The more important point atrios made is that there is serious brokenness in a market where people who write and approve the loans have no interest in whether they are actually paid back.

this has been a problem for a long time; I had to deal with an estate that included a condo that was out of the money. The market value was less than the outstanding mortgage. I had thought I'd be able to negotiate with the holder of the mortgage to go interest only for a period waiting for the market to turn. Dead refusal from the current holder, and, into foreclosure we went.

Posted by: jayackroyd on November 5, 2007 at 3:53 PM | PERMALINK

It's quite an ugly spectacle to see all the stern finger-wagging and tut-tutting from liberals about the CDOs, considering that these CDOs have allowed a lot of poor people to acquire homes. Sure, some of the subprime mortgages effectively cheated ignorant victims, but the vast majority went to people who got something they couldn't otherwise have, and with virtually no risk to themselves except possibly losing what they might never have gotten! Although I haven't run the numbers, it seems possible that CDOs have done more to alleviate the effects of poverty than all the welfare programs of the Great Society. The ones holding the bag here are Republican investors; the ones who have gained are Democratic working folk.

One other point, on valuation: valuing complex investment vehicles for accounting purposes is a bit like specifying the location of an electron. It can't be done precisely, but it can be statistically approximated. The main risk isn't the uncertainty of valuation, but the possibility that valuations are extremely low. Why? Because the vehicles are statistically weighted to remain stable in value under "normal" circumstances, and it may be that circumstances are no longer "normal." It's like the dam built to a 99% probability of resisting a 100-year flood (a flood of a magnitude estimated to occur every century or so), and that now faces a flood twice that large.

Posted by: Keith on November 5, 2007 at 3:57 PM | PERMALINK

"Not everyone agrees that the proper value for an asset is its liquidation value at any given instant."

Uhh. That's EXACTLY what the proper value for an asset is. The value of an asset is what someone will pay for it. If the seller believes it is worth more, tell the buyers why. If none of the buyers are convinced, well that's life.
I can claim (and even believe) that the rights to my unfinished novel are worth a million dollars, but that fact is of zero interest to the rest of the world. Economics is a SOCIOLOGICAL subject, not a PSYCHOLOGICAL subject.

Posted by: Maynard Handley on November 5, 2007 at 4:07 PM | PERMALINK

"Sigh.....those who ignore history are doomed to repeat it.... they never seem to teach these guys any lessons."

It's not some abstract 'those guys' who haven't learned their lessons... it's the American people that haven't learned.

Directly or indirectly the working people will bear the burden of these failures.

"Somewhere a billionaire is laughing so hard he wets his pants." (loosely borrowed from Lou Reed)

Posted by: Buford on November 5, 2007 at 4:11 PM | PERMALINK

Stick to your day job, Kevin. Liquidity risk is something that investors get paid to bear. Thats why the AAA-rated CDO tranches yielded higher than other AAA-rated debt ... because the holders knew that there were only a few potential buyers for the stuff and that (as in 1998), there might come a time when there were no buyers at all. Just because there is no market for an asset doesn't mean it has no value. There is no market for stocks on the weekend but they still have value. Effectively, the market for CDOs is closed indefinately. It will slowly reopen over the next few months. Forced liquidations won't make the market open sooner, but probably won't make things worse. It will just cause some wealth to be transferred from the sellers to the buyers in the liquidation.

Posted by: Rich on November 5, 2007 at 4:18 PM | PERMALINK

It is my desire that the poor people who were sold mortgages that are now worth less than they owe will default so that the Republicans who sold them the mortgages will go bust. Poor people now have some power, they should use it to impoverish Republicans and Mr. Rubin's company. Unfortunately, I smell bailout for the rich, which is probably why the board at Citi placed Rubin as the CEO.

Probably many of the recent record number of foreclosures are not caused by poor people unable to make their payments. Many of the current foreclosures are wealthy speculators defaulting on their loans to rid themselves of their bad investments. Poor people should follow their example.

Posted by: Brojo on November 5, 2007 at 4:24 PM | PERMALINK

Maynard Handley, treating the market value each day as an accurate indicator of the underlying asset value isn't how Warren Buffet and others got to be much richer than you and I. Put another way, if you are correct, then Jeff Bezos would have been just as well-advised to sell his Amazon stake at 10 dollars a share in 2001 or to sell it at 90 dollars a share in 2007. That can't be right.

I don't know anything about your novel, but, in general, an author with a half-finished novel would be very unwise to sell a half interest for whatever it would fetch on the open market, because, unless you are J.K. Rowling, the author would get almost nothing. That is because the market doesn't know how to value half-finished novels. That doesn't mean that every author is destined to starve; in some cases, that novel is going to be worth a lot, even though the market can't tell you which cases those are right now.

Posted by: y81 on November 5, 2007 at 4:26 PM | PERMALINK

Keith: It's quite an ugly spectacle to see all the stern finger-wagging and tut-tutting from liberals about the CDOs, considering that these CDOs have allowed a lot of poor people to acquire homes.

Being reality based, we realize that, no matter how much we want it, there's no such thing as a free lunch.

Contrast this with the "tax cuts pay for themselves because we want it to be true" crowd. While you're at it, click your heels three times and see if you wind up back in Kansas.

Although I haven't run the numbers, it seems possible that CDOs have done more to alleviate the effects of poverty than all the welfare programs of the Great Society.

Let me translate: I don't know shit, but am willing to blow smoke out my ass to confuse the issue. Wingnut super hero: Smokescreen Man! Able to cloud any issue with emanations from his posterior! Ignore those risks and they won't exist!

The ones holding the bag here are Republican investors

Pop quiz: which party is Robert Rubin associated with? Which corporation is he associated with?

The main risk isn't the uncertainty of valuation, but the possibility that valuations are extremely low.

At least get the terminology right. What you're trying to say is that the problem isn't the risk, it's the uncertainty.

It's like the dam built to a 99% probability of resisting a 100-year flood ... and that now faces a flood twice that large.

Since the housing bubble and its associated abuses have been around less than ten years, its been an awfully short century.

Gee, who thought that a housing bubble might not continue forever, or that interest rates could change? Whudda thunk?

Ok, the paper roof on that house didn't hold up, but who knew that someday it might rain?

Posted by: alex on November 5, 2007 at 4:27 PM | PERMALINK

Citibank and the other big institutions are the ones who would love to get their hands on our Social Security funds in the privatization scheme pushed by the Republicans. The assholes can't even run their own business in a competent fashion.

Posted by: cajun on November 5, 2007 at 4:34 PM | PERMALINK

"Maynard Handley, treating the market value each day as an accurate indicator of the underlying asset value isn't how Warren Buffet and others got to be much richer than you and I. Put another way, if you are correct, then Jeff Bezos would have been just as well-advised to sell his Amazon stake at 10 dollars a share in 2001 or to sell it at 90 dollars a share in 2007. That can't be right.
"

That is not what I said. What I said is that the value of something is what someone else (subject to various constraints --- competion, information etc) is willing to pay. The values of things fluctuate with time, there's no mystery there.

What do you imagine as the alternative? That there is some platonic value attached to every item in the universe, which the market may or may not accurately track? Do you think whichever go you happen to believe in spends his time working out the "correct" values for items?

Or perhaps you think that the value of an item is what some priviliged human being (the seller? you personally?) happens to think it is worth. That's a nice little fantasy to carry around but, you know what, the rest of the world doesn't give a damn about these opinions. If neither I nor anyone else thinks that your ten year old Camry is worth the $50, 000 you want to sell it for, it isn't going to sell, and it's not part of the sphere of economics.
As I said, economics is about human interactions, it is not about human individuals.

This view may appear to generate paradoxes, but that is a fault of the language we use to discuss these concepts, a language that, through phrases like "the price", implies the reality of platonic prices and makes it hard to say things like "they paid more for those assets than they are worth" without sounding like a contradiction. What one needs is a language that includes more easily the relevant concepts of uncertainty and different times: Citibank values certain assets at some period in the past based on a view of how the world would change, and that view was wrong; thus they now have on their hands assets that, today, are valued at substantially less than they were valued back then.

Posted by: Maynard Handley on November 5, 2007 at 4:50 PM | PERMALINK

But Kevin, the really question to ask is exactly what is the value of Inkblot - before he runs for president in '08 and after.

Here we go again, the "suckers" who got in over their heads are complaining that the "snake oil" salemens conned them into losing their shirts, and the "snake oil" salesmen are screaming at the government to bail them out, and Bernanke is complying.

Both parties deserve to lose their money, the whole "make your money in real estate" mantra was fraught with fraud right from the beginning.
Just like the tech stock bubble.

People will never learn.

INKBLOT FOR PRESIDENT. CAT NIBBLIES ALL AROUND.

Posted by: optical weenie on November 5, 2007 at 4:52 PM | PERMALINK

The reason there is no market for these securities is because they are not worth anything.

Posted by: Jose Padilla on November 5, 2007 at 5:29 PM | PERMALINK

Maynard, you'd make an excellent OCC examiner. Don't bother to analyze the asset, whatever the market says it's worth today is what the asset is worth. No wonder the OCC was at least partly responsible for the growth in the bank debt (distressed) market.

C(iti) has $134B in Level 3 assets (after earlier write-downs?) and others have noted market value/book value, but I didn't look at the 10-Q to see what the reserves are.

In the early 90s, when the downturn was homebuilders and commercial properties, , Citi had to borrow $750 million (preferred stock) from the Saudis and 6 months later had to go back to get more.

One sizeable issue will be the respective rights of each tranche as to the cash flow vs. liquidation value. The sub-prime pieces have houses and trailers, there may even be lean-tos, some of which can be restructured but not without the consent of all the layers. There's likely a trustee in there, but I don't know what role that entity plays besides collecting the payments and passing them along.

Posted by: TJM on November 5, 2007 at 5:35 PM | PERMALINK

Keith, I have to take issue with your idea that these schemes helped "poor" people become homeowners - all it has done it get poor people deeper into debt. Most likely many will not be able to afford refinancing at higher rates and will lose their homes and whatever equity they may have built up.

Posted by: Doug on November 5, 2007 at 5:38 PM | PERMALINK

I do Agree with Alex Bye Bye CITI They made there bed now they can sleep with the fleas.

Posted by: john john on November 5, 2007 at 5:53 PM | PERMALINK

If you could unravel them, a test would be: at what price would the homeowners be willing and able to "buy back" their mortgages. It would be nice if they had first chance .... but of course the contracts are built to ensure lots of hands get lots of fees, further driving down the resale value of the essential asset.

Posted by: polo on November 5, 2007 at 6:38 PM | PERMALINK

John John, the stock market is up 9% in dollars but negative in Euros. If Bernake and Co. drop the dollar and raise the Euro, they have discounted the CDO's and can be purchased in Euros say at 50% of current book value. Of course John John, the money in YOUR pocket is worth a lot less....inflation?

Posted by: Lyle on November 5, 2007 at 6:42 PM | PERMALINK

The 'value' of SIVs, CDOs et cetera, taken as the amount someone is willing to pay for them, is nowhere near zero. The problem for the banks, and hedgies, is that they don't really own this paper, but must go to the commercial paper market every three months to refinance. Now that the investors who had been routinely buying this commercial paper have decided to take a breather and buy some 84 day bills instead, the banks knew that they would, if forced to sell, take huge losses, like Enron with its off balance sheet vehicles. The banks now need to call on on balance sheet lines of credit, which makes their quarterlies look not so pretty as they had before, which makes them even more desperate to find a way to sell. Anyone with actual cash now knows that all they have to do to buy these instruments dirt cheap is wait, assuming no deus ex machina Fed action.

Posted by: jhm on November 5, 2007 at 6:59 PM | PERMALINK

Quoth Rich: Just because there is no market for an asset doesn't mean it has no value. There is no market for stocks on the weekend but they still have value.

Yes and no. Strictly speaking, the market value of an asset is the amount someone will pay for it. If there is no functioning market, this may be near zero.

Usually, if you're investigating your finances on a Sunday, everyone assumes that the market will resume Monday at about the same prices it closed at. As long as your creditors think this way, you're OK. But if you really need the money now, not tomorrow, your assets may not be worth much on a Sunday. And if people doubt that the market will reopen, that loss of value may be long lived.

The novel "Cryptonomicon" has some interesting scenes of the (IIRC) Hong Kong stockmarket as the Japanese invaded. All accounts had to be settled immediately, or never. I can't recommend the novel, but those scenes illustrate the behavior of markets in very uncertain circumstances pretty well.

In addition to the market value, assets have a fundamental value that is the net present value of the associated revenue streams. This value doesn't go away when the market closes, but it depends on your ability to wait for repayment. It is usually underlying the market value, with the important caveat that the market price includes a risk premium which may swing wildly depending on market sentiment. Still, you can use this as the value for your assets, if you can afford to be patient and if you can handle the risk of default.

Posted by: Jay on November 5, 2007 at 7:20 PM | PERMALINK

In 1996, Bob Dole had a campaign slogan, "We want you to keep more of your money in your pocket." The first thought to cross my mind was, 'Thank God it's not my money, or it would be worthless.' The logic of this is that the actual currency doesn't belong to the holder, only its value. The monetary system is a function of government, which in a democracy is the people. Therefore money is actually a form of public commons, similar to a public road system. Instead of transportation, it's a system of economic exchange. While you are in total possession of the section of road you're driving on, its value is due to it being connected to those everyone else is on. So is the value of the money in your pocket due to its broad interchangeability. It is not an issue of socializing wealth, but of understanding what money is to begin with. Your home, business, car, etc. are private property, but the roads linking them are not. Money is more like the public road system, than private property. It provides a broad economic connectivity, without which the economy could not function.

Money has always been a form of public utility (Render unto Caesar...), but because it evolved out of barter and for much of history was minted out of precious metals to gave it inherent value, the issue of function has been confused with the issue of possession. Now all monetary value is a matter of public trust in government accountability and this is being abused to the breaking point. When the liquidity bubble does burst, faith in the concept of printed money will be shaken to its core. In order to restore faith in an invaluable economic tool, it would be useful to emphasize this public function. There is no longer a gold standard and it is the taxpayer who bears ultimate responsibility for government obligations.

Here is a little history to consider in understanding why we are where we are.

http://www.exterminatingangel.com/index.php?option=com_content&task=view&id=203&Itemid=118

Posted by: John Brodix Merryman on November 5, 2007 at 7:24 PM | PERMALINK

I think the underlaying problem is the currency itself. Only as much money can be saved as can be effectively invested, otherwise it inflates asset values. So in order for everyone to have as much wealth as they can get their hands on, lots of investment vehicles need to be created. The derivatives market amounts to a form of parimutual wagering, where one dollar is bet against another and losing positions are rolled over into new ones, so potentially infinite amounts of money can be "invested." When the bubble does pop, it will be nuclear. One thing Roosevelt had to work with was the solid foundation of a stable currency. This time the currency will be quicksand.

Posted by: John Merryman on November 5, 2007 at 7:46 PM | PERMALINK

Doug,
I think it's a good question, just what happens to the borrowers of these loans when they default. My point is that we can't automatically assume that the entire scheme was fraudulent, or to the disadvantage of the borrowers; quite possibly, the borrowers are the big winners while, pace Alex, the investors are the losers, at least right now.
Keith

Posted by: Keith on November 5, 2007 at 8:11 PM | PERMALINK

Even a casual look at Citi's balance sheet shows that, unless they were on the wrong side of some really aggressive derivatives play, there is simply no way they will fail as a result of this. Probably, they could write off their entire portfolio of subprime exposure (55 billion bucks) and still be a functioning entity. It's hard to understand just how huge this company is, so think about this: all the writoffs they've made so far, around $18 billion, amount to nothing more than about a year's profits.

Posted by: Martin Gale on November 5, 2007 at 8:19 PM | PERMALINK

I like to think of it as trying to "unlaunder" money.

Posted by: kevin (not Drum) on November 5, 2007 at 9:23 PM | PERMALINK

I have no business commenting on this thread, so I won't offer any personal comment. I do run across info in my news reading though that I figure everyone here with a clue might find interesting. Such as:

"From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks' balance sheets. The new US accounting rule SFAS157 requires banks to divide their tradable assets into three "levels" according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme Level 3 assets have only unobservable inputs to measure value and are thus valued by reference to the banks' own models.

Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman's capital of $36 billion. In an extreme situation therefore, Goldman's entire existence rests on the value of its Level 3 assets.

The same presumably applies to other major investment banks - since they employ traders and risk managers with similar educations, operating in a similar culture, they probably have Level 3 assets of around twice capital. Citigroup, J P Morgan Chase and Bank of America may have less since their culture is different; before 1999 those institutions were pure commercial banks and a substantial part of their business still lies in retail commercial banking, an area in which the investment banks are not represented and Level 3 assets are scarce.

There has been no rush to disclose Level 3 assets in advance of the first quarter in which it becomes compulsory, probably that ending in February or March 2008. Figures that have been disclosed show Lehman with $22 billion in Level 3 assets, 100% of capital, Bear Stearns with $20 billion, 155% of capital, and J P Morgan Chase with about $60 billion, 50% of capital. However those figures are almost certainly low; the border between Level 2 and Level 3 is a fuzzy one and it is unquestionably in the interest of banks to classify as many of their assets as possible as Level 2, where analysts won't worry about them, rather than Level 3, where analyst concern is likely.

AND

"Defenders of Goldman Sachs and the rest of Wall Street will insist that less than 27% of their Level 3 assets are represented by subprime mortgages yet that is hardly the point. Subprime mortgages, estimated to cause losses of $400-500 billion to the market as a whole, though only a fraction of that to Wall Street, have been only the first of the Level 3 asset disasters to surface. There is huge potential for further losses among assets whose value has never been solidly based. These would include the following:

* Mortgages other than subprime mortgages.
* Securitized credit card obligations.
* Leveraged buyout bridge loans.
* Asset backed commercial paper.
* Complex derivatives contracts.
* Credit Default Swaps

Level 3 Storm About To Hit Wall Street, Hutchinson, Asia Times 11/3/07


Posted by: nepeta on November 5, 2007 at 10:00 PM | PERMALINK

Posted by: nepeta on November 5, 2007 at 10:00 PM | PERMALINK

This is simply bad journalism. Those investments have been around, in most cases, for decades; attaching the ominous label "Level 3" to them doesn't make them any more or less risky. The only real problem here is that many of the Level 3 assets derive their value from real estate (which makes sense, considering that real estate is an illiquid investment that is, further, difficult to assess), which means you have the potential for a cascade effect (Hutchison kind of alludes to this, but doesn't spell it out, for a reason I can guess: it's not going to happen). But the same potential existed before there were "levels" of investments.

Posted by: Martin Gale on November 5, 2007 at 11:50 PM | PERMALINK

Martin,

I'm at fault for the appearance of bad journalism. In order not to take up more page space for the quote I simply listed the six worrisome areas. In the article itself Hutchinson goes into each area at length.

Posted by: nepeta on November 6, 2007 at 1:42 AM | PERMALINK

A signal of endtimes?

A real, successful business (not some internet startup) may be going bankrupt before the pro sport stadium they bought the naming rights to is even finished.

BTW, Quicken Loans' sign is still up in Cleveland, and Aaron's rent-to-own still has their topflite NASCAR ride.

Posted by: ThresherK on November 6, 2007 at 9:57 AM | PERMALINK

>Citi would be close to bankrupt.

Close?

Hahahaha.

Time for a nice little visit from the minions of the Office of the Comptroller of the Currency. And jail cells for these jackals instead of golden parachutes.

'"The subprime mess is not so much a new crisis as it is a resumption of the saga that began with the savings and loan scandal of the early 1980s, when executives of S&Ls went on a risky lending binge with government-issued money. Then, as now, there were many individual culprits, but the real problem was the ideology of deregulation and the capture of public policy for private gain by the financial industry."' - Robert Kuttner

' [As] wealth became more concentrated in the hands of a smaller and smaller percentage of the upper echelon income strata, services catering to that niche meant intensified competition for the best class of customers. Along the way, wealth creation became tied and inextricably connected to the function of ‘lending’ as opposed to ‘investment.” Finance became the driving force for the new economy and within finance, the principle agent of growth became asset inflation. It has been a long evolution, with the finance economy beginning in the realm of traditional lending and morphing into the gross excesses of speculative structured finance.' - De-Industrialization and the 'Nordstrom's -- Wal-Mart' Economy - FRANK BARBERA

Posted by: MsNThrope on November 6, 2007 at 1:43 PM | PERMALINK

>Not everyone agrees that the proper value for an asset is its liquidation value at any given instant. >Not everyone agrees that the proper value for an asset is its liquidation value at any given instant.

Umm...Isn't that what 'markets' are supposed to exist to do? Bye, bye, mark-to-myth.

"The bursting of the housing bubble will act as a detonator for a massive pension crisis." - Henry C K Liu
http://atimes01.atimes.com/atimes/
Global_Economy/GI14Dj01.html
September 14, 2005
Greenspan, the Wizard of Bubbleland

Posted by: MsNThrope on November 6, 2007 at 1:47 PM | PERMALINK

dweb, what on earth do Citibank's credit card practices have to do CDOs?

Ummm...pay attention. Credit card balances have also been securitized and are being used in exactly the same 100-1 leverage schemes. Auto loans, too.

Defaults will skyrocket. Wile E. Coyote Moment!

“The most powerful force in the universe is compound interest”
- Albert Einstein

Posted by: MsNThrope on November 6, 2007 at 1:52 PM | PERMALINK

Paging the auditors from the Office of the Comptroller:

'This is indeed the message that comes from true market prices that are now indirectly available via the ABX indices.

Those prices tell you not only that the mezzanine and equity tranches of subprime CDOs are now worth close to zero;

they also tell you that prices for the AAA and AA tranches – that until recently were hovering near par of 100 – are now down to 79 and 50 respectively. Hundreds of billions of subprime RMBS and senior tranches of CDOs are still being evaluated as if they are worth 100 cents on the dollar. What the ABX is telling you is that they are worth much less; thus the losses from subprime alone are an order of magnitude larger than recognized by most firms. But most firms are not using such market prices – or their proxies – to value their illiquid assets.' Nouriel Roubini
http://www.rgemonitor.com/blog/roubini/

Posted by: MsNThrope on November 6, 2007 at 3:21 PM | PERMALINK




 

 

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