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Daniel R. Amerman, CFA, InflationIntoWealth.com
Something extraordinary happened on Monday, September the 8th, 2008. The government takeover of Fannie Mae and Freddie Mac triggered the pending settlement of $1.4 trillion in credit-default swaps. This single event could have led to a cascading series of failures that might have bankrupted Wall Street – and much of the rest of the financial world – by the end of the week. That isn’t happening, and indeed, the media is treating this as something close to a non-event. However, a very real $1.4 trillion event happened – whose resolution effectively constitutes one of the largest government bailouts in history. Nobody noticed, for even though this is occurring in “plain sight”, the simple fact is that few people outside of the financial industry understand the $600 trillion derivative securities market. In this article, written the day after the event, we will briefly explain why this hidden, massive bailout - not of Fannie and Freddie but of the financial derivatives industry - is hugely significant, with potentially profound – and arbitragable – implications for the dollar, the markets and your personal financial future.
(These
first several paragraphs in italics do not describe what did happen, but rather
what could have happened in an alternate universe in which we actually
had a free market that functioned without massive government interventions.)
The
financial news of the day was that Fannie Mae and Freddie Mac were both unable
to make debt payments and had defaulted on $5 trillion in bonds and
mortgage-backed securities. With the US
real estate market having fallen $4 trillion in the previous two years (non
inflation-adjusted), it should have been no surprise that these two highly
leveraged companies were not able to absorb the staggering losses. As this became clear to the markets, Fannie
and Freddie lost the ability to borrow - which their survival was based upon -
and actual default followed soon after. This
default immediately triggered settlements on $1.4 trillion in credit-default
swaps (credit derivatives), which had been entered into by major financial
firms who had promised - in exchange for lucrative fee income - that if Fannie
Mae or Freddie Mac were to default, these guarantor firms would make good on
the defaulted bonds.
As
the value of Fannie Mae and Freddie Mac debt plunged to 30 cents on the dollar,
this meant that there was a 70% loss on the bonds (if one could find a buyer at
all). This then triggered a call for
settlement on the $1.4 trillion in credit-default swaps outstanding. Because the debt of the two former titans of
the financial world was trading at a 70% discount compared to par value, this
meant that total credit losses were $1 trillion ($1.4 trillion X 70% = $1
trillion). This meant $1 trillion worth
of payments was due from the companies
that had guaranteed the value of this debt, through their entering into
credit-default swaps.
Settlement
was triggered, but as the credit-default swap beneficiaries soon found out,
collecting their settlements was an entirely different matter. The financial institutions around the world
who had guaranteed Fannie and Freddie in exchange for lucrative corporate fee
income (and multi-million dollar individual bonuses) were all highly leveraged
themselves (indeed, weaker than the companies they were guaranteeing), and
absolutely reliant on the day to day availability of large lines of credit and
general borrowing capacity. As the
creditors of these financial giants realized that a trillion dollar hit was
barreling straight at them, they pulled their financing. Having to repay or replace these loans,
without being able to sell massive portfolios of illiquid assets in a market
suddenly devoid of buyers, left nearly every major investment bank and
commercial bank in the United States and Europe unable to meet their
obligations – even before settlement of their trillion dollar credit-default
swap losses.
The failure of the major financial firms triggered another massive round of credit-default swap events, with amounts well over $10 trillion by Thursday, and over $20 trillion by Friday. By that time, however, no one was naïve enough to expect actual payment on those swaps, as Wall Street and the rest of the world’s financial hubs had all been insolvent since Wednesday. When the markets eventually opened for business again more than two months later, the official drop in the Dow Jones Industrial Average was over 10,000 points, meaning the index was trading at a level in the 1,000 – 1,500 range.
“They
say there are no atheists in a foxhole.
Well, there are no libertarians in a financial crisis, either.''
Jeffrey Frankel, Harvard economist
The above scenario is what might have
happened if we took the naïve perspective that markets actually function on
their own without government intervention, and that corporations take the
consequences for their own bad decisions, in exchange for the profits that come
from their good decisions. That is of course a hypothetical world that has little
to do with current global financial markets.
If you want a glimpse of the real world
future, and what is happening as the same flawed business model that destroyed
the $1.2 trillion subprime mortgage derivative securities market now threatens
the over $60 trillion credit derivatives market, then we need to look no
further than what actually happened with the $1.4 trillion worth of Fannie Mae
and Freddie Mac credit default swaps. The
companies were taken into conservatorship on September 6th. They have effectively failed even if legally
there are some different ways of phrasing it. As reported by Bloomberg on September 8th, that
led to a unanimous agreement by 13 Wall Street firms on Monday, September 7,
2008, that settlement of $1.4 trillion in credit default swaps had been
triggered.
If Fannie Mae and Freddie Mac had
actually failed to make payments on their debt - the consequences would have quite
likely destroyed Wall Street right there. As illustrated in the scenario above, there
simply isn't a big enough capital base on Wall Street to absorb a trillion
dollars in losses in a week, particularly once your creditors catch on to what
is happening. Much smaller losses from
subprime mortgage derivatives incrementally dribbling out over the course of the
year, still might have taken down Wall Street, had it not been for the ability
to hide losses in Tier Three assets (with the full complicity of the
government), as well as the reassurances that the Federal Reserve provided by
so swiftly bailing out Bear Stearns via JP Morgan, when a creditor driven
bankruptcy (as described above) threatened to take down a major player.
Of course, the hypothetical collapse
did not happen. The meltdown was averted
because the federal government proactively and aggressively intervened to keep a
financial disaster from taking down Wall Street (just as it did with Bear
Stearns, and Long Term Capital Management the decade before). When
the situation started to get bad, the federal government stepped in and - even
if they still are hedging a bit legally - effectively guaranteed the debt of
Fannie Mae and Freddie Mac .
Which means that they also – and
this is crucial – bailed out the firms who had guaranteed the $1.4 trillion in
credit derivatives. There may very well
be losses, perhaps significant losses, but there would be no catastrophic loss
there, that would threaten the viability of the financial system. Because what has really happened is that you
have replaced a credit default swap on a quasi-governmental agency, that being
Fannie Mae or Freddie Mac, with a credit default swap on the full faith and
credit of the United States government. If
the US guarantee had not been substituted then it would be a catastrophic
failure. But because the US guarantee
was substituted, it’s seemingly not a big deal, though much remains to be
worked out.
In
other words, the biggest beneficiaries of the $1.4 trillion Fannie and Freddie
bailout were not Fannie or Freddie at all, but the Wall Street firms whose
senior officers just happen to be major political contributors to both political
parties – with some of those senior officers also running the Treasury
Department on a revolving door basis.
How the ending valuation of the
credit default swaps for settlement purposes will work out is a fascinating
question. Arguably you could say that
the value of Fannie and Freddie debt just rose, not only in comparison to prices
during the recent financial turmoil, but also compared to par value. After all,
we have just gone from quasi-governmental debt to something that is much closer
to being explicitly a full faith and credit obligation of the United States
Government, which means we should be losing part of the small spread that
Fannie and Freddie traded at as quasi-governmental debt over direct
governmental debt yields. From this
perspective, one could say that the United States stepping in and taking over
actually improves credit quality and the value of the bonds, so there is no
loss at all - but a gain.
However there still remains a level
of uncertainty, as the debt has not explicitly been made full faith and credit
of the United States government. There's
a taint involved, and there could be liquidity issues - as investors typically
are not too fond of even small uncertainties. So there's a good chance the ending value will
end up somewhere in the 90s - perhaps very close to par or perhaps a little bit
further away. Wherever the ultimate
settlement prices, however, it will not be a massive loss, because what has
really happened is that a swap has indeed taken place, and the United States
government bailed Wall Street out of self-inflicted credit swap-driven
destruction, through preemptively swapping its guarantee for the guarantees by
Fannie Mae and Freddie Mac.
The real implication of this then is that there is no danger from credit default swaps directly taking down Wall Street, so long as the federal government is willing to aggressively intervene every time there is a potential failure. I think we can see a clear path to the future here.
Before going any further, let’s stop
and ask a simple question.
Where did the money for the bailout
come from?
How did a strapped federal
government come up with the trillions (if need be) to make good on all of
Fannie Mae and Freddie Mac’s obligations?
How did a government that is already
running over a $400 billion deficit so smoothly and easily come up with an
extra trillion dollars or two, if needed?
(With the $400 billion being based upon government accounting standards
whose usage would get an individual or private firm thrown in prison. The deficit is far, far higher when unfunded
retirement obligations are taken into account.)
And, for that matter, now that we’re
on the subject – where did the government come up with the money for the $170
billion “tax rebate”?
How about that $59 trillion number
for unfunded retirement related government obligations that keeps being bandied
around? (The real number is a good bit
higher as I cover in my article “The $2 Million Opportunity.”)
Where does the government come up with all that money, anyway?
The answer is simple – there is an
unlimited supply of dollars. When you
issue your own currency, and you are sufficiently determined, then there is an
infinite supply of money available.
Which could be a very good thing(?), for the Fannie Mae and Freddie Mac
credit-default swaps are only one small part of a much larger market – and much
larger risk. As we will discuss later in
the article, however, while the supply of money is infinite, the value of that
money is a different matter.
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Once you understand that the supplyof money is effectively infinite for a sufficiently grave emergency, then you
are ready for the next step in understanding some recent events which might
otherwise seem indecipherable. From some
perspectives, this near catastrophe which could have so easily taken down all
of Wall Street (had the federal government not intervened), was not a
catastrophe at all. It was instead a
highly successful experiment. For the
many firms which purportedly took on the risk in creating $1.4 trillion of
credit-default swaps for Fannie Mae and Freddie Mac did not do so for the fun
of it or out of the goodness of their hearts. They did so because they got paid enormous sums
of money for purportedly taking on all those risks. With much of that money quite directly passing
through to the already wealthy individuals involved.
If Fannie and Freddie had not run
into problems then the guarantor financial firms would have just pocketed all
of their fees, ultimately as pure profit. Instead of that, a worst case scenario
occurred that arguably should have destroyed every one of the firms involved in
this business - and would have likely done so if there had genuinely been a
free market involved.
What the experiment proved was that
as long as the risk that you take is big enough, then the federal government
and your former coworkers down at the Treasury Department can be absolutely
relied upon to bail you out. Now, Wall
Street felt this was likely already the case. It was kind of a shame to lose a firm like
Bear Stearns, but the good part about it was it proved that a major derivatives
market failure wouldn't be allowed to occur, as was remarked upon in the
article from last month quoted below:
“Government
intervention has saved the $62 trillion credit derivatives market from facing
the nightmare of counterparty failure during the credit crisis of the past
year…
After
the government backed rescue of Bear Stearns, the market views other major
derivative counterparties as also “too big to fail”, and this implicit support…
means the credit derivatives market will likely be spared the ultimate test.”
Reuters (Karen Brettell), August 7, 2008
With the takeover of Fannie Mae and
Freddie Mac, the markets have been shown to be correct, and the reliability of
the government bailout occurring has now been proven on a much larger scale. If the dollar amount is great enough, then no
individual firm has to go down. Instead
the United States Treasury and/or Federal Reserve will preemptively step in,
and effectively make every one whole (or close thereto), perhaps without even
affecting Wall Street bonuses.
The principle is very simple. Take huge risks that you know cannot possibly
pay out if you lose. In fact - that's
the key to the whole transaction. The
risks have to be so large that you cannot afford to lose, and the economy and
markets cannot afford for you to lose. Then one of two things happens. Either the risk event does not come about and
you make an extraordinary amount of money as an individual and as a firm for
having taken on this huge amount of risk. Or the risk happens and you have to pay
out. Except you really don't, because you can't
afford to pay out and you have effectively blackmailed the rest of the
population through being too big to fail. Then the government steps in and
bails you out. Except it's not really the government, because the government
can't truly do that, it is the rest of the population which bails you
out.
Situations like this are sometimes referred to as “moral hazard” – a weak and theoretical sounding term for an insider’s game of global economic blackmail that is growing at a rate much faster than the overall global economy. The cozy relationship between Wall Street and regulators is crucial, and much of the massive, hidden derivatives bailout that just occurred can be explained by looking at just who the chief “cop” is. US Treasury Secretary Henry Paulson built his half billion dollar personal fortune as the former head of Goldman Sachs, meaning he was chief executive of one of the world’s leading derivatives players.
It is only when you understand the
game that is being played, that the actions of Wall Street and much of the rest
of the financial world after the subprime mortgage crisis becomes clear.
The subprime mortgage derivates experiment
failed spectacularly. The firms that
were creating these derivative securities and the rating firms who were rating
them were making numerous and obvious mistakes. Yet once the fundamentally flawed business
model was disproven - the world did not move away from derivative securities. Oh, they stopped creating new subprime
mortgage derivatives, but when we look at the arguably much riskier credit
derivatives market (this greater risk is explored in my article “Credit Derivatives
Dangers In 2008 & Beyond – A Primer”), the market grew from $35 trillion in
outstanding credit derivatives in July 2007 -- the same time it was becoming
clear that something was going very badly wrong in the subprime mortgage derivatives
market -- to a current level of about $62 trillion. In other words the market reacted to the real
world proof that these things don't actually work, by almost doubling the amount
in existence in one year. Indeed, the
amount of credit derivatives outstanding grew at an annual rate that was about
twice the size of the entire United States economy.
Now if you are an academic modeling a
hypothetical world of free markets and rational behavior by sophisticated
investors keeping the markets safe and fairly valued for all involved, this
would make no sense whatsoever. Rational
investment firms ought to be fleeing markets like credit derivatives – not
doubling up on an already failed experiment.
The reason? It’s the best game in town. Take a huge amount of risk, be paid exceedingly well for it and if you screw up -- you have absolute proof that the government will come in and bail you out at the expense of the rest of the population (who did not share in your profits in the first place).
Once we recognize that what is
happening here is not a massive credit default, but a monetization by the US
government of those losses on a potentially multi-trillion dollar scale, then
our investment strategy changes dramatically.
We are no longer investing for the crisis – but for the bailout. The combination of this bailout and the
Federal Reserves unprecedented actions in forcing interest rates so far below
the rate of inflation creates a “target-rich environment” for the execution of
arbitrage strategies by both corporate and individual investors.
The federal government is not going
to let the financial system fail. It
will create however much money needs to be created to bail out the institutions
and attempt to bailout the economy, as it has already shown in real world test
after test, from the so-called “tax rebate”, to Bear Stearns, to Fannie Mae and
Freddie Mac. Which means that the government
is prepared to destroy the dollar, and is not just prepared to, but is currently actively destroying the value of
the dollar rather than let those firms fail. So the way you invest for the failure of an
out of control derivatives market is to invest for the destruction of the
dollar. Which means taking on new tools
for a new time.
The first step in creating wealth in
an unfair world - is to avoid getting cheated.
If you are investing money at short term rates of 1%, 2% or even 5%,
while the value of your money is eroding at 9% a year, then you are being
deliberately played for a sucker, and cheated out of the value of your money by
the Federal Reserve.
Not that secret meetings are being
held and an explicit agreement is being made to “get the little guys”. It’s just that sacrifices have to be made for
the greater good to try to avert a catastrophic market meltdown, and that means
that trusting individual investors get paid a negative interest rate on their
money (after adjusting for inflation), while paying taxes on (economically) non-existent
income for the privilege. Keep in mind
as well that one of the purposes in destroying the value of your money is to
keep the prices on financial assets propped above where they would otherwise
be, if genuine market forces were setting short term interest rates. Which means that you are systematically
overpaying for financial assets compared to actual fundamental values, and
are getting played for a sucker there as well, to the extent that you are not being
subsidized with below (real) market rates like the banks, investment banks and
hedge funds. (See my article “Fed
Manipulations Subsidize Wall Street & Cheat Investors” for more on this.)
The second step to turning financial
catastrophe into personal wealth requires understanding one simple thing –
which most investors do not. Inflation
does not destroy real wealth, at least not directly. Inflation redistributes real wealth. Indeed, inflation can be used by individuals
to quite directly take real wealth from both financial institutions and other
individuals, as I illustrate in my (slightly twisted) morality tale “Inflation
Pickpocket”. (To add insult to injury,
those doing the pocket picking can often do so tax-free, even while their
victims pay real taxes on illusory income.)
The third step is to understand that
wealth redistribution on a massive scale creates personal opportunity on a
massive scale. John Paulson (no relation
to Treasury Secretary Henry Paulson) saw the crisis that was coming in subprime
mortgages, researched and educated himself on this area (which had not been his
field of expertise), and he turned the crisis into a $3-$4 billion personal
payday in 2007. If you're not a hedge
fund manager like John Paulson, you may not have the tools that he used to turn
a market crisis into personal billions.
That’s OK, because Paulson didn’t start with the tools either. He started with educating himself and
learning about a new area, until he came up with a novel way to profit from
disaster. A method that wasn’t in the
financial textbooks, and that he didn’t find by reading a financial columnist
in the paper.
Next you need to understand that you
personally may have more tools than you may think, some of which may surprise
you. Tools which can give you the
opportunity to turn financial disaster into personal net worth. There are ways you can use those tools to
turn the destruction of the currency into perhaps the greatest real
wealth-building opportunity of your life, on a long-term and tax-advantaged
basis. But, if you want this to happen
--you will need to start with learning. That
is the irreplaceable fourth step. You
are going to have to educate yourself, and work to not just understand, but to
master some of the financial forces and methods in play here. You will have to learn how to turn the
destruction of paper wealth into real wealth.
With Turning Inflation Into Wealth being the key to this next step. My best wishes to you for turning this
challenge into an extraordinary personal opportunity.
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation – the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free “Turning Inflation Into Wealth” Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at InflationIntoWealth.com .
Contact Information:
Daniel R. Amerman, CFA
Website: http://InflationIntoWealth.com/
E-mail: mail@the-great-retirement-experiment.com
This essay and the websites, mini-course, books and audio
recordings, contain the ideas and opinions of the author. They are
conceptual explorations of general economic principles, and how people may – or
may not – interact in the future. As with any discussion of the future,
there cannot be any absolute certainty. What this website does not
contain is specific investment, legal or any other form of professional
advice. If specific advice is needed, it should be sought from an
appropriate professional. Any liability, responsibility or warranty for
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