Today’s post is the first in what will become a semi-regular feature at the blog: a guest column, categorized as “Brain Food.” The concept is simple: invite baseball historians or writers to contribute something original which is not baseball-related. It’s an intellectual sorbet, if you will; a chance to put away the microfilm, Win Shares and Bill James books for a couple of minutes and cleanse the palette.
A friend by the name of Dr. David Lawrence has volunteered to be our pioneer. Dr. Lawrence is a music historian by day, and baseball history wonk by night. He’s been a frequent contributor to the Baseball Think Factory, and is the author (along with Dom Denaro) of the Eastern Colored League monograph, which was published in conjunction with the release of ABPA’s Negro league set in 2003.
In his essay, David tackles our troubled economy and the carnage wrought by our high-risk mortgage epidemic. He wonders if it’s really just the bad home loans (as mainstream media would have some believe), or something larger and more sinister taking place behind the scenes.
David takes the same approach to writing about the economy as he does to writing about baseball. He has a gift for articulating complex concepts in a manner all of us can understand, turning brick walls of ignorance into sliding glass partitions. In this instance, Dr. Lawrence is to economics what former baseball writer/sabermetrician Nate Silver became to political polling this past election.
There’s more to baseball people than….baseball.
WHAT THE MELTDOWN MEANS
By David A. Lawrence
(October 11, 2008)
You would think I would have had the sense to use the past four weeks of fiscal carnage to earn some money; you would be wrong. Instead, I’ve spent virtually every waking hour in an attempt to educate myself about what’s going on in the financial markets, even if that means studying material as dreary as macroeconomics and bankruptcy law.
The number one insight I’ve had is a profound respect for the power of the idea of an economy based on credit. It’s right up there with splitting the atom in terms of the shaping force it’s had on our world. And like atomic energy, it’s a genie that you let out of the bottle only after having given the matter very careful thought. You’ll understand why in a minute.
Back in the day, if you wanted a chicken, but didn’t have money, goods or services to trade for it, you went home without the chicken. Credit changed all that; and if you take that one chicken incident, multiply it by a septillion or an octillion, what you get is the modern world. Virtually anything that exists on top of nature itself was built with a credit economy: the roads, the cars, the factories, the houses, and everything in them.
But what I needed to understand was how a business like Lehman Brothers, with control over hundreds of billions of dollars of assets, could collapse over the course of a few days. That’s the story of the genie and the bottle.
In a credit economy, if your debt obligations exceed the net worth of your assets, that’s not a problem: you just assume additional debt. But here’s the rub: if the situation should ever occur in which your debt exceeds the sum of your assets PLUS your ability to assume additional debt, that’s suddenly your last day on earth.
So now let’s back up and see how this whole mess started. In terms of getting a handle on it, you will need to understand that there are several categories of people, popping up as talking heads in the media, who should be ignored–because they have no idea what they’re talking about.
The first group is stock market analysts. I don’t mean to minimize the pain of any of you who have seen large losses in your stock portfolios, but the level of the markets has very little meaning outside of itself. It’s a psycho-emotive barometer of how people feel about the economy. As such, it’s reactive to good or bad events, it doesn’t create events. Any attempt to try to “heal” the stock markets is like trying to “heal” the thermometer in a sick person’s mouth–it makes no sense.
The second group is focusing on bad mortgages and the people who bought them. That’s far too narrow an outlook, because the mortgages are a problem that can be solved by throwing money at it; in fact, that’s already happening. It’s true that a bunch of crooks sold deceptive mortgages to unsuspecting (and/or greedy) homebuyers, which is the match that lit this fire. But there are any number of matches that could have ignited this crisis, and it’s important to stay focused on the big picture.
Think of it this way: you walk in the front door of a building. There’s a small entry room–perhaps a few hundred square feet. That’s all the bad mortgages and the resulting defaults. But behind that room there’s a 50,000 square foot mansion: that’s the “big problem,” and before we can have any confidence that we’re out of danger, we have to address that one.
That big problem takes the form of all the side bets that have been made in exotic financial instruments that banks, hedge funds and investment groups have been selling to one another. This is what’s often referred to as “The Shadow Economy,” and it’s unimaginably huge. These side bets consist of contracts–starting (but not ending) with derivatives such as “Credit Default Swaps“ (CDS)–that wager on the success or failure of an underlying financial transaction.
A CDS is an insurance policy against the mortgages it covers going into default. They’re deliberately called “swaps” rather than “insurance” however, because the insurance industry is regulated–an inconvenience the designers of these schemes took pains to avoid. That should have been our first clue that these financial instruments were unsavory.
Insurance policies require that the insurer maintain adequate funds on hand to pay out against potential losses. The CDS issuers, by contrast, were bound by no such constraints. In other words, if the mortgages went into default, and there were not funds available to pay the policy holders, those institutions had been sold worthless contracts. And many of the CDS instruments were issued with no assets behind them at all. In other words, they were 100% leveraged: a pretty nice business to be in for the CDS sellers–not so nice for the buyers.
If you wanted to be extremely generous to the participants in this crap shoot, you could argue that the economic philosophy behind the issuance of a totally-leveraged derivative like a CDS was built on the false assumption that assets, including homes, will always appreciate in value. Unfortunately, a far more compelling argument can be made that the entire business was a scam from the start: the mortgages were bad, the insurance on them largely worthless, and everybody involved was trying to make a quick and dirty buck.
Meanwhile, we’re left with all the toxic debits in The Shadow Economy. Here’s a good way to visualize it: you’re sitting at a poker table. Behind you, there’s a guy taking bets on whether you’re going to win or lose. Behind him, there’s another guy taking bets on whether the first guy is going to be right on wrong about you. And so on, and so on, and so on.
Beyond the absurdly risky nature of making all these bets, there are two other aspects of this situation that you need to understand. First, if unexpectedly bad events occur at your poker table, all 17 guys standing behind you, each one making bets based on the success of the guy in front of him, could fall down like a row of dominos.
The second danger, which should be formulated in traditional economic terms, is that neither you nor the 17 bettors behind you are producing any goods or services. That’s how we got into our current situation, in which 21% of our Gross Domestic Product consists of financial transactions that are side bets on other financial transactions. A financially sound economy produces things; it doesn’t stand around and make wagers on what other people are doing.
Now we’re at the heart of the matter. Experts put the size of this Shadow Economy at somewhere between 50 and 75 trillion dollars. That’s “trillion,” with a “T.” I warned you it was unimaginably huge. If the Shadow Economy’s debts all had to be paid off, there are not enough financial assets on earth to do that. We’d have to sell our planet to another planet.
But wait, it gets much worse. In order to grow this crazed subculture of side bets, the instruments themselves have become progressively more complex. It’s now standard practice for that 17th contract–based on the outcomes of the 16 contracts in front of it–to be 300 pages long, and understandable only to the one person who actually wrote it. In other words, the banks, hedge funds and other financial institutions that are holding these instruments really have no idea what they own, or in terms of their balance sheet, what that means.
So we’ve come a very long way from that transaction in which one person gets a chicken and the other person gets a nickel. These institutions will now admit, if pressed, that they simply don’t know what assets and liabilities are on their books, because they own thousands of these contracts, and it’s impossible to decipher them, much less evaluate them.
That’s exactly where we are right now. What the credit crisis is about is that Bank “A” is simply unwilling to make a loan to Bank “B,” because “A” doesn’t have any idea what kind of garbage “B” has on its books. Worse yet, “A” strongly suspects that “B” doesn’t know what’s on its books either. And without credit flowing from one entity to another, you have no capitalization of the economy. And given that the economy runs on credit, without capitalization it slows, and then eventually stalls out. We call that “The Great Depression.”
I hope it’s obvious, at this point, that a firewall has to be built in the house of finance, between the bad mortgages in the entry room, and the hopelessly tangled Shadow Economy mess in the rest of the mansion. We can solve the problem of the mortgages, but not if all the CDS and other derivative side bets come trailing along after them.
A lot of my studies have been devoted to possible solutions to the problem of the Shadow Economy; it’s going to have to be addressed somehow. The first realization, in this respect, is that a normal litigation process that would resolve the debits owed and the credits due is not within the realm of possibility. Since it would take an expert on contract law a year to decipher even one of these instruments, and there may be millions of them, that’s a process that would take centuries.
In real terms, what that 17th contract looks like, is that a bank or hedge fund or investment group owns some portion of a side bet on whether 27.4 percent of 13 thousand people will or will not pay off their mortgages. In other words, they either have a net debit or a net credit, flowing from the many outcomes on which this contract is based. But, even if it’s a credit, given how many ways these mortgages have been chopped up and repackaged, they would find it nearly impossible to find out who the co-complainants are that own the other 72.6 percent of that contract, much less who the debtors are from whom they’re trying to collect. No attorney, no matter how desperate for business, would take that case.
What I have proposed, instead, is called “The Mortgage-Attached Contract Nullification Act of 2008.” If passed by the Congress and signed by the President, it would simply wipe out all those side bets, and destroy the looming disaster that the Shadow Economy poses if it stays attached to the mortgage crisis. The tricky little problem with my proposal is that it’s almost certainly unconstitutional.
I could find only two cases in American history in which an attempt has been made to nullify an entire class of contracts through legislative or executive action. The first is the Emancipation Proclamation of 1863, which withstood the constitutionality test for a set of very complex reasons. The second, in 1932, consisted of Franklin Roosevelt’s attempts to staunch the bleeding from a liquidity crisis much like our own. That one did not pass the constitutionality test, and probably represented the worst policy failure of FDR’s presidency.
There is only one other possible alternative to my proposal, and it’s not pretty. That’s to pass all the Shadow Economy contracts through bankruptcy courts. In a sense, this is a pretty realistic option, since they obviously can’t all be paid. Unfortunately, it would require either a thousand-fold increase in the number of bankruptcy courts, or else the handling of the litigation by bundling it into huge classes of similar cases.
Anyone familiar with how bankruptcy works knows the term “cram down.” It’s what a defense attorney does in order to get his client’s creditors to take the smallest possible settlement on the debt he owes. The key is always to try to minimize the cram down percentage. Using only my wits and my handheld calculator, it seems to me that something like one percent of the total debt owed would be about the right cram down percentage in this instance. I realize that’s a very small number, relatively speaking. But anything much larger would represent more money than even the healthiest of the debtors could afford to pay.
In other words, this process would be a bloodbath. A pretty substantial portion of the debtors wouldn’t be able to meet even that very low standard, and those businesses would go bankrupt. At the same time, the creditors would be screaming about how deeply discounted their repayments were going to be. If they were both creditors and debtors at the same time–which is extremely likely in the cases of many financial institutions–they would be doubly screwed.
What would the end result of such a process be, and how would it look to the rest of us? Given the huge number of bankruptcies that would result, we could see 15 to 20 percent unemployment on a national scale, within a recession that might last somewhere between 18 months and 10 years. Whole sectors of the economy would be devastated.
Perhaps more importantly, what would the societal consequences be? Well, first of all, we would witness the flushing of a very big toilet on Wall Street–with everything that’s in there disappearing forever into the sewer. That would certainly be met with loud cheers from most of us, and would represent, I think it’s fair to say, a progressive socio-political event.
But the second consequence would be a profound redefinition of the role of credit in our society, and that one’s not so simple to parse. Just as both Washington and Wall Street have become dangerously comfortable with spending money they don’t have, so has Main Street. The average American household carries debt equal to 129 percent of its total net worth. As with Lehman Brothers, that’s OK until the day comes when you can no longer find people to lend you additional debt to pay off your debt. In effect, we may have to go back to paying for our chickens with actual nickels.
To give you the flavor of the problem, in one of George W. Bush’s State of the Union speeches, he laid out the goal of having every American own their own home. It’s fairly astonishing that this is a Republican president articulating an ideal that would have brought a smile to the face of Karl Marx. Never mind that he probably said it for a whole variety of cynical political reasons: the fact is, he said it. And what it clearly implies is that nobody really has to worry very much about whether they can actually afford to pay for what they’re buying.
That’s precisely the problem with letting the credit genie out of the bottle. If people, at any level, get the idea that credit is limitless, and that the endless accumulation of debt is somehow not a problem, by the irrefutable laws of economics there will eventually come a day of reckoning. The reason such massive fear set in as we watched gigantic and venerable financial institutions being eaten alive is that they made many of the same mistakes that some of us are making–just on a far larger scale. What’s so scary is that, in a worst case scenario, we are all Lehman Brothers.
© 2008, David A. Lawrence, PhD
(David A. Lawrence has served on the faculties of several universities, including UCLA and Stanford)
