Sub-Prime Time

I happened to watch some of the testimony of Paul Gallagher and Richard Freeman of the Executive Intelligence Review over the weekend when they appeared before a PA State House subcommittee chaired by outgoing Rep. Dave Steil. They spoke on the subprime loan crisis, and the numbers they communicated were pretty ugly (I’m trying to obtain a transcript, and if I do, I’ll share more information.

I know this has been covered by Atrios and Paul Krugman, among others, but I'll try to add more details here.

Now before I say too much more, I should point out that Gallagher and Freeman are associated with Lyndon LaRouche, and the Homeowners and Bank Protection Act that Gallagher and Freeman publicized was announced by LaRouche last August. And like many of you, I’m conditioned to avoid anything from a man who once claimed that Queen Elizabeth II of England ran an international drug cartel. But Gallagher and Freeman spoke with authority and conviction, and there are some good ideas in the Act.

Gallagher also said that federally chartered depository institutions (federal reserve banks, commercial banks, savings institutions, credit unions, etc.) should be protected first in this crisis to preserve their liquidity, but he alleges that that isn’t happening, with billions of federal dollars injected into Countrywide Financial, a financial marketing and service holding company, instead.

This article by Gallagher and Freeman tells of how credit derivatives (such as futures contracts and other speculative investments) have been built upon sub-prime mortgages, with these derivatives included substantially into hedge funds (I’m not a financial expert, I should add, but I’m trying to summarize this information as carefully as I can). And any discussion of hedge funds could not be complete without mentioning Long-Term Capital Management (LTCM), about which the eternal Molly Ivins, among others, reported here.

As noted in the Gallagher and Freeman article (with the current crisis referred to as “The Great Unwind”)…

The ominous "Great Unwind" report was written by Stefan-Michael Stalman and Susanne Knips at Dresdner Kleinwort Wasserstein bank for Dresdner Kleinwort's private banking clients; leaked sections of the report were covered in Barron's on Feb. 12. The report's assessment is stark: that the highly leveraged $1.3 trillion-in-assets hedge-fund sector, and its bank creditors, by following the practices of the deceased Long-Term Capital Management (LTCM) hedge fund, are headed toward a swift unwinding of its leveraged positions, which will result in a financial crash.

The report says that while the hedge funds control only 1-2% of all global assets under their management, they have contracted two-thirds of all worldwide margin debt (borrowing of funds for stock investment).

The authors warn that while it is made to appear "that hedge fund strategies across the industry [are] diversified, there is actually a high degree of correlation," that is, most hedge funds are betting using the same strategy. Further, during periods of high market volatility, the hedge funds had exploited the volatility to make quick, big speculative killings. Various forces have greatly lowered the volatility. Instead, "a clear majority of hedge funds ... employ long-short strategies—removing market risk with what are essentially spread or arbitrage bets with a relatively low return." This means that these hedge funds will realize a low return for each bet; therefore, in order to compensate, they bet large amounts of money—most of it borrowed (leveraged); i.e., if the yield on a bet is less than 0.5%, but one bets hundreds of millions of dollars on it, one can earn a million dollars.

Many of the bets, which thousands of hedge funds are synchronously following, is to bet on the spread (the difference in interest rates) between a high-yield instrument, such as a junk bond, and a low-yield instrument, such as a normal corporate bond or U.S. Treasury bond. The hedge funds often employ mathematical models that determine what the historical spread between these particular instruments are. In an insane, linear fashion, the hedge funds bet that the spread will return to the historical norm—they exclude those real world crises that diverge from and disrupt the norm.

This is exactly what LTCM did in 1998: It blew up. However, this time, the hedge funds have and are investing nearly 1,000 times the assets/money that LTCM had.

…

The emerging trigger for this "Great Unwind" is the horrific crisis in the market of credit derivatives, which have been built upon sub-prime mortgages. This is not a big market, but its failure has the power to bring down not only hedge funds, but the financial system.

And this Denver Post story tells us…

…the crisis is deepening. More than 400,000 subprime mortgages are expected to reset each quarter to higher interest rates through the end of next year, representing $362 billion in debt.

The prospects are so grim that a coalition of lenders, with government backing, is discussing whether to freeze adjustable rates on some subprime mortgages.

Among the economic forces that set the stage for the surge in subprime lending were historically low interest rates, rising housing prices and trillions in investment dollars fleeing the stock market after the technology bubble burst.

But the superheated mortgage market froze up last summer after investors panicked as home-loan defaults spiraled upward, interest rates adjusted higher and a sudden housing surplus collapsed prices in many markets. As many as 2 million homeowners are expected to face foreclosures by the end of next year. In Colorado, as many as 15,000 subprime borrowers could lose their homes in the next several years.

And just for the record, what did President George W. Milhous Bush and his minions (including HUD Secretary Alphonso Jackson, who as nearly as I can tell has been absolutely silent on this) tell us last August?

(Bush) is also expected to support legislation that would provide tax breaks to homeowners whose mortgage debt is forgiven, in whole or in part, by lenders. The federal government currently collects taxes on the amount of a loan that is forgiven.

Democratic presidential candidates and Congressional leaders have hammered the administration in recent weeks, charging Mr. Bush with indifference to the plight of an estimated two million homeowners whose mortgage costs are expected to go up in the next year and a half.

These two million mortgages, all held by homeowners with credit problems and with homes that are declining in value, are valued at $500 billion to $600 billion, administration officials said. The total value of American mortgages is about $10 trillion.

The administration is offering his plan, which will include what one official called jawboning of lenders to persuade them not to foreclose on some borrowers, at a time of growing attacks on Mr. Bush from Democrats who say he has remained on the sidelines amid increasing anxiety over whether millions of Americans could end up losing their homes. Other elements of the plan would need legislative action, requiring Mr. Bush to win over the Democratic leadership in Congress.

He called for Congress to act quickly.

But of course he did, so he could proceed to either sit on or veto anything the “Democrat” congress does and blame them instead (including legislation compelling lenders not to foreclose on those caught in this crisis such as the Gilpatricks in the Denver Post story).

Sadly, though, there is a “wheel of karma” aspect to this, as the laissez-faire, “government is bad” mentality led to capitalistic connivance run amok, which is currently resulting in a collapse of our financial markets to a point that cannot be determined at the moment, as Krugman noted from today above.

And you can just add this to the pile of failure on this administration’s watch that includes neglect of the climate crisis, the stagnation of our economy, and the Iraq War – one more epochal misery on top of another.