I have to say, this is a damn find lede.

Blowing up the Lab on Wall Street
By Richard Bookstaber

Looks like Wall Street’s mad scientists have blown up the lab again. The subprime mess that is cutting so wide a swath through financial markets can be traced to the alchemy of creating collateralized debt obligations (CDOs) compounded by the enormous amount of leverage applied by big hedge funds. CDOs are derivatives — synthetic financial instruments derived from another asset.

His point is that Wall Street has created instruments so leveraged, and so removed from reality that people are literally spending billions on nothing at all.

The cause for this, to me anyway, Mr. Bookstaber^* does not make this point, is that the systematic dismantling of the FDR era banking and securities regulations have allowed this to happen.

It’s human nature to go for a quick buck, and to believe that the good times never end, and the deregulation of banking and securities has had this predictable result.

^*Isn’t that name almost Dickensian in character?

CNN has a story on how the Subprime^* meltdown is Subprime hitting high-end homes.

I think that the story is fairly “cry me a river”, for rich people, but there is an interesting graphic.

The idea here is that Fannie Mae and Freddy Mac cannot fund home loans over $417K, so these so-called “Jumbo” loans carry a larger interest rate.

While Fannie Mae and Freddy Mac are the largest mortgage resellers, it’s not their size, or their ability to negotiate a good deal that gets the lower rate (at least not most of it).

It’s that both of them are GSE (Government Sponsored Entities), chartered by the federal government.

What this means is that while they are private corporations, and owned by shareholders, and both have publicly traded shares, there is the implication, and only the implication, that in the event that they were to become insolvent, then the government would bail them out.

Most of the difference in rates between conforming and jumbo loans is simply this fact, and all of the change relative to one another in the past few months is due to this implicit government guarantee of payment.

This gap has gone from about 0.2% to about 0.7% because people have little confidence in private financial markets, and this appears to be continuing and accellerating.

^*As I’ve said before, it’s not just Subprime

Dean Baker has a very good take on many of the bailout schemes for the mortgage debacle^*.

His point is very basic, that, “the hedge fund crew is doing what all good capitalists do when things go badly: run to the government.”

What’s more, he argues, rather convincingly, that they don’t want the problem fixed, but rather that they want enough time to sell these assets to less sophisticated investors.

He gives the actions of Citibank with regards to Enron as an example. They tried to get the Fed and the Treasury to lean on the ratings agencies not to downgrade Ken Lay’s pyramid scheme.

There actually was an effort at a federal bailout of Enron. A former Treasury secretary, who had taken a top job at Citibank, called a Treasury staffer to see if he could stop the credit rating agencies from downgrading Enron’s debt. At the time Citibank held several hundred million dollars of Enron debt. While the staffer refused to intervene, if Citibank had gotten its wish, it would have had the opportunity to dump its Enron debt on less informed investors before the price collapsed.

These examples should frame the debate on a bailout. If the assets held by the hedge funds are sound, and it’s just an issue of stemming a momentary panic, then the Fed should step in as lender of last resort and try to stabilize the market. However, if the issue is just one of giving the hedge fund crew time to dump their bad debts, then the Fed has no business getting involved.

^*It’s not just subprime…It’s everything in housing, it’s just moving first in subprime.

Hopfully, Times Select will shortly be free, but I found this from last Friday by Paul Krugman elsewhere:

Very Scary Things

Very Scary Things
By PAUL KRUGMAN
Op-Ed Columnist
The New York Times
August 10, 2007

….

What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in stuff that is normally traded all the time — in particular, financial instruments backed by home mortgages — have shut down because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.

….

But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn’t do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn’t do much if the cash stays in the banks’ vaults.

….

Let’s hope, then, that this crisis blows over as quickly as that of 1998. But I wouldn’t count on it.

Would someone please get him a Nobel?

It appears that noted vulture investor Wilbur Ross is looking at the mortgage meltdown.

He’s made a fortune picking through the bones of failed steelmakers, textile mills and coal miners. Now billionaire investor Wilbur Ross is taking aim at another beleaguered industry: subprime mortgage lenders.

He took his first step on Monday by providing $50 million in debtor-in-possession financing for American Home Mortgage Corp (AHMIQ.PK: Quote, Profile, Research), which filed for bankruptcy earlier in the day.

He buys things like coal mines and steel companies on the cheap, and resells them to people who kill coal miners and default on retirement and health insurance guarantees.

Lovely fellow, and he’ll have a lot of work in the immediate future.

Remember when I daid that Bear Stearns would be closed or bought out in a year? The avalanche is beginning, as S&P just downgraded their stock to negative from stable.

Someone is going to buy this company for a few dozen magic beans.

It appears that many of the companies that borrowed through the subprime market will take it on the chin.

The report shows that about $680bn of loans will mature between 2008 and 2011 compared with only $180bn of maturing high-yield bonds.

Mariarosa Verde, head of credit research at Fitch, said the loan market was “critical to the wellbeing of these companies”.

Many highly leveraged firms rely on their ability to roll over existing loan debt into new loans rather than repay it when it matures, which they often cannot do.

The basic calculus is this:

• Longer term loans are far riskier to the lender. It ties up the capital for a longer period, and there is a greater risk that the interest fall below market rates.
• Risk requires greater return, so long term bonds are more expensive
• Companies that get junk bonds cannot afford the rates of longer term loans, so they get short term ones, and roll them over at the end of the term.
• When these loans come due, they refinance.
• If rates have increased significantly, they take it on the chin, bankruptcies and liquidation.
• This increases the risk, and hence the interest rates, putting more companies at risk.

Greenspan’s policy of flooding the market with liquidity after the dotcom crash will have dire consequences in the next few years.