Economic Darwinism

Letter to Obama: Our Voices Will Be Heard

Dear Mr President,

It is almost unfair to criticize you given the extraordinary circumstances surrounding this country when you took the oath of office. Time was a precious commodity and you were forced to make urgent decisions. To be clear, I cannot think of anyone else I would rather have at the helm now than you. Choosing generals was job number one and, for the most part, you did a fantastic job.

However, we clearly find ourselves in a severe financial crisis that, due to improper handling and an initial failure to recognize the scope of the problem, has mutated into a full blown economic crisis. Continued failure to right the ship is increasing the chances of a total global economic and social breakdown. In 2007, Bernanke and Paulson’s assurances that the subprime mortgage crisis would be contained only served to illustrate their complete lack of understanding of the circumstances. The crisis was no more about subprime mortgages than an influenza outbreak is about runny noses.

People smarter than me will tell you that a large contributor to economic growth over the last 10 years (some would say 20) was fueled by increasing levels of debt. Debt came to pervade every aspect of developed economies from consumers, to corporations and financial institutions, all the way up to local and federal governments. This debt came in the form of credit cards, auto loans, school loans, residential mortgages, commercial real estate loans, corporate bonds, municipal bonds as well as Treasury bills, notes, and bonds.

Scholars will debate the true causes for decades, but let me offer this as a plausible explanation. Pension funds, endowments, and trusts have financial obligations that are met by targeting a given level of return on investments made over a period of time. When the Federal Reserve, in conjunction with global counterparts, brought interests rates below 4% in 2001, these pension funds, endowments, and trusts found it increasingly difficult to meet their obligations. This forced them to move away from traditional safe investments such as Treasury bonds and into other investments that appeared safe, yet paid higher rates of return. In fact, many investors were restricted to securities that were christened the coveted AAA rating from ratings agencies such as Moodys, S&P, and Fitch.

Cashflow Waterfall from Pool of Interest Payments

Cashflow Waterfall from Pool of Interest Payments

The investment instrument that many of these funds turned to was something called a collateralized debt obligation (CDO). There are many fantastic explanations of CDOs around the web, e.g. see This American Life for mortgage CDOs. Think of a CDO as a bunch of debt sources (some listed above) whose interest payments are pooled together into a cashflow waterfall. The advantage of having a pool is that it is less susceptible to borrowers not making payments. For example, if you gave one person a loan and you depended on them making their interest payments so that you could pay your own bills, you’d be in trouble if they stopped paying. But if you were receiving interest payments from 1,000 loans, the impact of single borrower stopping payments is less severe.

Champagne Tower: Cashflow Distribution to Investors

Champagne Tower: Cashflow Distribution to Investors

A CDO goes one step further. A CDO takes this waterfall and redistributes the cashflows in a way very much reminiscent of the champagne tower. As long as some borrowers continue to make interest payments, the top champagne glass is likely to always be full. Ratings agencies then published models that attempted to assess the risk that the top glass may run dry in order to facilitate the design of these pools. The goal was to achieve a AAA rating on that top champagne glass so that the banks could sell them (the cashflows, not the loans) to pension funds, endowments, and trusts that were starving for safe investments that paid more than traditional safe investments rendered unattractive by the Federal Reserve and the Treasury Department.

This was a boon for the ratings agencies because they charge fees to rate securities. If a bank owned a bunch of loans and wanted to get them off their balance sheets to free up capital, they’d structure them into a CDO, plug a few parameters into the ratings model, and essentially pay the ratings agency to christen the top champagne glass AAA. In some cases, the loans in the pool were so risky that even the top champagne glass was not sound enough to warrant a AAA rating. In such cases, the insurance companies were happy to step in, and for a fee, would guarantee that the top glass always remained full.

Now, Mr President, I understand that you are already familiar with CDOs. Nevertheless, I hope this short description was helpful because it sets the stage for what I need to say next. Statements by Bernanke, Paulson, and now Geithner have focused on the mortgage market because that was the first symptom to appear. If the problems were confined to mortgages, Geithner’s plan might have a chance to succeed. Unfortunately, the scope of the problem is more accurately described as a global epidemic infecting all forms of debt. Banks have been pooling together every form of debt imaginable and constructing CDOs from the interest payments. There are CDOs of auto loans. There are CDOs of school loans. There are CDOs of residential mortgages. There are CDOs of commercial real estate loans. There are CDOs of corporates bonds. There are CDOs of municipal bonds. There are even CDOs of other CDOs.

I’m sorry Mr President, but you do not have enough money to back stop all of these legacy assets. Drastic measures are needed and they are needed now. As incomprehensible as it may sound, I believe that you should consider using your Executive power to declare a national emergency. Seize the investment banks and give a blanket guarantee on existing bank deposits to avoid bank runs, while setting rates on new deposits close to zero to avoid draining foreign capital from other struggling countries. Halt the issuance of new CDOs. Impose a temporary 90% tax on all income in excess of $1,000,000.00 to temporarily reduce the need to raise funds from foreign central banks who are dealing with their own problems. Transfer all outstanding credit derivatives to an exchange and enforce punitive taxation on over-the-counter (OTC) derivatives transactions to encourage the swift migration to transparent exchanges, while offering substantive tax incentives for financial institutions who can demonstrate they have completely migrated and no longer participate in the opaque OTC derivatives market.

Your advisors will surely tell you that the OTC market should not be demonized and serves an important role in the market place. I say they are wrong and you should be looking for ideas outside of the establishment. I would be glad to argue my case for any of these proposals on a point by point basis. I would not suggest such radical measures if anyone other than you were in office. Your knowledge and personal conviction in the sanctity of the United States Constitution places you in a unique position to be able to make it work without destroying the foundations of this country.

Many people in the United States are not happy. Some are outraged. Some are confused. Personally, I am outraged by what is going on at the Federal Reserve, The Treasury Department, and on Wall Street and am determined to educate anyone who will listen to me. I hope that includes you. However, the general outrage has not reached critical mass yet. It is not too late to correct course. I am writing these letters because I am still audacious enough to have Hope in your ability to steer this country back to prosperity for all Americans, not just Wall Street cronies living in their echo chambers.

Despite progress you may be making on other fronts, you will ultimately be judged by how well you manage the economic crisis. You’ve chosen your generals and have placed your trust in them. It is time you consider that perhaps you have made a mistake. Geithner and Bernanke are not up to the problems that face them. It is not too late to change course. Listen to Krugman. Listen to Volcker. Listen to Roubini. They are capable and willing to help, but so far you have turned a def ear to them.

The last time public outrage began to overflow was in the 1960’s and 1970’s during the Vietnam War. At that time, many people found their voice in music. I want to leave you by pointing to an example of what makes this country great. Jonathan Mann is an amazingly talented writer and musician who, like me and millions others, have the audacity to continue to have Hope. But, as I said in an earlier letter, the only thing more audacious than the audacity of Hope would be the audacity of squandering that Hope. In this song, Jonathan powerfully communicates the internal struggle many of us feel as we hang on to our remaining strands of Hope:


12 Responses

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  1. Wil Martindale said, on April 1, 2009 at 12:38 pm

    Quite well said. I like the illustrations!

  2. Economic Darwinism said, on April 1, 2009 at 1:03 pm

    Thanks for the feedback Wil

  3. BobbyG said, on April 11, 2009 at 3:15 pm

    “If the problems were confined to mortgages, Geithner’s plan might have a chance to succeed. Unfortunately, the scope of the problem is more accurately described as a global epidemic infecting all forms of debt. Banks have been pooling together every form of debt imaginable and constructing CDOs from the interest payments. There are CDOs of auto loans. There are CDOs of school loans. There are CDOs of residential mortgages. There are CDOs of commercial real estate loans. There are CDOs of corporates bonds. There are CDOs of municipal bonds. There are even CDOs of other CDOs.”

    Yeah. The subprime credit card bank wherein I worked in risk mgmt got bought by a Wall St “bad paper” firm in 2004. See my “Tranche Warfare” blog post. e.g. –

    “My subsequent VP of Risk (my original Sup went back to Collections) explained the prospective M.O. expected by the new owners. In a word, “securitization.”

    Some E-Z round numbers readily illustrate the concept. Assume 100,000 new VISA accounts booked, each with a credit line of $1,000 (remember, this is subprime; a thousand dollar unsecured credit line was considered radical). My own portfolio studies had shown that our credit-hungry customers typically maxed out their cards within four to five months. So, in short order you have a pool of accounts representing a nominal “asset” present value of one hundred million dollars (100,000 accounts x $1,000 each). Now, some of these accounts will eventually go bad and charge-off, while others will perform acceptably ongoing (providing continuing fee and APR income), with many “graduating” to even higher lines (every dollar of which will get used). Securities traders, then, bid on the estimated blended risk-adjusted future value of blocks of such accounts bundled up into “SDOs” — our “Securitized Debt Obligations.”

    You take the proceeds from the SDO sale and plow it back into booking another 100,000 accounts, etc, etc, etc. Lather, Rinse, Repeat. Once you’ve sold the accounts, you, the issuing bank, no longer have to “reserve” (with set-aside capital) against future losses stemming from any of them that subsequently charge off. Someone else now owns that risk (and, the retail customer is typically clueless; they get the same billing statement month after month, and are simply unaware that your bank is now simply administering the account that someone else owns. For a recurring fee, of course.).

    You see where this is going?”

    I recall going to ship for a new truck during that period, pre-approved by my credit union for pretty much whatever I wanted (804 FICO), and the dealership cats seemed more interested in selling me their own financing than the actual vehicle. More money to be made in pushing the paper out the door than the truck itself, I guess.

    “There are even CDOs of other CDOs.”

    Are there CDOs comprised of CDS’s, I wonder? I mean, ANY contract seems to have become a tradeable commodity.


    • Economic Darwinism said, on April 11, 2009 at 3:18 pm

      Thanks for your comment. Yes, there absolutely were CDOs built on CDS. They are called “synthetic CDOs” and that is another disaster waiting to happen once corporate defaults begin to pick up over the next months/years.

      • BobbyG said, on April 11, 2009 at 3:34 pm

        See, I’ve feared that as well. There are also reports that AIG was pulling an Enron, by having various of its business units “buying reinsurance” from OTHER internal subsids.

        What a mess.

  4. Bill Woody said, on April 13, 2009 at 12:23 pm

    Dear Dr. Economist,

    May I ask a selfish question? First, the background.

    I’m a retired engineer, managing my retirement funds for my wife and me. Last year I bought some ING perpetual preferreds because of their high credit quality (as perceived by the rating agencies, of course) and good yield. Now they trade for about half what I paid. I don’t expect to ever recover all the principal, but I contemplate buying more to recover some of my losses at yields which are now around 16%. Obviously a major question is what is the risk of default, or indefinite suspension of payouts?

    Because of your familiarity with the worldwide economy and probably the European banking system, I would really value your opinion about this strategy, realizing of course that “No warranty, express or implied, is granted by the author”!

    If you have substantive advice and would like payment for same, say $40 or $100, pls reply with a mailing address and I will send a check. Thanks for reading!

    • RedSt8r said, on April 25, 2009 at 7:54 am

      Mr. Bill Wood,
      I am not the “Dr. Economist” but have long experience in the markets. I once owned a seat on the Chicago Mercantile Exchange in a failed attempt to be a floor trader in the S&P 500 futures. I also like poker.

      The 16% yield on the ING is definitive proof of the risk. Doubling down on an investment that went bad works perfectly right up until the time you run out of money. You could be lucky and double down right before an uptick in the valuation but that’s a long shot gamble. Would you sell if you did?

      Close out your position, take the loss. My trader background (failed or otherwise) has long proved the adage of the first loss is the smallest. My regrets on the loss but take it and get out.

  5. RedSt8r said, on April 25, 2009 at 7:50 am

    As a “saver” I greatly appreciate your lonely voice castigating the Fed for wiping out any hope of a reasonable return for my savings. Thus, as you accurately portrayed forcing me to choose between seeking reasonable returns at underpriced risk or underpaid returns at reasonable risk. At least I conciously avoided both the 2000 tech stock bubble and the 2007/2008 housing bubble.

    Your letter is reasonable – and understandable. Phew. I caught your blog from a comment you left at nakedcapitalsim. I struggle with the articles and comments there but slog on. However, while I don’t concur with all your recommendations they are better than most. For example: in lieu of your tax on million dollar income I believe a broad based tax on wealth (akin to property tax) for a limited time with exclusions for those with estates below the estate tax limit would raise copious tax revenues. I would like the revenues so raised to be allocated to specific uses but then money is fungible. However, unlike most I also believe such a tax needs to be expanded to include public and private charitiies, religious institutions, non-profits and the like. They too benefit from the public weal and ought to help pay for it.

    Apologies for a long winded note of appreciation.

  6. […] Don’t let the recent jubilation fool you. As I told you before, the credit crisis is much larger than residential mortgages. Easy credit pervaded every aspect of […]

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  8. political humorists said, on February 4, 2010 at 6:14 pm

    Is all your facts correct? I am not trying to be a jerk, on the other hand I don’t notice how this makes total sense! I often have to check the same silly things out for myself on my own Political News Blog site, here… White Rabbit Cult… but what you wrote is important, and I will place a link back to your blog. Peace!

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