The Swindlers by William Pfaff

The Swindlers

William Pfaff
Date 2008/3/19 17:20:00


Paris, March 18, 2008 – The international reaction to the present credit crisis, the most serious since 1929, reveals a curious disposition to accept what has happened as if it were an act of nature, the economic equivalent of a tsunami or typhoon. No one should be blamed. The market did it. No one can really be held accountable.

Those involved were all rational actors devoted to maximizing value, and the invisible hand of the market is already at its corrective work in shaking out the weak players. Some market fundamentalists say the only danger is that frightened politicians may bail out losers, recreating the "moral hazard" that invited the present crash.

Another view is possible.
The best concise description I have seen of what actually has happened appeared under the joint byline of Robert Winnett and John Arlidge in last Saturday's [March 15] London Daily Telegraph, an ancient and reliably conservative newspaper favored by the financial community in the City of London. Allow me to quote a longish bit of what they wrote:

"Unscrupulous lenders in America had lent billions to people with dubious credit records. The mortgages were typically offered at attractive knockdown rates for the first few years, after which the monthly payments rocketed. Tens of thousands of people were [then] unable to repay their mortgages and faced losing their homes...

"The sub-prime mortgages were in effect sold on by the lenders to investment banks that 'repackaged' them into complicated financial products. The poor sub-prime mortgages were split up and merged with other kinds of debt and then repeatedly sold on. A wide array of other financial products was then devised by some of the world's best mathematical brains to profit on slight movements in the price of the bonds and other investment schemes devised by the investment banks.

"The whole system – driven forward by investment bankers competing with their former colleagues who had joined hedge funds – resulted in an arms race to devise the most sophisticated schemes and ways of cutting up the different kinds of debt....[with the result that as the mortgages now fail] no one knows who owns the bad debts, trust is destroyed and even top bankers have to admit that they have no idea exactly how the system works or what they have invested in."

Please note that the crisis arises not from debt, not even bad debt, but from speculation in debt. The original lender in many cases knowingly made the bad loan for the sole purpose of creating debt that could be sold on at a profit.

Bundling this bad debt with "good" (repayable) debt in a new investment instrument was meant to disguise the bad debt, giving it apparent value by mixing it with good debt, but the actual result was to make the new investment instrument itself potentially valueless, since it no longer had appraisable value. (See Gresham's Law: bad currency drives out good.)

To overcome this problem, the holder of the debt went to the credit rating agencies. As has not generally been known, most of these agencies work for the institutions they rate, not the clients who rely on their ratings, and it is possible to shop among agencies for the most satisfactory result. Thus it was that new debt instruments obtained triple A assessments.

They therefore could be sold to customers unaware of their nature, some of whom – such as many municipalities across the world, from Norway to Australia -- are legally required to place municipal funds exclusively in AAA instruments on the assumption that these are totally safe.

Because of the AAA rating these instruments could also be used by hedge funds to leverage further borrowing, for speculative purposes, sometimes by multiples as great as 30, as in the case of the now defunct Carlyle Capital.

It is very hard to see anywhere in this the impartial workings of the market. What one sees is false value deliberately created for speculative purposes. The actual content of the debt instrument created was deliberately dissimulated by the attribution of unjustified ratings. This enabled speculation on an instrument whose only real value was the value for which it could be sold on to someone else, or used for leveraging speculative loans.

There were critics of this speculative boom, but few were taken seriously because it is widely held that a new economy exists that has rendered traditional rules obsolete. Objections were considered evidence of failure to understand the sophisticated refinements being made to a system generating immense and growing international wealth.

Speaking last week [March 13] at the presentation of the President's Working Group financial market recommendations, Treasury Secretary Henry Paulson criticized "excesses," weakened underwriting standards, and "complexity," but said new regulation to "catch up" with innovation must not "create new problems [or] make markets less efficient."

The collapse of this house of cards is a crisis of speculation, not of the real economy, and an appalling demonstration of market inefficiency. The imaginative might say that it has all been a version of the 19th century carnival swindle called Bunkum, but one in which those who conducted the game have ended up among the swindled.

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