More and more the economic news is dominated by the sub-prime mess which now threatens to work its way into the fabric of the entire economy. The reason is that the products have been bought by so many institutions, and purchased in confidence. We now know that this confidence was based more on a fiction or mirage than anything else.
In The Financial Times yesterday there appeared one of the most stirring and scariest analyses ever: 'Out of the Shadows: How Banking's Hidden System Broke Down, by Gillian Tett and Paul J. Davies. It noted the "plethora of opaque institutions and vehicles" that have emerged this past deacde in American and European markets. The authors also noted how the esoteric products, namely SIVs (structured investment vehicles) and CDOs (collateralized dent obligations) have been create by a second tier, hidden "banking system" which has effectively taken the loans of banks and repackaged them as these obscure products.
Few people had a clue what these products embodied, but they were packaged as bonds and promptly given the highest bond ratings ("AAA") to ensure investor confidence. As the sub-prime mess has unfolded, we've seen all those bonds were overrated and probably not worth much more than the "junk bonds" of the Michael Millken era.
We now know that the toxic current of this unregulated junk effluent has permeated every nook and cranny of finance, and the other shoe is still waiting to drop. In an article some weeks ago, the FT estimated the liability cost will come to over $1.5 TRILLION when all the ledgers are finally tallied. The pain will be widespread and strike every kind of insitution, from pension plans to insurance companies - which was sold a bill of goods an invested in good faith in these parlous products.
What happened? It is the end and culmination of a process called securitization which actually began after the passage of the Bank Holding (De-regulation) Act of 1984, which sped the way to speculative excesses resulting in travesties such as the S&L scandal in the late '80s.
These included forming a new type of bond known as "collateralized mortgage oblgations" - which turned out to be the "daddy" of today's CDOs. These sprung up in the financial gardens like toxic weeds along with other entities, IOs (inverse only strips) and reverse floaters - promptly branded as "TOXIC WASTE" by the bond traders themselves (License To Steal: The Secret World of Wall Street Brokers and the Systematic Plundering of the American Investor, by T. Harper, page 211).
The CMOs represented the ideal way for mainline banks to dispose of risky mortgage loans they no longer wanted - and didn't wish to deal with. Why deal with such loans, which could always "come a cropper" with defaults on the loans and the bank losing - when one could dispatch them to a secondary entity on Wall Street that repackaged them into thousands of separate loans, and sold them as "bonds" - wherein the CMOs were bundled.
As the CMOs proliferated and no one saw any force or intent of regulation, the geniuses on "the Street" eventually came up with more aggressive concepts - esecially after 12 or so Greesnpan fed cuts made a ton of cheap money available soon after 2001.
Why package just ordinary loans as CMOs, when sub-prime loans could be packaged by the tens of millions into CDOs, or SIVs? The profits would be enormous! Of course, so would the risks, but as usual, Maul Street never took these into account.
The Fed now is caught in one hell of a crunch, between the proverbial rock and hard place. On the one hand it has to bear in mind the inflation risk, and on the other a recession.
My take from reading numerous financial articles is that the former now is much more a threat and in any case, some manner of recession is needed as "medicine". Better to take it now, than later when the pain will be a hundred times more.
The Fed's course is therefore clear: they have to cease from now pandering to the markets, especially the bond market (which continually factors in rate cuts into future bond issues as a method of extortion) and let them sink to the level that reflects the real value of the bogus instruments they circulated. Not to do so is to invite a second bubble on the back of the first, and delay, compound the pain.
This means NO MORE RATE CUTS! Indeed, I predict by early next year - possibly as soon as March - they will have to reinstitute rate increases. The crack money that fed the sub-prime mania has to be shut off. Yes, the withdrawal symptoms will be horrible - but this is the price that will have to be paid for the Street's recklessness, greed and "irrational exuberance" that makes the 1927 peddling of "investment trusts" piddling by comparison.
It is time to take the medicine, sooner rather than later.