Posted by: tristar3research | May 4, 2009

Bubble Dynamics – A Systemic Problem

Well respected Financial Times columnist Gillian Tett released an excerpt from her upcoming assessment of the roots of the financial crisis called “Fool’s Gold.”

Backstopped- or NOT?

Backstopped- or NOT?

Entitled “Genesis of the Debt Disaster”, the article details JP Morgan’s hell bent rush into the derivatives markets in late 1990s. It was all about leverage: These pioneering structures were known as “Bistro” deals (short for Broad Index Secured Trust Offering). Masters and Demchak had done the first couple of Bistro deals on behalf of their own bank without knowing the answer to their question for sure. But when they were doing these deals for other banks, the question of reserve capital became more important – the others were mainly interested in cutting their reserve requirements.

Watch out below!

Watch out below!

Call it a house of cards or a stack of dominoes, this is a mess that just kept getting bigger and biggerer and biggerer with no adult supervision. There were warning signs a decade ago! Gillian reports, “The first sign that there might be a structural problem with the innovative bundles of credit derivatives that bankers at JP Morgan had dreamed up emerged in the second half of 1998.”Aha, the regulators were told to approve the deals since they would be backstopped – YES COVERED- by the issuer is anything went wrong!

When the team did their first Bistro deal, they pooled more than 300 of JP Morgan’s loans, worth a total of $9.7bn, and issued securities based on the income streams from these loans. The lure of the idea was clear: the team had calculated that they only needed to set aside $700m – a strikingly small sum – against the risk of defaults among the 300-plus loans. After much debate, the credit rating agencies had agreed with the team’s assessment of the risks, and the deal had gone ahead on the basis that if financial Armageddon wiped out the $700m funding cushion, JP Morgan would absorb the additional losses itself. To Masters and Demchak, the chance that losses would ever eat through $700m were minuscule.

The sad truth is that this is a systemic problem that has spread from corporate finance to government finance and finally to household finance, with the greatest toll being taken on by households. Take a little time to see how the credit card reform bill of 2009 and the bankruptcy reform bill of 2009 have been handled. MIDDLE CLASS SCREWED AGAIN!

Note that 12% two day Taiwan rally? Driven by mainland speculation

Note that 12% two day Taiwan rally? Driven by mainland speculation

Doug Noland at Federated nails it: Bubble Dynamics have taken root throughout government finance. This unprecedented inflation includes Federal Reserve Credit, Treasury borrowings, agency debt, mortgage-backed securities issued by government-sponsored enterprises (GSEs) such as home-loan guarantors Fannie Mae and Freddie Mac, Federal Housing Administration and Federal Deposit Insurance Corporation insurance, massive pension and healthcare obligations, the myriad new market support programs, and so forth. This government finance bubble is domestic as well as global. Amazingly, the scope of the unfolding bubble dwarfs even the mortgage finance bubble. And, importantly, it is reasonable to presume that the Federal Reserve will find itself in the familiar position of being trapped by the risk of bursting a historic bubble…I fear the government finance bubble is on track to destroy the creditworthiness of the entire economy. And this Ponzi dynamic is the greatest cost to what I fear is a continuation of unsound policymaking.

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