Ali’s blog

Mostly quant stuff with occasional digressions

Is this the big one?

Posted by alifinmath on January 23, 2008

A riveting piece of analysis by Mike Whitney:

“The United States has now effectively entered into a serious and painful recession. The debate is not anymore on whether the economy will experience a soft landing or a hard landing; it is rather on how hard the hard landing recession will be. The factors that make the recession inevitable include the nation’s worst-ever housing recession, which is still getting worse; a severe liquidity and credit crunch in financial markets that is getting worse than when it started last summer; high oil and gasoline prices; falling capital spending by the corporate sector; a slackening labor market where few jobs are being created and the unemployment rate is sharply up; and shopped-out, savings-less and debt-burdened American consumers who — thanks to falling home prices — can no longer use their homes as ATM machines to allow them to spend more than their income. As private consumption in the US is over 70% of GDP the US consumer now retrenching and cutting spending ensures that a recession is now underway.

On top of this recession there are now serious risks of a systemic financial crisis in the US as the financial losses are spreading from subprime to near prime and prime mortgages, consumer debt (credit cards, auto loans, student loans), commercial real estate loans, leveraged loans and postponed/restructured/canceled LBO and, soon enough, sharply rising default rates on corporate bonds that will lead to a second round of large losses in credit default swaps. The total of all of these financial losses could be above $1 trillion thus triggering a massive credit crunch and a systemic financial sector crisis.” ( Nouriel Roubini Global EconoMonitor)

Decades of stagnant wages have left the American worker hamstrung and unable to continue to account for 25% of global consumption. Tightening credit and lack of personal savings have only added to his problems. The American consumer is tapped-out. That means that aggregate demand will fall dramatically across the world triggering increases in unemployment, decreases in capital expansion, and widespread slowdown in business activity. These are the beginnings of a deflationary spiral that will wipe out trillions of dollars of market capitalization in the real estate, equities and bonds markets. Even gold and oil will retreat significantly. (as we saw in Monday’s results)

The present crisis is not the result of normal market forces, but price fixing at the Federal Reserve and the financial engineering of the main investment banks. If there had been sufficient regulation of the activities of the Central Bank, so that interest rates had not been kept below the rate of inflation for over 31 months straight (under Greenspan) than the trillions of dollars in low-interest credit would not have flooded the real estate market, igniting a frenzy of speculative home-buying and creating the biggest housing bubble in US history. Despite his feeble excuses, Greenspan’s role in destroying the US economy is no longer in doubt. Even the far-right Op-ed page of the Wall Street Journal conceded Greenspan’s culpability in Saturday’s edition.

Greenspan is not the only one responsible for the present calamity. The financial markets have been reconfigured in a way that accommodates all manner of corruption. The new model, “structured finance”, allows worthless assets to be disguised by fraudulent ratings and sold to unsuspecting investors. At one time, this assertion might have been dismissed as the ravings of a conspiracy nut. But now we can find the similar accusations in the Wall Street Journal and on CNBC.The Wall Street Journal admits that a new “structured debt” market was created to package dubious subprime liabilities (from “no doc”, no collateral , “bad credit” loan applicants) and sell them to hedge funds, insurance companies and foreign banks as if they were precious jewels. The WSJ avers that this is the way that “smart people” “exploit” the opportunities from lavish “capital flows”.

Fortunately, that question was answered this week in an extraordinary outburst on cable TV by market-insider and equities guru, Jim Cramer. In Cramer’s latest explosion, he details his own involvement in creating and selling “structured products” which had never been stress-tested in a slumping market. No one knew how badly they would perform. Cramer admits that the motivation behind peddling this junk to gullible investors was simply greed.

Trillions of dollars in structured investments (CDOs, MBSs, an ASCP) have now clogged up the global economic system and are dragging the world headlong into recession/depression. Cramer’s confession is a candid admission of criminal intent to defraud the public by selling products which people–within the financial industry—KNEW were falsely represented by their ratings. They sold them simply to fatten their own paychecks and because there is no longer any regulatory agency within the US government that curtails ilicit activity.

As the stock market continues its inexorable downward plunge, foreign central banks and investors need to reevaluate the present situation and aggressively pursue legal alternatives. They should initiate a boycott of all US financial products until an appropriate settlement for the hundreds of billions in losses due to the “structured finance” swindle can be negotiated. That is the best way that they can serve their own national interests and those of their people.

Deregulation has annihilated the credibility of US markets. There is no oversight; it’s the Wild West. The assets are falsely represented, the ratings are meaningless, and there’s a clear intention to deceive. That means that the stewardship of the global economic system is no longer in good hands. There needs to be a fundamental change. As the “nightmare scenario” of global recession continues to unfold; we need new leaders in Europe and Asia to step up and fill the void.

Financial engineering is the most toxic poison around. A more socially redeeming occupation than financial engineer would be heroin peddler. Fancy equations served up by quants have served to camouflage the most blatant swindles and robberies. Quant finance is not science: it’s the emperor without any clothes, enlisted to serve the ends of the most criminal elements on the globe.

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