The Trillion Dollar Meltdown

The Trillion Dollar Meltdown
By Charles R. Morris

Charles Morris’s book, The Trillion Dollar Meltdown, is a forensic look at the catastrophe that is subprime and other dangerous liabilities on corporate America’s balance sheet. The book is insightful, packed with interesting figures, and the arguments sit within a well-constructed historical context. The premise of the book is simple, if the title hasn’t already given it away: “In this book, I lay out, on quite moderate assumptions, the likely course of writedowns and defaults on the whole asset gamut—residential mortgages, commercial mortgages, high-yield bonds, leveraged loans, credit cards, and the complex bond structures that sit atop them. It comes out to about 1 trillion.” Here’s my qualm, I don’t think his assumptions are all so moderate. Of course, as a percentage of each class the writedowns he proposes do look tame—except the subprime writedowns should be less than the 20% he postulates—but this assumes a spillover effect from one debt instrument to another, ultimately affecting everything. I see this as unlikely. In an alternate universe where we could Ceteris Paribus anything, then sure, we could hold many variables constant and the spillover would not abate. A more likely course of events, the one we see unfolding now for instance, has a scared Fed throwing gobs of money at a financial system that whimpers at the slightest pain. This will salvage many debt groups. It will also create the necessary moral haphazard for our next bubble.
I say all of this, of course, with the benefit of hindsight, something not afforded to Morris who wrote this book before the credit crises exploded in true form. Mr. Morris wrote this book between mid and late 2007, after the collapse of the Bear Stearns hedge funds (the spark that lit the fire of the credit crisis) but before the majority of writedowns, the stock market meltdown, and the Bear Stearns bailout. Morris was more right than wrong; I only find fault with his overblown estimates. My bet is this: 400 billion. That’s it. Here are some quotations from his book that I found insightful:
How big investors express their risk appetites: “Big investors were never completely delighted with mortgage pass-throughs. One problem is the ‘barbelled’ nature of many institutions investment appetites—they tend to invest on either extreme of the risk spectrum, putting most of their assets into super-safe instruments and a smaller allocation to high yield/high-risk paper.”
Who can fail: “As a general rule, only the very smartest people can make truly catastrophic mistakes.”
Why models break down: “For shares truly to mirror gas molecules [price movement as heat diffusion model], trading would have to be costless, instantaneous, and continuous. In fact, it is lumpy, expensive, and intermittent. Trading is also driven by human choices that often make no sense in terms models understand.”
Why the credit crisis is actually the result of rational behavior: “When money is free, and lending is costless, the rational lender will keep on lending until there is no one else to lend to.” The Agency problem: “There has never been a starker demonstration of the Agency problem—if loan originators have not stake in a borrowers continued solvency, the competition for fees will inevitably degrade the average quality of loans.”
On OPEC’s oil embargo: “The fire-house blast of dollars during the Nixon-Carter years brought the whole system to the brink of collapse. The tenfold run-up in oil prices mostly reflected OPEC’s implicit switch from the dollar to gold as its pricing standard.”
Bernanke’s explains away the current account deficit: “Ben Bernanke created a minor academic industry with a 2005 lecture that suggested that the persistent, and growing, current account deficit of the United States was…a natural consequence of a ‘global savings gluts’. The headline argument went like this. A big emerging country like China had no choice but to adopt an export-led growth strategy, for it lacks the basic banking and credit infrastructure required for an internal consumption-led boom. During the long transition to modernity, it would need to keep industrial wages low to dampen inflation and to moderate the internal stampede to industrial cities. Over time, the build-up of export earnings would provide the capital base for its own modern banking system, while also protecting against the kind of currency and bank runs that hit East Asia in 1997 and 1998. In the meantime, its dollar investments would benefit from the world’s deepest, most liquid security and trading markets. The upshot was that for the foreseeable future, China, India, the smaller Asian tigers, and the oil exporters would have to absorb dollars. Even if the dollar fell steeply, the broader development gains would be worth it.”
Morris offers the reader a delicious morsel on nearly every page. The historical context alone is worth many times the price of this book.

Saving the Americas

Saving the Americas by Andres Oppenheimer

Andes Oppenheimer does yeoman’s work in Saving the Americas, his rollicking socio-political treatise on US-Latin American relations. Oppenheimer’s story is not necessarily a sad one, though he does convincingly portray Latin America as an increasingly irrelevant global player; it is the story of a host of characters who face a forked path, one way which leads to prosperity and the other which leads to slow ruin. And while these characters linger at the crossroad, biding time or quarreling with one another, Oppenheimer reminds the readers that the decision of which path to take has been made before, to the success of some and the detriment of others. These characters are clearly the leadership of Latin America, and their option is to clean up their internal violence, reinvest in themselves, and compete in the world economy or to wallow in complacency and to hold the ludicrous fantasy that commodity borne wealth will last indefinitely. For Oppenheimer’s taste, too many Latin countries have been stalling or choosing complacency. To be sure, these questions have been raised before. In a defining touch, Oppenheimer rises above the simple criticisms and offers solutions, real solutions, solutions which have been implemented before and were used to drive the success of Ireland and China. Perhaps Oppenheimer’s most trenchant observation is that success often depends on making decisions that will cause suffering to increase at first until things begin to get better. “Many countries in the region have yet to break out of their peripheral blindness and realize that while they are blinkered by ideology and obsessed with the past, rapidly-growing Asian and Eastern European countries are driven by pragmatism and committed to the future.” To be taken in equal doses, Oppenheimer prescribes:

1.) Get into free trade agreements and give up the stronghold on stodgy industries. Just because these industries offer jobs immediately does not make them the wise place to allocate ones resources.
2.) Stop making it easy for people to major in sociology. Latin America needs more engineers.
3.) Create incentives for universities to pursue commercially viable technologies.
4.) Create incentives for nationals to repatriate money they keep offshore.
5.) Create a rock-solid legal framework that protects foreign investments.
6.) Regional trade agreements must include the creation of agencies that enforce the trade contract. There must be real accountability.