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Toxic Liabilities Are Not Assets
(Zeus Yiamouyiannis, Ph.D., October 23, 2008)
Answering reader response to Imaginary Worth, Empire of Debt: How Modern Finance Created Its Own Downfall (4 part series, links below)
A reader posed excellent fundamental questions on the nature of debt, asset, and liability:
"I read with interest the four essays by Zeus Y. on CDS's and understand that they are valueless given no collateral backup. I would think, however, that there is still liability on the part of the writer of a CDS if the purchaser were to make a valid claim. A liability which can not be paid usually results in bankruptcy, does it not?
I’ll provide answers to these excellent questions and then follow with some observations, filling in the back story about why traditional notions of asset, debt, and liability are not obtaining in the present environment.
First, credit default swaps (CDS’s) have produced exactly that scenario which the reader suggests in the first question. Many of the fly-by-night operators that originated and or peddled CDS’s did go bankrupt. They simply made promises to cover defaults without adequate capitalization or collateral. Their companies were essentially shells which leveraged paper phantom assets, “marked to model,” as if they were real assets. These companies could not pay so they went bankrupt, as did many fly-by-night mortgage companies. This did not stop them from siphoning off huge personal incomes and fees before their companies went bankrupt. Since the personal liability (bankruptcy, etc.) of the owners of those companies is not tied to the performance of the company, they simply were able to take the money and run.
This becomes a theme—big short-term returns, no personal consequence, and “externalized liability” by people who don’t really have a stake in the matter.
Two, the bigger companies (as in Lehman Brothers, AIG, Citigroup, Goldman Sachs, etc.) did not do their due diligence on CDS’s and should have eaten their losses associated with CDS’s. If they did not understand these financial instruments, they should not have bought them. However, they did buy many CDS’s in their greed-driven frenzy to cover their own skyrocketing short-term returns in risky markets (i.e. sub-prime). Now, to fully reveal and write down those losses would be to show how undercapitalized they are, send their stock prices plummeting, and guarantee their bankruptcies as well, with results that would ripple through the entire market.
This would affect and has affected necessary short-term lending and borrowing in the broader economy like those loans extended to regular, productive businesses to ensure they meet payroll. So these big banks and investment houses were deemed “too big to fail” and were not allowed to go bankrupt (except for Lehman Brothers), because the ripple effect was considered too dire. In fact some recent revisionist assertions (not ones I necessarily agree with) suggest that significant negative cascading effects on the economy were generated by the Lehman Brothers bankruptcy and that Lehman should have not been allowed to go into bankruptcy either.
However, this commitment sets up another serious systemic jeopardy, not just a “moral hazard,” in which non-transparency is used to shore up markets and avoid panics. Hence we see the very stupid, short-sighted, and frankly corrupt plan by Henry Paulson to have the U.S. government simply absorb private “toxic assets,” take them off the books with taxpayer money, and “make it all go away.” This will not work since there are tens of trillions of dollars of toxic liabilities (do not call them assets) in the form of CDS’s, not simply a couple hundred billion. Sub-prime loans are not the source of this problem. It is the LEVERAGING of sub-prime loans that is the problem. The too-clever-by-half, clean, handsome, Ivy League-schooled power brokers are the ones creating the problems. Poor people, including minorities, who got over their heads in trying to own a home are not to blame, notwithstanding Republican lawmakers attempts to assign them blame. We could simply buy up their mortgages for that 700 billion dollars, and get at least 30-40% of our money back.
Answer this, how could any true asset be “toxic”? Houses, sub-prime or otherwise, have at least some worth, even if they have lost a good deal of their value. These kinds of precipitous losses happen in stock markets all the time. However, as I explained in my essays, the leveraging of these mortgages IS toxic and IS NOT an asset, since it is simply a fabrication of value with no real backing. This leveraging truly poisons the economic system by diluting the worth of real assets and by calling into question the veracity of any claim of value: you are not sure the 100 dollar bill in your pocket is real or counterfeit because the money supply has been flooded with (unregulated) counterfeit bills, mixed in with the real.
Sooner or later we have to recognize a massive fraud has been perpetrated. It needs to be revealed that major companies have trillions of dollars of junk on their books and are likely not solvent according to traditional notions of solvency. So we have a Catch-22, but not one that will be solved by hiding: expose the fraud and risk likely short-term collapse and re-scaling of economic confidence and systems, or cover the symptoms, hide the toxins, and allow them to fester and rot out the economy in a prolonged sickness that may spread and gain momentum beyond attempts to assuage the problems.
Regarding the reader’s second question, “your” ability to pay “me” (or confer to me something of equal or greater value to cover your debt) is the asset NOT your actual debt to me. If you borrowed a million dollars from me and gave me a choice of receiving real estate “conservatively valued” at a million dollars or a “valid” promissory note signed by Warren Buffet, you bet I would consider both and extend the loan to you on either account. Both have substantial backing, not simply promises, but actual assets that have sound, plausible present and future value. Now if you gave me the choice of real estate whose value was inflated to three times what a rental market could support by an appraiser you hired, and/or if you gave me a promissory note signed by Jeffrey Skilling of Enron fame, I’d tell you to take a walk.
The key phrases uttered by the reader were “conservatively valued” and “valid”. Both indicate that the collateral provided to me for my loan are “real” and not simply contrived. Neither value is inflated, and both conform to tried-and-true market fundamentals. If the money I lent to you was counterfeit, or the “asset” you offered as collateral was contrived, that would corrupt the system of borrowing and lending. It would destroy trust and reward deception. In a word, it would show, both in the positive and negative case, that sound markets runs on INTEGRITY. The reader assumes this integrity in his/her question. Evidence suggests that the present system lacks integrity.
Integrity is the basis of all sound valuation of currency and assets. Warren Buffett has made a career, many billions of dollars, and great returns for his investors by researching and rewarding integrity—companies who are productive, follow good business practices, offer something of real value, and address real needs for customers. His good reputation has been built on his integrity, his performance, and his no-BS analysis of the potential of companies. Moody’s and Standard and Poor’s, in contrast, have wasted whatever reputation they had by rating junk as AAA, something that could have been revealed simply by investigating what real assets these ratings were based upon. (Rule: if you can’t explain to me the assets, then they are crap.)
Other essential economic “system” assets deriving from integrity include sound regulation, enforcement of laws and contracts and punishment of violators, tax incentives for pro-social, responsible financial behavior, an effective judicial, legislative, and executive government which guarantees the rule of law, a functioning democracy, a large and healthy middle class, an attitude and practice of care for each other. All of these system assets have taken a beating in the U.S. from Ronald Reagan’s presidential term onward (including Bill Clinton’s, frankly). Cowboy investing has been rewarded. The rule of law has been deemed “quaint” even in areas like the torture of prisoners. Regulatory agencies were staffed by industry lobbyists. Even a fundamentalist Christian notion has taken hold that you are spiritually favored if you are rich.
In each of these a “prosperity gospel” has emerged that subverts sound notions of value: “By virtue of having lots of money by whatever means, you are by nature upright, good, and just,” rather than “By your virtue, intelligence, ingenuity, and integrity you develop sound practices, products, and plans, that generate well-earned money.” In this sense, though I am a committed progressive socially and politically, I honor and agree with a traditional foundation and understanding of economic value. Perhaps it was my days growing up on a farm requiring productivity, hard work, and knowing BS when you stepped in it.
If a whole economic system loses its integrity, the phrase “buyer beware” loses its meaning. If my pension managers bought junk they were assured was secure investment by supposedly reputable experts, who do I trust now?
We need to construct an economic system, which puts integrity into the driver’s seat. This will mean more than criminal prosecutions, as necessary as those may be. This will mean identifying and rooting out the rot in the system that rewards irresponsibility. This will mean admitting the ways in which we have all aided and abetted this theft and corruption of value. This will mean we acknowledge and support examples of economic exchange that have retained integrity and good sense.
Proposition one: I think it is high time we rigorously re-visit the notion of public charters for corporations. If corporations are chartered by the public, then they need to be both answerable to and regulated by that public. There should be no unregulated, quasi-regulated, or self-regulated publicly chartered companies. I don’t have a problem with privately chartered companies. If a hedge fund or private equity firm wants to take private funds (and that means only personal private funds, no public pension fund money, for instance), then they should be allowed to do so with no guarantee from the public or for their investors. They gain, they gain; they lose, they lose. If fraud happens, the investors can sue and/or press criminal charges. Any public business done by an unchartered company must be audited to ensure real assets back that business and guarantee primary standing for repayment in any downturn.
Proposition two: We should revisit the public/private dynamic regarding distribution of risk. Current laws and practices seem to favor a system that privatizes benefits and publicizes liability. Presently any person can set up an unregulated, dummy company (i.e. a mortgage or brokerage firm), use it to essentially fence financial goods (i.e. bad loans or CDS’s) and then sell them off. This “any person” can also skim off huge fees and salaries, and just walking away when the company goes bankrupt without any consequence—no injury to personal credit score, no requirement to give back ill-gotten wealth, etc. If there were a tax on these free-wheeling deals, and if one’s private credit score and net worth could be at least somewhat affected by one’s financial decisions as leader or manager in decisions that have public consequence and from which there was private benefit, then one could conceive that some of these excesses might be mitigated.
Proposition three: Corporations should not be considered persons and should not have the attendant rights of citizens. This was based on court decision at a time in the country’s history when corporate robber barons basically ran the government. It was a nonsensical decision, allowing for a raft of abuses, and should be vacated.
Proposition four: Bankruptcy laws should be restructured so that citizens who legitimately fail on the private level can get back on their feet. Two-thirds of personal bankruptcies result from divorce, job loss, or failure of health. Well-considered attempts to start a business, for instance, aided by scrupulously examined lending, and personal investment should be encouraged and supported toward success, through training, tax incentives, etc. If the business goes under, the hit one takes should not swallow one’s ability to simply live and provide for family.
Proposition five: The “good life” should not be about retiring early with wealth gained from speculative investing, but rather investing time, talent, treasure, and trust in communities of care and exchange with “returns” in higher quality living and respected, honored retirement as an elder within the community. “Get rich quick” mentalities should be called out as simply an effort to elope with other people’s money and leave them holding the bag.
Proposition six: Quality should be emphasized and rewarded over quantity/volume. Currently the “maximum profit” meme that drives big business provides incentives to cut corners and think short term. It contributes to the practice of creating phantom assets, so one can appear to be increasing market share. It contributes to corporate heads pulling gimmicks like buying back their own stock to inflate prices. It reinforces the generation of transactions, just for the sake of transaction, so one can deduct fees. Quantity without any regard to quality or long-term impact is another way to say “mindless business, heedless of consequence.” We need better quality (again, see Warren Buffett on this) focused on long-term profit and viability and stability. This is sort of the “seventh generation” view of Native Americans except applied to the economy.
Proposition seven: Use microfinance as a model for good business. After the tsunami hit Southeast Asia in 2004, it was microfinance institutions that continued to get steady repayments and which remained viable and even profitable. Microfinance, small loans to the working poor largely in developing countries, demonstrates not only the opening of the world market to a new class of entrepreneurs and a way to lift many millions of people out of poverty, it also serves as a template for good financial practice to so-called developed countries: diversification (many loans are given to many different people), low default (2% or less, usually), high stakeholdership (lendees need the credit to run their lives and business; it is not expendable), cooperation (group lending allows lendees to cover each other and lower default rates), pro-social lending practices (focus not just on absentee exploiters trying to ring every penny out of a business, but on clients and owners themselves providing real services and goods to maintain a modest income which is invested in family and community).
Here is the four-part series:
(copyright 2008 Zeus Yiamouyiannis, Ph.D.)
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