We Don't Solve Problems Because We Don't Look At Them

The Wall Street Journal in an article on an upcoming Senate probe into bond-rating firms had what I think is a telling quote:

Sen. Carl Levin (D., Mich.), who heads the investigations subcommittee, has called attention to financial derivatives known as credit-default swaps, which he calls "one of the prime culprits responsible for this financial disaster." Investigators are expected to look into how those derivatives were marketed and used by banks.

Consider that language carefully for a second: one of the "prime culprits" for the current financial debacle is the category of financial derivatives called credit default swaps.

When disaster hits and we as a people look for answers, we tend to point to the simplest and most obvious causes we can cite. These, however, are not causes. They are simply mechanisms that allow individual and collective weaknesses of greed and lying to act with increased effect. Derivatives of any type are nothing more than a legal fiction, a business arrangement between two parties that may or may not be based on quicksand. It is the behavior and willingness to ignore sense on the parts of the people involved that is the problem. You might as well say that cars cause automobile accidents, not their drivers.

I've lately been working on some articles about how executives pull their companies out of difficult economic times and otherwise manage risk. According to the experts I asked, the biggest problem companies have is when top managers refuse to see reality. They pretend that the worst cannot happen. They create one excuse after another for why the company must operate as it does. When bad things happen, they look for people to blame and don't think about the further unintended consequences of their actions. On BNET, I recently covered how high tech lay-offs were generally bad management. That was nothing more than a specific instance of a more general case. The problem is bloated staffing for the business that is here. But who is responsible for that level of hiring? The executives who then lay off the employees with no control over how the business runs. It is those top managers who are responsible - and who execute the innocent.

That's a practical example of finding someone else to blame, and of not noticing the problem as it developed. How long has GM had to see and fix its problems? Instead, management blames the high cost of employees, not the lack of understanding customers and providing what they would want. Until managers overcome the baser parts of their human nature, or at least struggle with them a bit, nothing will change, none of us will learn lessons, and the same behaviors that got us into trouble will shortly restart and then continue as though nothing happened. What a pity.

The Disease That Was Subprime Lending

Those who think that the subprime mess was an unfortunate accident that could not be anticipated by management should read a BusinessWeek story called Sex, Lies, and Subprime Mortgages. Fraud and trading of sexual favors for mortagages that could be bundled into hot securities were supposedly common, and whistle blowers were shut down by managers who didn't want the good times to end. What went on was literally criminal, and I suspect that the major Wall Street institutions simply turned blind eyes to everything in their quest of deals that could yield profits and a quick exit before the players got caught. Unfortunately, the collective moral depravity set off a chain reaction that we will be facing for years. It does make me wonder what similar may have gone on in credit default swaps, credit card-based CDOs, and other such debacles.

Credit Card Derivatives: Facing Reality, One Step at a Time

The amount of single-minded focus that the media has placed on the mortgage market and the collateralized debt obligations surrounding it is nothing more than a fad. I don't mean that the problem is a fad - far from it. This is part of something bigger that is here to stay for many years. But the media pays attention like an industry with ADD. Journalists have grabbed on this because it was big and bright, essentially as it latches onto a story about a celebrity or the murder of a pretty coed.

But the financial crisis is much more than mortgage-based CDOs and the London inter-bank rates. According to whom you ask, the derivatives market has hit between 1 and 1.25 quadrillion dollars. Yes, a thousand trillions. That is so massively beyond the size of the 50 trillion GDP of the entire world as to be stunning and scary.

We've seen two shoes drop in mortgages and credit default swaps (which is continuing to evolve as more defaults happen and more institutions become liable for the "insurance" they offered). Chances are strong for future rounds of stock market plummets as companies continue to need cash to cover their positions and sell securities to get it.

The next one is likely credit card derivatives. As I've mentioned before, there's an entire bond market created in the bundling of credit card and auto loan debt. I have yet to find a good estimate of the total market size. But consider this: a large part of the quarterly $5.29 billion write-off that AIG took in the last quarter of 2007 was for credit card derivatives exposure, possibly through credit default swaps. And around the end of September, Citi said that it "faced up to $10 billion in credit losses, partly because of rising credit card defaults."

Subprime mortgages got into enormous trouble with, what, a ten percent default rate? Last quarter, U.S. banks charged off 5.47 percent of all credit card loans, or about $50 billion. That was up from 3.85 percent in 2007.

To be sure, credit cards don’t represent a huge portion of assets for most banks. For example, they comprise about 14 percent of all consumer loans and leases at Bank of America, the country’s largest credit card issuer. The main problem, Nishikawa said, is that “everyone is so weak after what happened with mortgages that another blow to a consumer product would be hard to handle.”

Consumer groups have long complained that credit card issuers push cards onto people who don’t need them or can’t afford them. They say rising credit card defaults —- just like mortgage defaults —- are largely the fault of banks who lent to risky borrowers.

Innovest estimates about 30 percent of Bank of America’s credit card loans are to subprime borrowers —- second only to the failed Washington Mutual Inc., which had almost half of its credit card loans held by subprime borrowers.

What that story doesn't say is that in the event of a mortgage default, the bank still owns the property -- probably not longer at the value the bank had assumed when writing the mortgage, but still something. Credit cards? Totally unsecured. And when auto loans go bad, the car has lost enormous value once driven off the lot.

Even if the credit card and auto CDOs are smaller than CDOs based at least in part on subprime mortgages, the impact they'll have has the potential to be far larger.