how $200 billion of bad mortgages could have created such a falling-pyramid effect

Foreign Exchange Currency Outlook : It’s conceivable that if oil were still falling and if gold were not rallying so strongly that the US dollar could survive this latest “fix” for the financial sector mess. But oil is rising and gold is rallying, and the perception is spreading that we are probably only half-way through the plans that will be needed, and haven’t even started the economic consequences of the failure. Many other shoes are out there to be dropped, especially now that the Feds have their wallet open for the picking.

We wrote last week that we are happy to see a vigorous initiative from the US government and a comprehensive one instead of the case-by-case situation we have had since Bear Stearns. But don’t be misled—nobody in his right mind can be “happy” about this outcome.

It’s awful in just about every way imaginable.

It favors the institutions that created this mess in the first place (those still standing, that is) and nowhere is there a single provision for the ordinary Joe, whether as mortagee or investor. It may just manage to resolve the liquidity crisis, but it doesn’t solve the problem of under-capitalization of the banks, which still need to raise more funds. With the Middle East and Asian investors already licking their wounds from having jumped in with both feet at the beginning of this crisis, where is the capital going to come from? The need for US government’s action has already demonstrated that the private sector isn’t willing to cough up fresh capital.

This means more bank failures, more mergers, and a giant contraction of credit everywhere in the world, not just the US.

We are having a hard time understanding how $200 billion of bad mortgages could have created such a falling-pyramid effect. It’s true that banks and brokers tried to make a silk purse out of a sow’s ear, with the aid of the ratings agencies, believing modern portfolio theory was the alchemist’s stone, but still, how did something so small become so big? The answer is that it didn’t. The $200 billion in liar’s loan mortgages were not magically, virally multiplied to infect every CDO and other alphabet-soup asset class to the extent of $700 billion or $1.5 trillion or any other number. In fact, because of various accounting and mark-to-model rules, the ultimate owners of a lot of this paper are going to make a tidy profit of it. It’s not bad, just not trusted. (That doesn‘t mean the US taxpayer will get the profit. The agencies tasked with buying and then selling the paper will manage to siphon off the gains to the insiders and interested parties).

The key is “not trusted.” Trust is everything. It’s everything in romance, commerce and finance. In a nutshell, the banks don’t trust one another today, perhaps projecting their own bad actions on others, and the old banker’s principle of “know your customer” is out the window. You can’t legislate trust. Critics are moaning about how the fat cats will only get fatter from the bailout while the little guy gets hosed, but anyone with a 401k plan is not complaining too loudly and in any case, the immediate losses or escape from losses is not the main event. The main event is the loss of trust in society at large, not just the financial sector. The social contract was broken, and it was broken in Washington. Raw naked capitalism may be good at setting optimal prices, but that’s about it. To say total lack of regulation is a necessary corollary of capitalism is to have read no economic history and to misread human nature.

And gosh, isn’t Washington where the rescue is coming from? If a poll were taken today asking the public whether it trusts Wall Street or Washington to “do the right thing,” the answer would be an overwhelming “no.” This is not a political statement (please don’t write) but rather an economic observation. Trust is essential to economic activity. You need trust to get new companies funded and trade conducted (think of letters of credit, not to mention open account trade). You need trust to let the gas tank in your car go down to one-quarter and not be filling it up every day just to be sure you can get it. You need trust to have a successful economy.

Observers in less developed countries note that the key reason they do not get growth is that they have no banking sector or capital markets.

Well, why not?

In large part because Tribe A doesn’t trust Tribe B.

We can see nothing that Washington or Wall Street can do this week to reverse the situation. In fact, more bad news is surely on the plate. The only thing that can save the US Dollar Outlook now is a Shock from elsewhere, like Germany. (Japan seems safe for the moment.) Aside from the mysterious yen, the US dollar is toast. This doesn’t mean take a short position and walk away. Prices never move in a straight line and after the giant move Friday, we must expect a corrective move on profit-taking and re-consideration…. But let’s start looking at foreign exchange charts on a weekly basis. Aside from the nice summer rally, we are back to the multi-year euro uptrend.

Bye for now

Barbara Rockefeller

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