Swap? Or Swamp?

By SHLOMO MAITAL
Column from Issue 15, November 10, 2008 of The Jerusalem Report. To subscribe to The Jerusalem Report click here. No, it is not 1929. But for millions of people in Israel, America and all over the world, watching their savings and pensions evaporate daily, it feels like it. Bank Hapoalim, Israel's largest bank, is reported to have lost $109 million in investments with now-bankrupt Lehman Brothers, Bank Leumi some $90-$95m, while the Mivtachim pension fund, has $60m. at risk, and Clal Insurance, $60m. Even the Bank of Israel may have lost $4m. Despite these losses, Israeli banks appear solid, although Bank of Israel Governor Stanley Fischer and Finance Minister Ronnie Bar-On are discussing contingency bailout plans in case of emergency. The immediate problem is that Israelis are pulling their money out of pension funds, and thereby threatening their solvency. One plan suggested by the Bank of Israel is for the government to compensate these funds for losses, thus forestalling huge redemptions (withdrawals), a plan that would lead to large government budget deficits. As for the impact on the job market, Ofer Eini, chairman of the Histadrut umbrella labor union, is predicting that 10,000 public employees will be fired in 2009. The Manufacturers Association expects 30,000-40,000 more unemployed in industry, and the Chamber of Commerce predicts 60,000 additional lost jobs. Even if we ordinary working people can do little about it, can we at least understand why this enormous mess happened? Perhaps there is some small comfort in trying to penetrate what for many is a thick fog. Here are three true fables, each of which is much stranger than fiction. Together they help lift the fog and show how a handful of brilliant, creative people nearly destroyed the world's economy. 1. The Man Who Had to Clean Up His Own Mess Once there was a man called Hank, who headed America's most feared and respected investment bank, called Goldman, Sachs. His full name was Henry Paulson, Jr. One bright day, April 28, 2004, to be precise, he and his friends asked the U.S. Securities Exchange Commission (SEC) to change an existing law. The old law limited the amount of debt (and risk) the stock brokerage parts of investment banks could incur. Paulson wanted to use the money to make money by investing in an innovation called "credit default swaps" or CDSs (Confused already? See Fable 2, below). And indeed, the SEC approved the change in the law and exempted the brokerages, in only 55 minutes. They will regret it for 55 years. Paulsen and other investment banks (Bear, Stearns and Lehman Brothers) dashed headlong into CDSs. When the market collapsed, so did they. In 2006, Hank was appointed Secretary of the Treasury by President George Bush. When America's capital markets plunged into crisis, Bush asked Hank to clean up the mess. But alas, he was not quite as good at cleaning up as he was at messing up. Moral: Wise leaders avoid crises from which smart leaders can extricate themselves. 2. Swap? Or Swamp? Once there was a great bank named J.P. Morgan, named after its founder, financier John Pierpont Morgan. In 1994, J.P. Morgan gave a small group of young MIT graduates in financial engineering an assignment. We lend money, the bank said. The law makes us keep cash reserves to back those loans. But we want to use those reserves to lend more money. Find a way. Why not insure the loans, said the young geniuses, so there is no risk? Then, J.P. Morgan need not hold reserves. We will call these insurance contracts "credit default insurance." For instance, the global insurance company American International Group (AIG) will insure default on mortgage-backed bonds, at a premium of 2 per cent a year. And J.P. Morgan will insure $10m. in bonds by paying AIG $200,000 every year. If the bonds become worthless when people default on their mortgages, AIG pays J.P. Morgan $10m. Wait, said the experts. Let's call them credit default swaps (CDS), because, if we call them "insurance," they will be subject to government regulation. According to the Commodity Futures Modernization Act (2000), "swaps" are specifically exempt from any government regulation. Wow, what a loophole! So yearly, the market for these CDSs doubled. It soon equaled some $60 trillion, larger than world's Gross Domestic Product. The CDS market became a great Las Vegas in the sky. Anyone who wished could place huge bets on whether companies might default. And better yet, they could help their bet along (thumbs on the roulette wheel) by selling company stock short, i.e. selling shares they did not have, to drive the stock down and push the company toward default or bankruptcy. Then, the perfect storm happened. One company after another went into default. AIG could not pay. It was as if everyone who held a life insurance policy died on the same day. The Wild West CDS unregulated market became, in revered investor Warren Buffett's words, "a financial weapon of mass destruction." One company after the other failed and, like dominoes, began to knock over other companies. The U.S. government had to bail them out. A credit default swap turned into a financial swamp. Moral: Government regulators put up walls for our safety but experts find ways to knock them down and we all lose as a result. 3. When Money Is the End and Not the Means, There Is No Happy End. Once there was an industry called financial services. It was a good little industry and it did good things for working people. It lent money to help their businesses make things, like houses, that made families happy, warm and secure. Gradually, a new idea emerged. Why not help people make money with money, instead of making money by making real stuff like houses, bread, shirts, cars and computers? So financial services companies helped people make money with money, by buying and selling pieces of paper. Then an even newer idea emerged. Why don't we, financial services companies (commercial banks, investment banks, hedge funds) make money for ourselves with money, instead of making money for other people? And so they did. In 2005 nearly 30 percent of all U.S. corporate profits came from financial services. Some nasty prophets warned that this bubble would burst some day, and that it would end badly. But the rulers told them to shut up. "We are getting rich and having fun," they said. The bubble began to burst in July 2007. The wreckage is still mounting. Moral: When you see people earning $100 m. bonuses from using money to make money, instead of real things, start worrying. Turn everything you can into cash, get out of debt - and fasten your seat belt. How will all this play out? During the week ending October 17, America's Dow-Jones 30-stock index swooped and dived like a roller coaster, rising and falling up to 7-10 percent daily, finally closing the week at 8,852 points, down 37 percent from its 52-week high. The global panic spread to Israel, too. The Tel Aviv stock exchange was mercifully closed a lot, owing to High Holidays and Sukkot. When it opened on Sunday Oct. 16, it rose sharply, though it has lost over a quarter of its value since topping 1,000 this year. The shekel-dollar exchange rate rose to over 3.70, apparently as investors bought dollars to pay debts abroad. The festival of Sukkot, which has just ended, provides us with another lesson. During Sukkot, for a full week we live in temporary huts to recall those the Israelites built in the desert. This year, we also recalled that despite our technology, brains and supposed savvy, millions of people are losing their homes to foreclosure. In Israel, 2,000 families a year are evicted for non-payment of mortgages. In the end, it is very small comfort indeed to look back and understand how and why we got into this mess. It would be far better if we could see through the fog how and when Israel and the world will emerge from it. But that fog is still as thick as ever. • The writer is Academic Director of the Technion Institute of Management, Tel Aviv. • Finance Minister Ronnie Bar-On gave an informal pledge in mid-October to bail out depositors should any Israeli bank fail, stating that "the government will take care of the financial system out of concern for the public and its savings. For the past 60 years, depositors have not been harmed, and they will not be harmed now." There is no official deposit insurance in Israel. Bar-On further stated that intervention in the financial markets was an option that was not being ruled out. • In an early sign that an anticipated worldwide recession will lead to reduced consumer spending in Israel, forecasters predict that at most only 180,000 new motor cars will be purchased next year, compared to 200,000 in 2008, a drop of 10%. Car importers have begun reducing orders. • Inflation remained unchanged in September, surprising forecasters and leading to speculation that the Bank of Israel will reduce its interest rate, currently at 3.75%. Increased housing, food and health costs in September were offset by drops in transportation, apparel and communications. • The shekel has been slowly but steadily losing ground to the dollar, dropping 16% since July, and the exchange rate has surged beyond 3.70 shekels to the dollar. Analysts ascribe the shekel's weakening to a reduced flow of foreign currency entering the country, along with the Bank of Israel's regular purchase of $100 million per day towards its goal of increasing foreign reserves by $10 billion. • The world financial crisis has led to an "upsurge" in anti-Semitic expressions on the Internet, according to the Anti-Defamation League. On October 6, a Hamas spokesman in the Gaza Strip blamed the crisis on "a bad banking system put into place and controlled by the Jewish lobby." Column from Issue 15, November 10, 2008 of The Jerusalem Report. To subscribe to The Jerusalem Report click here.