Credit Risk: Capitalism's Big Problem

It is amazing to see the financials still hold up so well. Well, in a relative sense. With so much (overwhelming) negative talk from Washington, it is amazing to think that we even have a market place.  But the government is taking decisive action in order to restore the complex (broken) functions of the capital markets. Progress has been made as far as isolating and understanding the components (and processes) that have been so immensely destructive to capital expansion and preservation.

The massive global government bailouts aim to support the financial system by guaranteeing (defaulting) debt in hopes of (eventually) re-introducing (worthy) credit elements to the capital markets. These guarantees will eventually have to come face to face with much weaker economic output, and/or a soft labor market. Or, they will pose challenges to concerns regarding the U.S. as a great nation of debt. So the question remains: Can our government convince its creditors (and world markets, alike) that U.S. credit (at its origination) will once again return to normalcy.

The recent housing boom/collapse is an exemplary illustration of the massive damages that a credit securitization world can inflict upon capital markets. For a while Wall Street was able to deliver financial instruments and derivatives tied to the securitization of credit. The (undeniably visible) risk elements associated with these credit instruments were quantifiable and hedged through counterparty credit-risk swaps. And more importantly, there was a hot and bubbly market on these risk instruments that in turn enabled the assets, at which securitized instruments were valued, to rise. And rise, they did.

Wall Street (at some point in the not so distant past) was able to convince market players that debt can be securitized, no matter what the risks were. Wall Street also went along, thinking that its capital is always secured. Maybe that was partially due to the fact that the financials enjoyed the benefits of being recipient to unlimited amounts of capital. But that shouldn't be of much concern to the financials considering that they never really held on to capital. Quarter after quarter, year after year, their accounting (and other practices) solidified their undisputed role as the sole contributor (and backbone) of and to the capital markets.

So should there be any further concerns regarding equitability or solvency in light of bubbly hot securitized credit elements valued as balance sheets items? Well to answer that, consider that these asset elements are still very much tied to the capital available in the market place. Therefore, in the absence of much needed counterparty risk players, the potential of further (drastic) revaluation of these assets (on the books of the financials) still exists. This is a scenario that has been more or less sidestepped by unrelenting waves of (new) government policies and interventions.

There is, however, one instance where capital markets can experience (or at least watch) the creation of a (mock?) credit securitization world in the absence of risk players. As we peek inside the dark chambers of the Lehman liquidation courts, we watch a seamless unwinding of (similar) credit-risk elements. Maybe the counterparties/creditors are finding themselves a bit startled by the prospects of removing (reversing) substantial risk components from the capital markets via the liquidation of these assets. And while anxious creditors and their clearinghouses decide on terms of (unswapping?) future payments, the capital markets are left wondering if there ever was a capital world with credit risk. And if there wasn't, why were these instruments valued or secured in the first place.

So who were these Wall Street guys, then? Just a bunch of crazies? No. They were right about risk. But, apparently being right does not make things better. The business of debt has been around for ages. The problem is that the government will have a very difficult time trying to replace the same kind of risk support elements that have been (until recently) propping up debt/credit markets.

As difficult as this process will be, at least there is an ongoing perception (to supporters of capital markets) that (something as important as) our government cares about the damage to the system. And that damage is apparently still a great concern to players within the capital market arena where (now frozen) credit is expected to originate, yet again. The efficient markets (through their elimination game) have already signaled that they will take no risk when it comes to credit. Even at the cost of experiencing massive capital contractions. That is about the only clear message the markets are willing to send to anyone these days. Not a bad message, I think.

Disclosure: None. Short Financials from time to time.

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The Federal Reserve is Guilty of Helping Create the Global Financial Meltdown

Many investors and concerned citizens around the world are showing their outrage at what the Federal Reserve has done to the American economy with their easy money policies which caused the credit & real estate bubble and subsequent global financial meltdown.

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2008 Oct 15 08:01 AM