Why Ask Why?

I sometimes wonder why the Fed and Treasury are doing such stupid things. Today I have eight hundred billion more reasons to ask why. Yet, in the immortal words of a famous man, "stupid is as stupid does." So I count the days - 56 - until stupid is is stupid gone.

So what is wrong with the $800 billion plan announced today to buy credit card, student loan and other consumer debt from banks to free up more lending? It would take me less time to say what is right with it, which nothing, zip, nada, the big goose egg, but I like to rant and rant I will.

I have mentioned before that the U.S. consumer is already drowning in debt. We are tapped out. Our consumer debt in relation to GDP is at record levels. We have to revert to the mean and spending $800 billion to actively try to stop that from happening is a royally bad idea. Consumers need to save and pay off debt, not incur new debt.

Now I am not too worried about the $800 billion working as intended. Consumers are worried about jobs, about heating bills, about putting food on the table. They are hopefully not stupid enough to add on new debt unless truly desperate. And, for that matter, the banks are not likely to let them. Yes, we can take $800 billion of consumer debt off the bank balance sheets but the banks are not likely to turn around and lend that money to consumers again. They know consumers are on the edge. They are tightening credit standards (which we should applaud) and raising rates (not so much applause here) and they are not about to revert any time soon to throwing money at any body that can fog a mirror. That's what got us in this mess.

I suspect the Fed and Treasury know this. I truly believe they have labeled this as a package to help the consumer, the guy on the street, with no real intention of doing so. This is just a disguised way of getting more money to the banks to help them without all the taxpayers barking about the Fed and Treasury not caring about main street. Another bank bailout cleverly hidden as a consumer bailout. Perhaps these guys are not so stupid after all . . .. Nah, I take that back, as they are the ones that let us get into this mess.

Far East Falling

Different day, same story. Asian stocks down. Toyota has lost its AAA rating. Rio Tinto deal is off. Just not much good news.

http://www.bloomberg.com/apps/news?pid=20601087&sid=a8LwbsOVLKyw&refer=home

http://www.bloomberg.com/apps/news?pid=20601087&sid=anFNosF2SNkQ&refer=home

CDS

I am not talking CDs, the music format. I am talking credit default swaps. These are a problem, a major problem, in the current recession and no one yet knows exactly what to do about them. Basically, they are a form of insurance against a credit default event. They have traditionally been individually negotiated, OTC, which means there is little in the way of reliable data on what is out there or the terms of the deals. It is a major big black hole.

There is talk about putting them on an exchange, which will help to avoid them being a problem prospectively, but you still have perhaps over $50 trillion in notional value out there not on an exchange. The problem is that they act like insurance for debt but you do not need what they call in insurance parlance - an insurable interest. It is like being free to take out a fire insurance policy on you neighbor's house. Let's say you paid a visit to your neighbor and saw a lot of frayed electric wires, dozens of appliances plugged into the same outlet and grandma sleeping on the couch with a lit cig still in her tobacco stained fingers. You go out and buy a policy to insure the house against fire and you get it cheap. Then you tell all the other neighbors in the neighborhood to do the same. Soon, the $250,000 house next door has a couple of million dollars worth of insurance on it and if it burns down, the insurers pay a couple of million, as opposed to just the value of the house that burned. It acts a bit like insurance but lacks all the underwriting criteria of any good insurer. So, what to do?

I don't have an easy answer here and no one seems to have one. Going forward, those issuing CDS protection - if anyone does - should probably require that the company buying the protection actually have a risk to protect, i.e. has the loan or bond they can surrender in a default event, i.e. has an insurable interest. That would be a constructive prospective change, but it does not change the current situation.

Let's discuss the current situation a bit so we are on the same page. The AIG bailout (nationalization) was a result of CDS exposure. AIG issued hundreds of billions of CDS contracts to banks in the EU. In the EU, the banks were allowed to use this "insurance" to shore up their capital to debt ratios, which allowed them to take on more debt. Take away this hundreds of billions of (shadow) capital with an AIG bankruptcy and you have major bank issues (beyond the existing major issues) in the EU. So the government caves and does a bailout of AIG. Moreover, a credit downgrade of the party issuing the CDS can lead to collateral posting requirements, which was what started AIG's problems. This is just one case example.

Every potential financial or corporate default now requires the Fed or Treasury or, hopefully, Congress to look at the CDS knock-on effect. The car industry reportedly has over a trillion in CDS protection that could be triggered by a default event, which I am sure (hope) is being considered by Congress. It is a serious issue and it complicates greatly anything the government would like or consider doing.

It is undoubtedly one reason that the Fed and Treasury have to date chosen the path of cash infusions and buying corporate toxic debt over taking down companies and getting on with it. Cash infusions will not trigger defaults under CDS contracts, whereas taking down the companies certainly will. We learned from Lehman that the knock-on effects can be worse than the immediate loss. Perhaps, just perhaps, I have been a bit too tough on Ben and Henry, but they did allow us to get into this mess, so nah, I still say it is time for stupid to go. Nonetheless, some of my criticism has ignored the CDS knock-on effect, so I need to go take a branch and whip my own back for my failings.

Bonus points here. I started this by talking about CDs. Can you name, without looking it up, the first music CD and/or its artist? Hint, he is from New Jersey. Extra bonus points if you can name the year. I will be checking the comments and will buy a drink for the first correct answer, assuming I know who gave me the answer.

Update: I stand corrected. ABBA did the first CD 26 years ago and ABBA is decidedly not from New Jersey. I heard on the radio that it was Bruce Springsteen that did the first CD. Last time I believe what they say on radio. So if anonymous becomes less anonymous at some point, I need to buy him or her a drink.