Michael Lewis' The Big Short: Diabolical Castles in the Sky

Voiding Credit Default Swaps

In a book stuffed with scathing insights and blockbuster revelations, here's perhaps the biggest one (courtesy of Michael Lewis, writing in The Big Short):

The reason Citigroup (amongst others) is considered "Too Big Too Fail" isn't because it holds over $1 trillion in ordinary Americans' savings in their vaults.

It's not because inflicting billions of dollars of losses on Citigroup's creditors and shareholders would jeopardize other financial institutions -- and by extension, the U.S. financial system and economy (domestic and global).

And it's not even because the U.S. would then have to step up and make good on its guaranties of hundreds of billions of Citigroup's crappy mortgages and other collateral.

The Real Reason Citigroup is TBTF

No, the real reason that Citigroup is considered to be TBTF is that it may be the object of billions -- maybe trillions -- in Wall Street bets, just like the housing market was before:

Citigroup's failure . . . would trigger the payoff of a massive bet of unknown dimensions: from people who had sold credit default swaps on it to those who had bought them. This is yet another consequence of turning Wall Street partnerships into public corporations: It turns them into objects of speculation. It [is] no longer the social and economic relevance of a bank that renders it too big too fail, but the number of side bets that have been made upon it.

--Michael Lewis, The Big Short (p. 263)

What to Do

If Lewis is right -- and I have no reason to think he isn't -- the appropriate policy response couldn't be more obvious, or necessary.

Step One: the federal government should void all such credit default swaps, immediately.

Aren't those private contracts?

So what?

So were millions of contracts (presumably unwritten) making human beings owners of other human beings.

What do you think happened to all those contracts on January 2, 1863? (the day after The Emancipation Proclamation).

Step Two. Break up the monster banks that ushered in this toxic, dysfunctional and highly combustible state of affairs (cue Warren Buffett's line about "financial weapons of mass destruction").

Step Three. Hold their leaders accountable for their epic greed, negligence and corruption* (vs. giving them, collectively, ongoing billions in bonuses).

No, that hasn't happened yet.

In fact, it hasn't even started.

*Let the courts figure out the proper weighting; mine would be 50% greed, 30% corruption, 20% negligence.

Foreclosure "Wipeout's" Skew Housing Market Stat's

Where: 328 Burntside Drive, Golden Valley
What: 6 BR/5 BA; 4,407 FSF
How much: $369,900
Last sale: $899,000 (3/8/07)
Tax assessed value: $757,700

Just like not all stocks have dropped equally in a market now down more than 50%, not all homes or neighborhoods have suffered equally.

In fact, one of the reasons why the Twin Cities overall is down about 25% from the 2006 peak is that, while many homes have suffered relatively small price declines, others have been near wipe-outs.

Call them the "Citigroup's," "General Motors," and "Fannie Mae's" of the housing market.

The home pictured above, 328 Burntside, is a good example of the latter group.

Sold last for $899,000 in March, 2007, its new asking price of $369,900 reflects an almost 60% drop -- and less than half(!) the current tax assessed value. And that's just the asking price; the ultimate selling price could very well be lower (because I haven't been in, I'm not going to venture a guess).

Typical of the homes that have dropped the most, it's a foreclosure.

"Bank Runs," Circa 2009

No "Run on the Banks?" Define, "Run"

It's true that depositors haven't raced to withdraw their money from the nation's -- indeed, the world's -- largest, so-called "money-center" banks the last 18 months or so (basically, the ones considered "too-big-to-fail"). That's largely a credit, literally, to deposit insurance -- administered in the U.S. by the FDIC.

However, that doesn't mean there hasn't been a run . . . in the world's stock markets, by (and on) their shareholders.

In a devastating post, "Bank Market Caps, Then & Now," financial blog The Big Picture graphically depicts the collapse in value of the world's 18 largest banks since the second quarter of 2007. The list includes not only such storied names as Citigroup and Bank of America, but the "Citigroup's" and "Bank of America's" of the U.K, Germany, France, and Spain -- international entities such as HSBC, Santander, BNP Paribas, and Credit Suisse.

To date, the average drop in value exceeds 80%. And that excludes the fate that befell shareholders at AIG, Fannie Mae, Freddie Mac, Bear Stearns, Lehman Bros., etc., whose drops ranged from 95% to 99%-plus.

All this is against the backdrop of an historic stock market rout, and increasing speculation that the new Obama administration is close to embracing the "Swedish model," or temporary nationalization, to deal with the ongoing financial crisis.

Until now, the U.S. has been focused on preserving some semblance of private ownership through the various, tortured iterations of bank bailouts, debt guaranties, TARP, etc.

Judging by the leading banks' rapidly shriveling market cap's, the equity markets clearly anticipate full-blown nationalization . . . soon.

The Coming Bank Bailout Backlash

Boycott Citigroup . . .
Pay Higher Taxes?

How do ordinary citizens disgusted by serial government bailouts of Wall Street register their displeasure?

Assume that you are not prepared to join the ranks of the posse comitatus, and mail in your 1040 next April with just an expletive scrawled in crayon at the top, no payment enclosed.

Further assume that you do not have the ear of anyone in a position of authority, either on Wall Street or in Washington, and therefore are powerless to stop extremely good money -- trillions of money -- from being thrown after merely very good money.

Finally, assume that you have neither the inclination nor the aptitude (let alone the time!) to become a latter-day Howard Jarvis (of Proposition 11 fame in 1970's California); a Frank Capra-style Mr. Smith, bent on cleaning up a corrupt system; or even a Howard Beale ("Network"), decrying its ills.

What's left?

The one course of action remaining to the "little guy" would seem to be to vote with your consumerist feet. In other words: commit acts of financial civil disobedience.

Financial Civil Disobedience

Purely hypothetically, say the object of your displeasure is Citigroup. (Unfortunately, AIG has fewer retail lines of business.)

You could cut up your Citigroup credit card and replace it with one issued by another bank; withdraw your (diminishing) savings from Citigroup branches and open up an account across the street; and vow not to apply for a mortgage from Citigroup (not that you'd get one, anyways).

After all, it's supposedly a free country, and a free marketplace. What better way to punish an especially irresponsible financial scofflaw than to pull all of your business, modest as it may be?

Unfortunately, there are at least three problems with such an approach.

One. It might boomerang.

Imagine that such financial civil disobedience actually caught on, and Citigroup's business began to suffer as a result (the term's relative).

Citigroup would lose even more money, bringing it close to collapse (again). To prevent that, the government might very well feel compelled to inject yet more of your money into Citigroup to save it.

Perversely, the greater the public's resolve to kill Citigroup . . . the more expensive the government rescue.

"To Tell The Truth" -- Banking Version

Two. No good alternatives.

What if the bank across the street is just as bad? That is, what if every bank did what Citigroup did, and is now getting federal bailout money?

Imagine for a moment that you run a bank, and all your competitors who screwed up are getting cheap -- or free -- no-strings-attached, government money. Wouldn't you grab some, too, even if your bank was run conservatively (and profitably)?

Given that you compete with the "bailee-banks" for loans, deposits, etc., your competitive position would suffer if you didn't.

Now imagine that the government purposely obscured the distinction between "bad banks" and "good banks," by forcing the latter to accept bailout money. (Unfortunately, you don't need to imagine this -- it just happened.)

The result would be a surreal game of "To Tell the Truth," in which millions of ordinary consumers-cum contestants have to figure out which banks are genuinely virtuous, and which are impostors.

Three. Financial temptation/co-option, or, "cutting off your nose to spite your face."

The reason that Fannie Mae and Freddie Mac, so-called government sponsored entities ("GSE"s), had such spectacular access to cheap money was that its lenders believed -- correctly, it turned out -- that the federal government guaranteed their loans.

Now, the government is not only guaranteeing a big chunk of Citigroup's debt -- it's a shareholder! To protect its investment (and Citigroup's market share), the government logically should now make sure that Citigroup's rates on everything from mortgages to car loans are competitive. Perhaps too competitive.

Calling Howard Jarvis

If 30 year mortgages are available from Citigroup for 5%, and Hometown Bank for 5 1/2%, which are you going to choose? Ditto for CD's yielding 4% vs. only 3% at the competition. H-e-l-l-o . . . Citigroup!

These conundrums (and more) are exactly why government shouldn't decide which financial institutions should live and which should die, and why doing so leads to absurd and potentially disastrous outcomes.

In a market economy, the marketplace -- and the millions of consumers who comprise it -- make those decisions.

Sadly, the expression, "you can run, but you can't hide" now describes the futility of trying to shield your wallet -- and your descendants' -- from a federal government bent on ever-more expensive and wrongheaded bailouts.