Sunday, December 28, 2008

Debt as an Asset

I did some reading up on the 2006 merger of Golden West Financial and Wachovia. Golden West Financials was a media darling that was giving to all of the politically correct causes. The two principles of Golden West were Herbert and Marion Sandler. According to Wikipedia and other sources, the Sandlers were in tight with and George Soros and very much dedicated to bringing a progressive regime to power in the US.

The Wikipedia page for George Soros credits Mr. Soros as the financier who broke the Bank of England in 1992.

At the time of the merger, Golden West had a loan portfolio of over a hundred billion in loans. Oddly, in the years after the merger, Wachovia found itself saddled with several billion in bad loans (mysteriously centered in the areas served by Golden West). Wachovia imploded. Wells Fargo picked up the pieces of Wachovia for less than the price of Golden West.

Wachovia is a politically incorrect bank with accounts from tobacco companies and tobacco workers. Wachovia's greatest crime against humanity came in the form of donations to the hated George W. Bush.

As Wachovia and Golden West were contributing to vocal groups on different sides of the political fence, I suspect that there will be some intriguing books written about the merger.

As the players involved with this story are rich, powerful and desirous of producing a history which paints them in a positive light. I suspect that the telling of the story itself will itself become a story as players seek to slander opponents and whitewash their activities.

It is a story that should be followed closely by historians and the public. The Charlotte Observer has an in depth article on the merger.

What struck me about the story is the overall absurdity of developing a debt portfolio as an asset. This system where banks hold billions of dollars in loans as an asset is guaranteed to lead to calamity as economic times change.

I know little about this merger beyond press releases and articles about the event. I bring up the case as a sensational intro to the topic on my mind which is the absurdity and danger of this system where banks hold, trade and leverage huge blocks of debt as assets.

Such a system is inherently instable, and is prone to manipulation. In reading about this case, I realized that it would be possible for a person (or foreign power) of malicious intent to create a debt bomb. Skipping from headlines to a thought experiment, I present an argument on how a group of mal intent could create a debt bomb:

A Debt Bomb

A bank can easily create a debt bomb simply by approving questionable loans, then lending customers in default the money to make their loan payments.

Throwing good money after bad is suicide for a person trying to create a solvent bank. In a world where financial institutions treat large blocks of loans as an asset, the growing pile of festering debt would look like a valuable investment.

Lending money to insolvent borrowers earns kudos in the progressive press. It increases the overall size of the loan portfolio and it decreases, for the time being, loan defaults.

When the debt bomb is ripe, the group that created the bomb need simply sell the bank.

In this system that treats debt as an asset, the people who created the debt bomb would make out handsomely. They can make even more money if they begin aggressively shorting the party that acquired the bomb.

I should note that while it is possible for a person to maliciously create a debt bomb, it is also possible for a person to do so accidentally. They could approve bad loans out of the goodness of their heart and throw good money after bad in a desperate attempt to save face, then sell the bank to an unwitting party.


On watching the financial collapse of 2008, I am left with the observation that this thing where financial institutions hold and leverage massive amounts of debt is inherently instable. While I think our financial collapse occurred simply because financiers saw massive debt loads as good thing, exploring the question (Was any of this intentional?) is a valuable exercise. When one creates an instable structure, it is possible for a person to push it over.

The ability of a malicious actor to create debt bomb simply highlights the instability of financial system based on massive debt loads. The simple conclusion is that we should replace the financing mechanisms that create massive debt loads with financial systems based on a more direct and stable relation with the underlying equity that serves as the collateral for the debt.


Scott Hinrichs said...

Our finance industry turned liabilities into assets and assets into liabilities. If any other sector had tried this they would have been stopped dead in their tracks. Only the right kind of connections allowed this system to proliferate. But the piped had to be paid. That should have been obvious from the start.

y-intercept said...

The troubles within the banking system are only obvious in hindsight (or to insiders). The reason a debt bomb is so dangerous is because it is impossible to distinguish a debt bomb from a pile of legitimate mortgages.

The real value of a mortgage portfolio is the equity behind the portfolio. A debt bomb simply is a pile of paper that looks the same as a solid mortgage portfolio, but has no solid backing.

The fact that bank's accounts are reverse of the public's at large is to be expected. In double entry accounting every debit on the ledger is a credit in another ledger.

My thoughts are that, in an ideal world, the assets held in banks should try to mirror the real economy. What seems to have happened is that the financial sector invented all sorts of tools to protect themselves from risk, and they created a system that no long reflected the real economy and became self destructive.