National Commentary

Nicholas F. Benton: How Bad Will The Crash Be?




As Congress becomes swiftly distracted and preoccupied with rearranging the deck chairs on the $700 billion Wall Street bailout package, the stubborn if overlooked gigantic elephant sitting in one of them ain’t budging.

He comes in the form of two interrelated questions that no one has answered: How big is the problem this extraordinary move is supposed to fix, and will this fix it?

Without answers to these questions, Congress runs the high risk of pouring $700 billion in good money after much, much more bad.

This is just another case of Congress being given the bum’s rush in hopes of a short term solution to what could be a problem with a magnitude far greater than this move can correct.

In fact, the unwillingness of Treasury Secretary Henry Paulson and Federal Reserve Chair Ben Bernanke, in all their public testimony, to be specific about the scale of the problem is a tip-off that they know it is way bigger than they are willing to reveal. It looks like Congress has bought into the cover-up, as well.

After all, their main objective is to avoid panic, while buying time. But is time worth $700 billion? All the taxpayer billions going to the so-called economic stimulus and Bear Stearns rescue to date has bought us only a few months.

The real news here is the hidden true scale of the problem.

There are only clues, so far, to its real magnitude. Consider the report by Julie Satow, writing in the New York Sun last week, about the exemptions extended by the U.S. Securities and Exchange Commission (SEC) in 2004 to five investment banking firms – all five of which have, or nearly have, collapsed.

The exception allowed these institutions – Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley – to burst the established SEC limits on how far it could go to lever a dollar.

The original SEC “debt-to-net capital” ratio limit is 12-to-1. That means for every dollar a bank takes in, it can invest, or incur debt, on the value of that dollar up to $12. That kind of leveraging works as long as values continue to rise, overall, while the financial system remains stable. A sudden panic, or a run to recover values, would expose all the value above the original dollar as pure paper, nothing more.

But that’s nothing. In the case of the SEC’s exemptions for the five above-named institutions, the leveraging limit was lifted. These banks were permitted to lever a dollar up to 30 or even 40 times its original value.

Now, a run on this house of cards would result in far greater, utter chaos than under terms of the original limit.

Such derivatives, mortgage-backed or not, are worthless the minute they’re called into question. The introduction of mass foreclosures on sub-prime mortgages triggered such questions.

So, how much real value is there between a “debt-to-net capital” lever of 40 and the original dollar it was based on?

I suspect the problem may have ballooned into hundreds of trillions of dollars, or more, both here and overseas. There have been, after all, in the almost-30-year Republican era of government deregulation, fewer and fewer limits or oversight on any of this.

The SEC so-called “net capital rule” limiting leveraging was written in 1975, and the idea of the 12-to-1 limit was that it was an absolute final limit, with institutions required to notify the SEC if they began approaching it, and to be forcibly stopped from trading if they exceeded it.

This was explained in the Sun article by Lee Pickard, a former SEC official who helped write the 1975 rule.

Current SEC Chair Chris Cox also let slip a clue to the magnitude of the problem in his comments to the Senate Banking Committee Tuesday. The extent of so-called “credit default swaps” has exploded to $58 trillion, he pointed out, a number that doubled just since 2006.

That was the only reference to a number nearly that high in the long two days of Congressional hearings and everything that Paulson and Bernanke said.

But that might have provided a fleeting window into the scale of the problem, certainly far greater than anyone will confess. Maybe everyone, in Congress, the administration and the media has agreed to cover this up to avoid panic. Instead, they will continue to fleece the public as long as they can, until they simply can’t do it any more.