Monday, October 13, 2008

The twilight of John McCain

The fact that Bill Kristol’s advice to John McCain is being taken seriously is itself nothing short of comical.

When McCain secured the Republican nomination in the spring, many patriotic Americans sighed felt a sense of relief. While John McCain could not be counted on the bring balance to a Supreme Court heavily weighted with Republican nominees, he was a men of integrity and credibility as a national politician who would stand against the most partisan forces, and act in the broad national interest.

That is to say, he would be a departure from the last eight years. Eight years that have greatly damaged our nation. Economically we are deep in debt and our financial system is teetering on the brink of collapse. Militarily we are overstretched and hamstrung in our ability to respond to new threats. Internationally, we have lost much of our credibility in the world and our capacity to lead—at a time when centered leadership is badly needed and hard to find. And morally, our embrace of torture as a tool of national policy has undermined the national character that has been part of our strength in the world.

But it was John McCain himself, not some Washington cabal as Kristol suggests, who brought McCain’s candidacy to its current state of affairs. Despite his attack ads accusing Barack Obama of Unbridled Ambition, it is John McCain who cast his faith in the American people to the wind, and tried to remake himself in the mold of George W. Bush.

It is John McCain who cast aside his principled opposition to torture as a tool of public policy in an effort to reach out to the Party base.

It is John McCain who cast aside his opposition to tax cuts that benefited the rich and drained the national treasury in a time of war, to embrace new and deeper tax cuts in an effort to gain the affection of the Party base.

It was John McCain who reached out to evangelical leaders—not just evangelical voters—and muted his opposition to their contribution to the destruction of civil discourse in our society and in our politics.

It is John McCain who cast aside his long-time political advisors––who had help craft the McCain Brand that stood for integrity and straight talk that was critical to his success as a national candidate—and hired in their place his current team of Bush era and Rove-trained advisors, who have cut him off from the press and done much to destroy the essential character that—we thought—set John McCain apart from other candidates.

And finally, it is John McCain who failed to stand up to his new campaign team and select the centrist vice-presidential candidate of his choosing—Joe Lieberman or Tom Ridge—and elevated in their stead a candidate who lacked any of the core attributes of experience and wisdom that he valued above all else.

Above all else but winning, it seemed.

John McCain is a man driven by his political instincts, and by a sense of decency in the public square. But he has proven in this campaign—despite the profound irony of the Country First slogan—that this time around, he was going to do what it takes to win.

Many supporters looked at the Palin nomination as the final moment when McCain himself could pivot toward the center. Palin would be sent out to placate the base, while McCain would return to the ground on which he is most comfortable. Openness. Candor. The politics of the center over the braying of the extremes.

But this is not the choice that John McCain made. Not this time. Instead, McCain lost his bearings. Perhaps it the roar of the supporters who turned out to see Sarah Palin. Perhaps it was the anger at being upstaged by young, stoic and unflappable Obama. But rather than veering to the center, McCain embraced a new populism and raged against the machine.

His campaign strategy changed week to week. Day to day. His rhetoric has become shrill and pandering, disconnected to any core message or program.

I’ll get Osama bin Laden… I know how to do it.

I will lower gasoline prices.

I know how to lower food prices.

I can fix this financial crisis. I know how to do it.

I know how to fix Wall Street.

This race is about Main Street vs. Wall Street.

There have been hints of old McCain from time to time, as he has shown discomfort with the quality of the campaign rhetoric, and has balked at elements of his newfound strategy. But as much as Bill Kristol would like to deflect the responsibility from his candidate, the failure of the McCain campaign rests firmly with the candidate.

Now, as the Barack Obama as un-American Terrorist Sympathizer strategy has failed, the McCain campaign is making a belated effort to return to the McCain Brand: John McCain as courageous and measured centrist, who will bring balance to the Democratic majorities in Congress and steady leadership to a the nation in its hour of need. Finally, John McCain will reach out to the large political center, where once he found succor and support, and which in the sunset of the Bush era has once again emerged as the key to electoral success.

But it is too late for that. John McCain chose personal ambition over principle and trust in the American people. He took his beloved brand and tossed it to the gutter. His integrity and credibility—all one has in politics—have been destroyed. Instead of centered and wise, he has proven to be fickle and petulant and impetuous.

We will never know which is the real John McCain. But he alone is responsible for where he finds himself today. All he has left is to consider his legacy.

Saturday, October 11, 2008

Credit default swaps and the crisis of confidence

Five years ago, billionaire investor and American icon Warren Buffett suggested that financial derivative products were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Five years ago, few people were paying attention, and even fewer understood what he meant. Even today, as the term credit default swap (CDS) is migrating from the financial cable networks to CNN, MSNBC and the mainstream media, the critical role of these arcane derivative products in the undoing of the financial markets is not well understood.

The term derivative product is a general term for a contractual agreement between two parties whereby the counterparties exchange––or swap—payments based some underlying benchmarks, applied against a contract notional amount.

The most widely used derivatives are interest rate swaps, which account for more than 75% of the global $530 trillion derivatives market, compared to the 10% that comprise credit default swaps. In its most basic structure, an interest rate swap provides that Party A will pay Party B an amount equal to a fixed interest rate times the contract notional amount, and receive an amount equal to a variable interest rate times that same amount. Many businesses that borrow money from commercial banks at the variable prime rate use interest rate swaps to fix their annual cost of borrowing and avoid interest rate risk.

In contrast, credit default swaps are financial products that allows for the transfer of the default risk related to owning a corporate bond from one party to another. For example, imagine that before the current market meltdown, CalPERS––the large California public pension fund––owned $100 million of IBM bonds, but wanted to insure against the risk of a bond default. CalPERS could accomplish this by negotiating a $100 million, five-year credit default swap with AIG––which up until a month ago was a global, triple-A rated financial institution.

Under the terms of the swap, CalPERS would make an annual swap payment to AIG equal to––for example––1% of the $100 million swap notional amount. In return, AIG would pay CalPERS the amount of any losses that CalPERS realized in the event of a default by IBM. For example, if IBM went bankrupt during the contract period, and bondholders were only repaid twenty cents on the dollar, AIG would pay CalPERS $80 million. And to secure AIG’s obligations, the swap contract would require that if AIG were downgraded from triple-A level to below double-A, AIG would post collateral equal to 20% of the notional amount of the swap contract, or $20 million.

Then came the AIG collapse.

While the general view of the AIG collapse is that it was a function of collapse of the mortgage-backed securities market, in truth it was a direct consequence of AIG’s CDS exposure. Four weeks ago, AIG was a triple-A rated insurance company. Today, it is being dismantled. If AIG had large investment losses in mortgage-backed securities, but no CDS exposure, AIG would still be in business today.

In simple terms, AIG’s collapse came as a result of the following sequence of events:

1. In the wake of the decline in real estate prices, the market value of mortgage-backed securities declined.
2. Under accounting rules that were established after the downfall of Enron––implemented to require rapid disclosure of investment losses––AIG marked down the value of its mortgage-backed securities portfolio.
3. These investment losses resulted in a reduction of AIG’s capital reserves––the core measure of its financial strength.
4. As a result of the decline in AIG’s capital reserves, Standard & Poor’s and Moody’s Investors Service downgraded AIG from triple-A to the single-A level.
5. These rating downgrades to the single-A level triggered collateralization requirements under AIG’s CDS contracts.
6. The amount of the collateral that AIG had to produce under its estimated $450 billion of CDS contracts approximated $100 billion.

And AIG did not have $100 billion in available funds.

This was the explosive event that destroyed AIG. It was not the market losses on its investments in mortgage-backed securities. It was not payouts on CDS contracts where default events had actually occurred. It was a collateral call.

The AIG story illustrates two important aspects of the current crisis of confidence within the financial markets. First, AIG’s collapse in a matter of days resulted from the collateral requirements under the terms of contracts that are opaque, unregulated and difficult to track on corporate financial statements. As Buffett and others have suggested, the risk in the AIG derivatives portfolio was explosive—and ignored until it was too late.

Second, the AIG story illustrates how a collateral call under a CDS contract can have the effect of positioning the CDS counterparty—the institution on the other side that claims rights to the collateral—senior to the AIG policy holders and bondholders.

As US and European central bankers are working to define a collective strategy to rebuild confidence in the financial system and to reinvigorate inter-bank lending, the destabilizing impact of the CDS market remains one of the central problems to be addressed.

The problem seems straightforward. After the AIG collapse, how does one institution trust its exposure to another? If CitiBank seeks a loan from JPMorgan, how does JPMorgan know whether some event might be looming that will result in a collateral call under some of the myriad derivatives contracts to which CitiBank is a party, a collateral call that in a matter of hours could bring Citibank to its knees.

The US has now signed on to the British plan to make direct investments in banks, but simply injecting liquidity and capital will not address this concern. But US officials appear to be resisting the second British proposal––which provides for direct central bank guarantees of inter-bank loans. Like guaranteeing deposits, guaranteeing inter-bank loans would transfer the risk of the unknown from the banks to the central banks.

Paulson and Bernanke may view this last British proposal as one step too far in the socialization of the financial system. But until the CDS market is brought into an effective regulatory framework and the legal rights of creditors are clearly established, do we really have any choice but to take this next step?

It seems that long ago—weeks maybe—we stared the moral hazard issue in the eye. And we blinked.

Whatever the theoretical importance of letting people and institutions fail, it seems that we have already decided that as a matter of public policy and political priorities, we just can’t take the pain.