Wednesday, April 29, 2009

The Governmental Boiler Room

A must read piece in The National Review Online from Richard Epstein, director of the law and economics program at the University of Chicago. Despite its legalese tint, the article focuses on the two most troubling developments for private market players as a result of flawed policy after flawed policy: i) the notion that the government may be permitted to disrupt financial transactions between parties in ways that frustrate the unambiguous expectations of the parties and ii) the idea that the government need not honor its own promises in dealing with private individuals.

The biggest threat, imminently, is to creditors, who have come to realize that in order to prop up equity valuations for whatever optic purposes the administration may have on any given day, they are at peril of incurring massive losses merely to prolong the cheap market fallacy at least one more day.
One part of the mix is the continued uneasiness over the risks of further interference in mortgage markets down the road. Investors and banks know that the government has disrupted private transactions to the detriment of creditors once, and fear that it will do so again.
The premise of transacting in the capital markets on the basis that someone less informed will pay more for your short-term holdings as a result of perpetuated hopes for ongoing informational imbalance would traditionally be persecuted to the fullest extent of the law (see Bernard L. Madoff). The only difference is that unlike Madoff's pyramid, the dominants actors in this case are willing participants in the ponzi.

Regardless, as the imminent unwind occurs (not if - when), it is always the equity tranche that will take the first loss, despite the novel development of the creeping equitization concept for companies such as Citigroup (and soon Bank Of America) where dilution and value destruction of senior capital tranches is only voluntary because the administration deems it so - the loaded gun of total system collapse pointed at one's temple can be a persuasive mechanism. In the meantime, as equities become obliterated, private creditors will likely never again participate (absent massive incentives) in a market in which they have no faith in the rule of contracts, which serve as the foundation for any capitalist system.

So yes, while the market creeps higher for reasons unknown on shrinking volume, as pandemics rage, and GDP hits historic lows, and as commercial mortgages present a $1 trillion + cash black hole question, all is good, as current securities holders seek the gullible ones to offload their existing exposure. When the sentiment finally turns and there is no one left to pick up the hot potato, despite numerous warnings to the contrary, the threat of systemic collapse will be much more real than the prognostications of Bernanke and Geithner who use the term wantonly at any juncture when they seek to achieve their own misguided and near-term goals.

The article is worth your time.

Hat tip to Lookout.

Sphere: Related Content
Print this post
blog comments powered by Disqus