Burnin’ Down the House! Part Two: Wall Street has a Weenie Roast With Your 401k

Last week I wrote about the first part of my talk to the Bellevue Kiwanis Club on why our economy is in the position it is today. It is a story about good intentioned policies – like modifying credit scoring for Americans working in a cash-economy – that were bastardized in the execution – like some Americans using modified credit scoring to lie about their income. Just like there were superstar firms among the original “junk bond” companies, there were also firms like Enron and WorldCom.

In the first part of my story: banks wrote mortgages, their broker-arms sold them to the public in the form of bonds, they paid fees to Standard & Poor’s and Moody’s to get triple-A credit ratings, and they devised crazy default protection schemes which they also sold in the public capital markets. On top of all that, they screwed up the paper work so there was no relationship between houses and the ultimate financial paper that could be used to cover potential losses.

That’s when Wall Street staged a weenie-roast over the blazing fire of your 401k plan. They were making so much money in fees and trading profits that they decided to extend the scheme to car loans, credit card debt, and anything else they could package and sell off in capital markets around the world. When new money stopped flowing in and when the value of the underlying assets began the decline, the whole mess came falling down over their – and our – heads.

In case after case, there are more derivatives than their underlying assets. Here’s an example of just how absurd this is: The market value of Bank of America (BofA) is $32 billion; the contracts that payoff if BofA fails are worth $119 billion. This isn’t rocket science math. It’s worth a lot more to someone to see BofA fail than it is to see them succeed. Here’s a table of some of financial companies and home builders, alongside some countries, to give you an idea of what the potential cost would be of letting them collapse – because the derivatives would have to be paid off if they collapsed. Where the market value of a company’s publicly-traded shares (or the outstanding public debt of a nation) is greater than the derivatives outstanding (a negative number in the difference column), the “market” is probably betting in favor of the company.

Derivatives outstanding is data made available by the Depository Trust and Clearing Corporation for publicly traded credit default contracts. Market value is for public companies generally in early March 2009; public debt is for countries generally from year-end 2008. Difference is author’s calculation. The average derivatives outstanding for entities with positive differences are 22 times the value of the entity (excluding GMAC as an outlier with a multiplier of 17,816).

In other words, you could buy all the shares of Lennar for $1.2 billion. However, if they go bankrupt, the payoff will be $40 billion for the holders of the derivative contracts. And at this point, we – the US taxpayers – are in the position of paying off on these contracts if the banks and other “too big” companies fail. This table also tells you that the “markets” think that Bank of America is significantly more likely to fail than, say, Brazil – which is probably true, if for no other reason than the fact that Brazil has an army and Bank of America doesn’t!

The bottom line is that the government has to continue to bailout these banks and large companies because many of them, including AIG which is now owned about 80% by us, are the same entities that will have to pay off the bets if the other companies fail. There’s really no way out of it now. I remain opposed to the bailouts – they create “moral hazard,” the scenario whereby it is more profitable to fail than to succeed. But: I understand why they are being done and why we have to keep doing it.

The reason is: it matters to our 401k plans, the pension plans of teachers and firefighters, the retirement benefits of loyal, hard-working Americans. You see, the debt of insurance companies and other triple-A rated credits (AIG had a good credit rating less than 12 months ago) are required investments for money market funds, pension plans, etc. Take a look at the prospectus for any of these investments if you have them and you’ll see what I mean. It is necessary for such funds to make triple-A investments because the funds need to be able to make payments and honor withdrawals, sometimes on short notice. That means they have to hold some very safe, very easily sold investments. Investments like those issued by AIG.

If the mutual funds holding your 401k and the pension fund supporting the school teachers and all that go broke – well, no one wants to imagine what that America would look like. Despite all the bad economic news, few Americans have run out in the streets in protest and even those who did didn’t vandalize any property, public or private. Nor did we take our CEOs hostage. In fact, I think a little civil unrest may be called for: print this story, wrap it around a hotdog, mail it to the New York Stock Exchange and tell them to enjoy their weenie-roast!

Here’s why: the time is coming very soon when Wall Street will need us again. Uncle Sam is doling out the bailout money to the financial institutions, but even now they are devising ways to get ordinary investors to come back to the markets – and to use our own money to do it.

Susanne Trimbath, Ph.D. is CEO and Chief Economist of STP Advisory Services. Her training in finance and economics began with editing briefing documents for the Economic Research Department of the Federal Reserve Bank of San Francisco. She worked in operations at depository trust and clearing corporations in San Francisco and New York, including Depository Trust Company, a subsidiary of DTCC; formerly, she was a Senior Research Economist studying capital markets at the Milken Institute. Her PhD in economics is from New York University. In addition to teaching economics and finance at New York University and University of Southern California (Marshall School of Business), Trimbath is co-author of Beyond Junk Bonds: Expanding High Yield Markets.