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Market volatility in recent days prompts one to ask, “Just what is going on here?”

The quick answer is that Federal Reserve manipulation of the money supply causes these crisis periods when previously available Fed money is no longer available.

The long answer requires a very winding explanation.

The Federal Reserve, however, still plays a major role in the long answer.

The Federal Reserve has been pumping new money into the economy for decades. A lot of this new money, not surprisingly, has found its way into the mortgage markets. With Wall Street’s “securitization” of the mortgage industry, close examination of mortgage borrowers disappeared. Banks and mortgage companies had incentives to originate mortgage loans, but since they sold the mortgages off (via securitization) they had no incentive to carefully weigh the risks of individual mortgages.

If you had a warm body, banks and mortgage companies only had incentive to figure out how to get you a loan. Bad credit, no problem. Can’t afford to make monthly interest rate payments, no problem. Thus, we had the era of “no docs” mortgages and “Adjustable rate” mortgages with early year rates set sometimes at zero often times at 1%.

On the buying end of these securitized mortgages were institutions with faulty economic models. These models were quantitative in nature. As Austrian economists have warned many times, economics is a qualitative science, not a quantitative science. This is so because the world of human action contains no constants, when you are dealing with humans everything is a variable. The models designed by these institutions must therefore assume that some variable is a constant, since an equation with all variables just can’t be.

Some of these variables will indeed over very long periods of time “act” like constants in their relationship with other factors and not change much. These are the variables that econometricians plug in as constants to design their equations. Every once and awhile one of these pseudo-constants begins to act up and act like a variable again. At such time, the variable will blow up the misplaced belief in the equation and quite possibly blow up an investment portfolio or even an entire economy. The designers and money managers who believe in these equations are in fact playing “Equation Roulette." The blow-ups can occur at any time.

The collapse of funds like Long Term Capital Management (Equations designed by Nobel Prize winning econometricians!) and the current hedge fund blow-ups (because of subprime mortgage investments held) always collapse because variables start to dance.

In the subprime mortgage arena, the variables are dancing.

The equations used as the data points of how mortgages would perform come from the data from the decades of the 1980’s and 1990’s, before securitization. So the models did not take into account the change in the way banks and mortgage firms would change the types of mortgages they would originate if they did not have to worry about the risk.

Thus, a market of nutty mortgages, with no docs and, goofy ARM’s structures, developed, one that only an econometrician with nutty equations in hand would buy — encouraged by a Fed pumping money in so that real estate flippers could hide the fact the mortgages were nutty.

Along this happy road of Equation Roulette, before the subprime crisis started to bloom, the government stepped in with small changes in some regulations as to who could get mortgage financing. Naturally, the econometricians in their models didn’t include for a change in regulations, but this change in regulations started the subprime crisis. At the margin, these regulation changes took out some of the real estate flippers. For the first time in decades, there was a small decline in the true number of real estate buyers.

The few smart, more detailed oriented, buyers of subprime paper picked this trend up and stopped buying the subprime paper. The Fed was still printing money, it was just starting to be re-directed. The smarter players just started to put their money into LBO’s and private equity deals instead of mortgage securities.

The decline in subprime paper buyers, coupled with the regulation changes, formed the start of the subprime crisis in near perfect storm timing, since these factors dovetailed with the first zero percent and 1% ARM mortgages coming due for readjustment and the Fed notching interest rates up a bit.

This was a formula for disaster. Equation roulette was about to blow up another batch of econometricians. As default rates climbed, more and more subprime paper buyers backed away from the subprime market, until we have reached the point today where there is near zero liquidity in the subprime market.

The near zero liquidity of these highly leveraged funds has resulted in margin calls, panic, and some of these funds being forced to sell positions in other sectors of the market. But, this crisis is near over. The Fed has come to the “rescue." Just today it has pumped $19 billion in new reserves into the banking system by buying mortgage securities. My rough calculation suggests that over the last two days the Federal Reserve has pumped in enough new reserves to increase the money supply by somewhere between 10% and 15%.

This is a stunning number. The money supply in a year rarely grows by 10%, for it to do so in 48 hours is mind-boggling. Yes, the Fed has come to the rescue by further pushing the dollar on the road to collapse. While most eyes are on the current mortgage crisis, the bigger danger is the potential collapse of the dollar on foreign exchange markets. The dollar has been slowly falling in value against most currencies for a while. It is at multi-decade lows in some cases. I have feared a further major collapse of the dollar even before the Fed’s moves over the last two days.

The mortgage crisis will pass. The Fed will print its way out of this crisis. But, the dollar crisis is ahead and the Fed won’t be able to print its way out of that since it’s been Fed money printing that is the cause of the world being flooded with dollars.

From the outrageous money printing that fueled the mortgage “boom” to the Fed “rescue," the Fed step by step is setting up the economy for inflation and a crash of the dollar that won’t just affect mortgage holders and hedge funds, but anyone holding deteriorating dollars in their bank accounts and wallets.

August 11, 2007

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