Date: 01/30/22
Author: Kent Moors, Ph.D.
Last Thursday, Nobel laureate economist Paul Krugman wrote a New York Times column entitled “How Crypto Became the New Subprime.”
This is hardly the first comparison to be made between crypto and the subprime credit crisis that ushered in a global dollar-dominated asset collapse more than a decade ago. Well before the ongoing, more than month-long dive in crypto prices shaved in excess of 40% off coin value, I had devoted parts in three earlier issues of Classified Intelligence Brief to the matter (see “The Bitcoin Paradox,” Classified Intelligence Brief, June 27, 2021; “Why a Crypto Currency Wrinkle Could Usher in the Next Asset Crisis,” Classified Intelligence Brief, July 11, 2021; “The Need for Regulating Crypto Currency,” August 8, 2021).
But the parallel suggests a deeper problem.
Krugman emphasizes that investors in crypto are different from those investing in other, more traditional, assets. They disproportionately appear to be less versed in market risk, less able to withstand fluctuations in price, and more prone to discount the dangers of the surrogate currency in favor of a “get rich quicker” mentality.
There are also anecdotal indicators that the average crypto investor is less educated, less affluent, and more likely to be minority and/or an average working guy stiff. Now initially all of this had been hailed as a long overdue broadening of the investment horizon to those folks too often excluded from more conventional ways of making money.
After the collapse now underway, we don’t hear such arguments as much.
As subscribers in Sigma Trader and PRISM Profits well know, I track four indices of crypto daily to estimate the use of the currency as a hedge against a larger marker contraction. These days, however, crypto is marching in the same direction as the declining market.
Before moving into my latest observation about how crypto currencies reflect the shortcomings of the subprime bubble, my earlier discussion is worthy of a revisit. This is what I wrote about the connection last July:
Over a decade ago, the implosion in US mortgage-backed securities produced a world-wide collapse in dollar-denominated assets. The expansion in the crisis occurred because a weakness in what ordinarily would be a confined sector of the economy (subprime mortgages, that is those provided to debtors who cannot afford them) infected broader classes of property and accounts.
This crisis differed from previous “boom and bust” cycles in its far broader scope. Earlier crises tended to focus on a particular market sector. This one may have appeared to begin that way – clothed as a subprime mortgage collapse. However, the impact was much more severe, affecting financial, credit, and asset markets well beyond real estate.
This time, purveyors of a new financial sleight of hand challenged one of the major premises upon which markets had traditionally operated. They came to the unsettling conclusion that the market could effectively ignore the relationship between the extension of credit and the assumption of risk.
The core problem was extended, disfigured, and prolonged by a wave of apparent paper profits from the milking of the spread between tangible asset valuation (actual, physical real estate) and paper values (mortgages on that real estate).
This was accomplished by interjecting between the two a new way of making even more money without having to supplement the value of the underlying asset. The mortgage paper was “securitized,” with suspect mortgages packaged along with stronger paper and rated as one entity. It created a quintessential “bubble accelerator.”
The mortgage-backed security (MBS) along with its cousins – collateral debt obligations (CDO) and a myriad of asset-backed security (ABS) clones – inflated the problem out of proportion. As collateral for all manner of exchange, it propelled the suspect mortgages into a wide array of international transactions.
The securitization schemes also introduced two major roadblocks preventing the market from easily correcting the overheating spiral. First, since the toxic assets had been parceled out into so many derivative issuances (both the initial MBS offerings and secondary/tertiary papers based upon them), a relatively insignificant percentage of overall suspect outstanding debt caused a significant constriction in global liquidity.
The subprime loans were now so thoroughly intermixed with other debt holdings – themselves representing paper asset and collateral value for an ever-greater range of investments –that they prompted wide areas of the market to come under suspicion, brought into question huge holdings by major banks worldwide, and ushered in a cataclysmic credit freeze.
This was accentuated by the fact that securitization by its very nature decreases transparency. Therefore, once there is a question about the structural integrity of asset-backed securities, the loss of confidence or trust becomes more difficult to offset.
Second, this becomes a classic example of moral hazard, since those who are responsible for issuing the loan (mortgage) to begin with are no longer the parties shouldering the risk if there is a default. In such an environment, at some point, there is little structural difference between the paper and a chain letter or a Ponzi scheme.
Yet, this is hardly an enticement to end securitization across the board. Securitizing debt, utilizing assets as collateral for additional applications, and the spreading out of risk are not bad ideas per se. In fact, I have personally designed securitization programs in the past for oil projects, pipeline capacity, refinery crude oil cuts, surplus electricity, discounted sovereign defaulted debt, and even the financing of first-run Hollywood films that all achieved their purposes without engineering a run on banks or an epileptic seizure of credit.
We need to avoid rejecting securitization altogether. It remains a quite useful, sometimes essential, tool. Correctly structured and employed, it succeeds in lessening risk for projects to transactions unlikely to move forward by traditional financing methods. It also is successful at allocating capital and does so (when adequately structured and overseen) very efficiently.
The fatal problem in the case of subprime MBS was the fundamental disconnect that emerges when the primary source of profit becomes the securitization itself, while the underlying revenue stream becomes increasingly dependent upon an expansion of the securitizing network. Once that network becomes a base for wider transactions, the crisis intensifies and dollar-denominated assets become suspect across the board.
Well, we may have the foundation for a déjà vu all over again.
This time, the problem area is rising in crypto currency. It is called stablecoin and it seeks to become a bridge between traditional asset valuations and digital currencies. A stablecoin is tied to a “real-world” asset (usually the US dollar), thereby providing a “stable” valuation, unlike better known crypto issuances like bitcoin or ethereum that have exhibited wide price volatility.
Tether, a stablecoin tied to the dollar, has been accelerating fast and is now the third largest crypto coin by market value. And it has some analysts worried that it could become the source of the next subprime-like major asset bubble implosion.
Since it is tied to the dollar, tether should have a value that remains at $1. However, that has not always been the case, prompting some panic upon occasion among investors. Crypto traders will often use the tether to buy cryptocurrencies, rather than the dollar or other traditional fiat currency. Digital traders are increasingly preferring this approach to provide transaction safety via a more “stable” asset during times of sharp volatility in the crypto market.
That was my read a bit more than six months ago. Unfortunately, the situation is worse today. The use of tether and other stablecoin clones has expanded as the overvaluation of the crypto space has declined.
And it is in this move that those digital currencies are reflecting the most dangerous part of the subprime crisis. Rather than replacing money, it effectively calls the integrity of hard assets into question when a crisis emerges in the relative value of crypto. But it does so without the underlying protections that the traditional functions of money provide.
Money has six of these, as a: (1) medium of exchange; (2) a measure of value; (3) the basis of credit; (4) a unit of account; (5) a store of value (assessing comparative purchasing power); and (6) a standard for postponed payment.
Now at the basis of all of these is the assumption that, at any given time, money can be used as a surrogate to determine the relationship(s) between two or more other objects of acquisition interest, savings, investment holdings, or, most importantly, held assets.
The subprime collapse undercut such a market exchange mechanism by calling into question the perceived valuation of underlying physical assets. The intermediary paper did that by undermining the essential functions of money.
Crypto currencies run the risk of accomplishing the same unwanted result. At present, the estimated global valuation of the crypto realm at anywhere between $1.4 and $3 trillion (depending on whose calculations you accept) would seem to heighten the concern.
Yet that actually is unlikely to pull down worldwide markets on its own. The collapse in crypto has nonetheless retained the coinage as an alternative mechanism with some value, a value that is likely to increase over time as the volatility moves in the other direction. The subprime mess had a “timebomb” buried within asset valuations that threatened to have no value when the need arose to exchange underlying assets or use them in a further collateralized transaction.
The reality that crypto still does not act within most of the traditional functions of money is thought by some as an insulation against a recurrence of an asset valuation crisis. Bitcoin and others still cannot figure (easily) in most market transactions, while the costs of use when it can limit its replacement function.
Unfortunately, the rising reliance upon stablecoin undercuts that insulation. It is beginning to expose far wider portions of the conventional market to the same kinds of problems witnessed in the asset valuation collapse arising from subprime mortgages.
The danger then was not so much the suspect mortgages themselves as the intermediary derivative paper cut on them. The new generation of crypto currency that supposedly has a direct line to the value of money is the new harbinger of disaster.
The true suspect nature of tether and other stablecoin issuances arises from two underlying factors. First, what is supposed to be a 1:1 connection with money has been discounted in practice. Second, that becomes more acute when the market value of money is under its own pressure.
That’s the case now, as we endure the ongoing inflationary wave and the way it is forcing a revaluation of otherwise secure assets. Once the functions of money begin to vacillate, the resulting multiplying effect makes matters worse.
Because it is usually operating at less than full value against money, stablecoin seems an adequate connection to conventional valuations only when the broader market is itself “stable.” These days that is hardly the case. As the broader situation intensifies and exchangeable money experiences its own valuation crunch, crypto begins to serve as a new subprime crisis. Only this time, by virtue of its connection to money, it is connected to everything else in the market. That makes it not simply the next subprime crisis. Rather, it is now threatening to become a larger asset valuation crisis on steroids.
Dr. Kent Moors
This is an installment of Classified Intelligence Brief, your guide to what’s really happening behind the headlines… and how to profit from it. Dr. Kent Moors served the United States for 30 years as one of the most highly decorated intelligence operatives alive today (including THREE Presidential commendations).
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