A Financial System under Siege

Chronique de Rodrigue Tremblay

If these items [promised benefits in Social Security,
Medicare, Veterans Administration and other
entitlement programs] are factored in, the total
[debt] burden in present value dollars is estimated to
be about $53 trillion. Stated differently, the
estimated current total burden for every American is
nearly $175,000; and every day that burden becomes

David Walker, comptroller general of the United States
The economic forces driving the global
saving-investment balance have been unfolding over the
course of the past decade, so the steepness of the
recent decline in long-term dollar yields and the
associated distant forward rates suggests that
something more may have been at work.

Alan Greenspan, former Fed Chairman, July 20, 2005
The subprime black hole is appearing deeper, darker
and scarier than they [the banks] thought. They’ve
worked through ... about 40 percent of the backlog of
the leveraged loan side, and there’s definitely some
signs of thaw there.

Tony James, president and CEO of Blackstone Group LP
The global dollar-based financial system
is in crisis and is threatening the prosperity and
stability of many economies. Financial excesses of all
kinds have undermined its legitimacy and its
efficiency. The U.S. dollar is losing its preeminence
as the main international reserve currency while many
banks are caught in [the turmoil of the subprime credit
The overall background is the unprecedented real
estate bubble that took place worldwide, from 1995 to
2005. In the United States, for example,
owner-occupied home prices increased annually by an
average of about 9 percent. The market value of the
stock of owner-occupied homes in the U.S. rose from
slightly less than $8 trillion in 1995 to slightly
more than $18 trillion in 2005. It has been
contracting ever since, confirming the working of the
18-year Kuznets realestate cycle, which
has gone from the top of 1987 to the 2005 top.
What makes this period especially dangerous is the
fact that the average [54-year long
inflation-disinflation-deflation Kondratieff cycle
->http://www.thelongwaveanalyst.ca/cycle.html] is also
at play, having begun in 1949 after prices were
unfrozen. World inflation then rose for twenty years,
until 1980, which was followed by a period of
disinflation under the Volcker Fed. The [entry
of China
into the World Trade Organization (WTO) on December
11, 2001, with its abundant labor and low wages,
unleashed strong deflationary forces worldwide. This
in turn led to lower inflation expectations paving the
way for the Greenspan Fed to keep
interest rates abnormally low.
Persistent low interest rates and low inflation
expectations led to a binge in borrowing and to a vast
increase in market valuation, not only in real estate
but also in stocks and bonds. Banks and other mortgage
lending institutions took advantage of the opportunity
to introduce some financial innovations in order to
finance the exploding mortgage market. These
innovations resulted in the severing of the
traditional direct link between borrower and lender
and the reduction in the lending risk normally
associated with mortgage loans.
Thus, with the connivance of the rating agencies and
of the Federal Reserve System, large banks invented
new financial products under various names such as
["Collateralized Bond Obligations" (CBOs),
"Collateralized Debt Obligations" (CDOs) or
"Structured Investment Vehicles"
(SIVs), which had the characteristics of unfunded
short term commercial paper. In the residential
mortgage market, for example, mortgage brokers and
retail lenders would sell their mortgage loans to
banks, which in turn would package them together and
slice them into [different classes of mortgage-backed
(RMBS), carrying different levels of risk and return,
before selling them to investors.
Indeed, these new financial instruments were the end
result of a process of "asset securitization" and were
slices of bundles of loans, not only of mortgage loans
but also of credit cards debts, car loans, student
loans and other receivables. Each slice carried a
different risk load and a different yield. With the
blessing of rating agencies, banks went even one step
further, and they began pooling the more risky
financial slices into more risky bundles and divided
them again to be sold to investors in search of high
By selling these new debt instruments to investors in
search of high yields and higher yields, including
hedged funds and pension funds, banks were doubly
rewarded. First, they collected handsome managing fees
for their efforts. But second, and more importantly,
they unloaded the risk of lending to the unsuspected
buyer of such securities, because in case of default
on the original loans, the banks would be scot-free.
They had already been paid and had been released from
the risk of default and foreclosure on the original
The banks' residual role was to collect and distribute
interest, as long as borrowers made their interest
payments. But if payments stopped, the capital losses
incurred because of the decline in the value of
unperforming loans would instead be carried by the
investors in CBOs and CDOs. The banks themselves would
suffer no losses and would be free to use their
capital bases to engage in additional profitable
lending. In fact, the end of the line investors became
the real mortgage lenders (without reaping all the
rewards of such risky loans) and the banks could reuse
their capital to pyramid upward their loan operations.
These were the best of times for banks and they gorged
themselves without restraint. Some of them paid their
employees [tens of billions of dollars in year-end
Indeed, and it is here that the Fed and other
regulatory agencies failed, first line mortgage
lenders became more and more aggressive in their
lending, with the full knowledge that they could
profitably unload the risk downstream. This explains
the expansion of the "subprime" mortgage market where
borrowing was done with no down payment, no interest
payments for a while and no questions asked as to the
income and creditworthiness of the borrower. These
were not normal lending practices. Such Ponzi schemes could not
last forever. And when housing prices started to
decline, foreclosures also increased, thus shaking the
new financial house of cards to its foundations. Banks
became the reluctant owners of some of the foreclosed
properties at very discounted values.
Why then are so many banks in financial difficulties,
if the lending risk was transferred to unsuspecting
investors? Essentially, because when the housing boom
burst, the banks' inventory of unsold "asset-backed
securities" was unusually high. When the piper stopped
playing and investors stopped buying the newly created
risky investments, their value plummeted overnight and
banks were left with huge losses still not fully
reflected in their financial balance sheets. Indeed,
banks that did not unload their stocks of packaged
mortgages were forced to accept ownership of foreclose
properties at very discounted values. With little or
no collateral behind the loans, bad-debt losses became
Since noboby knows for sure the value of something
which is not traded, it will take months before banks
come to terms with the total losses they have suffered
in their stocks of unsold pre-packaged "asset-based
securities". It is more than a normal "liquidity
crisis" or "credit crunch" (which results when banks
borrow short term and invest in illiquid long term
assets); it is more like a "solvency crisis"
if the banks' capital base is overtaken by the
disclosure of huge financial losses incurred when the
banks are forced to sell mortgaged assets in a
depressed real estate market.
This is this financial and banking mess which is
unfolding under our very eyes and which is threatening
the American and international financial system. There
are four classes of losers. First, the homebuyers who
bought properties at inflated prices with little or no
down payment and who now face foreclosure. Second, the
investors who bought illiquid mortgage-backed
commercial paper and who stand to lose part or all of
their investments. Third, the holders of bank stocks
who profited when the system worked smoothly but who
now face declining stock values. And, finally, anybody
who stands to fall victim, directly or indirectly, to
the coming economic slowdown.

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