How U. S. Politicians and Bankers Built a Financial Debt House of Cards (whose Collapse Threatens to Destroy the World Economy)

Chronique de Rodrigue Tremblay

“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
"All for ourselves, and nothing for other people, seems, in every age of the world, to have been the vile maxim of the masters of mankind."

Adam Smith (1723-1790), (The Wealth Of Nations, 1776)
"This economy of ours is on a solid foundation."

President George W. Bush (Jan.uary 4, 2008)
"While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover."

President Herbert Hoover (1874-1964), (May 1, 1930}
Why does the world economy seem to be caught every 60 some years in a financial and banking turmoil that threatens to collapse the real economy? The answer has to be sought in human greed and political corruption that seem to collaborate in pushing to the extreme all types of speculative and parasitic practices.
Between 2002 and 2007, we have witnessed the culmination of such an example of greed and corruption on a very high scale, as an unstable pyramid of artificial financial debt instruments was built to higher and higher unsustainable levels, to the benefit of unregulated financial operators who raked in hundreds of billions in excessive profits, juicy fees and obscenely high year-end bonuses. Similarly, parasitic speculators took advantage of the situation that regulators had allowed to develop, and they made billions (not millions) speculating against the shaky house of cards of mortgage-backed securities. — These are the winners: bankers and speculators. — The losers in that charade are about everybody else: homeowners, investors, taxpayers, retirees, and workers who are poised to lose their jobs and incomes, as a consequence of the failure of government to prevent these financial excesses.
Indeed, the problem is both political and financial and this has to be understood in order to disentangle the web of causes that produces a financial and economic collapse. It is that combination of political corruption and racketeering financial and banking practices that creates the right environment for a major crisis to develop. Why each 60-some years? Essentially because the lessons learned the hard way by a grandparents' generation, sixty some years ago, are forgotten by a succeeding spoiled brats current generation, and the same past mistakes and fresh ones are made anew.
On that score, the big financial crises of 1873-1880 and 1929-1939 had pretty much the same type of causes as the one we are entering into today: the collapse of public and private basic morality among a very small elite that pushes its exploitation of public institutions to the breaking limit. For such a small elite, there comes a time when all means justify the supreme goal of enriching itself at the expense of the rest of society. All combines, tricks and schemes become acceptable and justified by pious ideological slogans such as “the market always knows best“, the new “wealth (no matter how acquired) will trickle down”, or, for the more delusional ones among them, “God is placing all that money in my hands, therefore, I must be doing good”!
The immediate technical question that must be answered is how a casino-like financial capitalism was allowed to develop? Why were banking practices twisted in such a way as to turn capital into the equivalent of casino chips?
Indeed, banking's primary function is to allow capital to be used in the most productive ways. It is the primary function of financial intermediaries (banks, savings & loans associations, stock exchanges, etc.) to convert savings into productive capital (plants, roads, etc.). Investments are kept tradeable and liquid by secondary capital markets. Properly regulated to avoid combines and scams, capital markets usually function smoothly.
It is when politicians, or regulators themselves, throw out such regulations that things can get ugly. In the U.S., a few disastrous steps were taken in 1999, 2000, 2004 and 2007, which can explain the current financial crisis.
A Decade of Planned Deregulation
Indeed, under the advice of then Fed chairman Alan Greenspan, a libertarian at heart, the Republican controlled Congress and the Democratic Clinton administration passed two laws designed to deregulate the American financial industry. First, in 1999, it passed the Gramm-Leach-Bliley Act (GLBA) that, in effect, abolished the 1933 Glass-Steagall Act, which had regulated investment banking, and which established tight barriers between the banking and insurance industries. With this new law, the large unregulated Wall Street investment banks and commercial banks, as well, could enlarge tremendously the range of their financial activities.
Then, in a one-two punch, the lame-duck 2000 U. S. Congress went further and reintroduced legalized gambling into the financial sector, a prohibition that had been in place since after the 1907 financial crisis. Indeed, by adopting the Commodity Futures Modernization Act of 2000, Congress, and President Bill Clinton who signed it, exempted outright financial gambling from state gaming laws. With the new law, the entire American financial system could be turned into a large unregulated casino where everything goes (legally).
Another step toward a near complete deregulation of previously regulated financial activities was taken in 2004, this time by the regulatory agency of the Securities and Exchange Commission (SEC). Indeed, on March 28, 2004, the Securities and Exchange Commission (SEC) removed the ceiling on risk that the largest American investment banks could take on so-called securitized loans. Such loans were based on mortgages, but also on credit card debt, auto finance debt, student loans, etc.
Finally, the Securities and Exchange Commission took the last step toward deregulating financial markets when in the the month of July 2007, weeks before the onset of the subprime crisis, it removed the “uptick” rule for short selling any security.
The Story of the Two Bubbles
The table was then set for what could turn out to be the biggest financial mismanagement in history. It was the product of two interrelated bubbles: a housing bubble and a financial debt bubble.
The housing boom was fed by extraordinaryily low interest rates and by lowered lending standards for mortgages. Indeed, from 2002 to 2005, under chairman Alan Greenspan, the Fed maintained excessive monetary liquidity in the financial system and short-term interest rates fell to 1 percent, with real interest rates negative.
Indeed, after the tech-bubble burst in 2001, and the March- November 2001 recession, the Greenspan Fed aggressively lowered the Federal Funds rate from 6.5 percent to 1 percent in 2004, the lowest it had been since 1958. It is widely accepted today that this aggressive monetary policy lasted too long and has played an important role in fueling the housing bubble.
But the housing bubble would have only been an above normal top within the 18-year Kuznets cycle, ( from a 1987 top to the 2005 top) if it had not been reinforced by an extraordinary debt bubble.
Last February25, 2008, I explained the extent of the debt bubble, in the United States, in these terms:
“When one looks at a graph provided by the U.S. Bureau of Economic Analysis (BEA) and which shows the relative importance of total outstanding debt (corporate, financial, government, plus personal) in relation to the economy, one is struck by the fact that this ratio stayed around 1.2 times GDP for decades on. Then, something big happened in the early 1980s, and the ratio started to rise, with only a slight pause in the mid-1990s, to reach the air rarefied level of 3.1 times GDP presently, nearly 200 percent more than it used to be.”
That “something big” was the combination of the breaking up of the regulation apparatus we have already mentioned, and the appearance of new risky financial instruments.
Reckless Lending
On the one hand, first came the “subprime lenders” or what some call the predatory mortgage lenders. Spurred by an incentive system that rewarded risk-taking (big bonuses), mortgage banks and other lenders began to accommodate subprime borrowers with dubious credit by extending mortgage loans to homebuyers who would not have qualified in other times. —They lowered their lending standards.
Nontraditional home loans were advanced to borrowers who had no documented incomes. Some loans were interest-only loans with down payments of 5 percent or less. Some were adjustable rate loans (ARMs), with low rates for one or two years to be reset later at much higher rates. In 2006, about 25 percent of American mortgages were subprime and close to 20 percent were adjustable rate loans. Mortgage lenders and home buyers alike assumed that home prices were not going to fall on a national basis or that the Fed would intervene to save the industry by slashing interest rates.
The New Alchemy: Finance
On the other hand, the main reason of such lending recklessness was the facility with which subprime lenders could sell their risky mortgages upstream to bigger players, investments banks for example, which undertook to buy them, pool them into mortgage bonds and re-channel them into new financial instruments through a process of aggressive securitization.
These new "structured investment vehicles" (SIVs), which fall into the large class of derivative products, came under various names such as "Collateralized Bond Obligations" (CBOs) or "Collateralized Debt Obligations" (CDOs). They had the characteristics of short-term asset-based commercial paper that were backed by the underlying income producing mortgage assets downstream and were graded according to a certain risk of default. — The asset-based security (ABS) was born. [For reference, let us keep in mind that total derivative products around the world amount to more than $500 trillion, or more than 10 times the output of the global economy. This is a staggering overhang on the world economy when something goes wrong.]
More than one trillion and a half dollars of these asset-backed financial products were sold, not only in the U.S., but all over the world. However, the market for such artificial or fictitious financial instrument began to tighten significantly when the housing bubble burst in 2005 and 2006, as a wave of foreclosures and mortgage defaults hit the industry. It got worst after the August 2007 subprime crisis, and it became de facto frozen in the spring of 2008, after the demise of the investment bank Bear Stearns. The credit rating agencies (Moody's, Standard & Poor's and Fitch) had no choice but to lower their artificially high ratings on asset-based securities (ABS), and the prices of ABS plummeted.
Enter now another new financial instrument that made matters much worse and led directly to the crisis: the Credit Default Swaps (CDS). Because of the lack of proper government regulation, this new financial product really became, in financier Warren Buffett's words, a true financial weapon of mass destruction. Essentially because it became the tool of choice for the newly legalized activity of high level financial gambling by entities that were unrelated to any genuine lending operation. Indeed, as we will see below, in a panic environment, large off-shore hedge funds with their large pools of money could literally raid imprudent and weakened financial institutions with so-called “naked” short sell orders that far outnumber the buy orders from any potential buyers. In other words, they were in a position to corner the market.
Initially, in order to protect against the risk of default on the new asset-backed securities (ABS), some insurance companies—but also some investment banks themselves — began to issue bilateral “insurance” contracts against the newly created ABS. These were called Credit Default Swaps (CDS). In theory, they were supposed to offer protection against the possible default of an investment instrument, such as an asset-backed security. The issuer of ABS, or an investor looking for protection, could buy such an insurance contract and pay a premium, which was a small fraction of the asset being protected, say 5 percent. Understandably, when housing prices were on their way up, with little risk of mortgage default, the cost of such “protection” was low, and conversely, in a period of price decline, when the risk of default increases. This was a financial innovation, the so-called “insurance against default”, that opened the floodgates of money to be invested in the new financial instruments. Indeed, it allowed investors such as pension funds and other institutions which have a fiduciary obligation to buy only high-quality securities, to legally buy artificially highly rated (but risky) ABS securities, or to invest in hedge funds which specialized in leverage trading in derivative products.
But the hic is that the issuance and use of such financial “insurance” contracts were not regulated by any government agency, because the word “insurance” was not used; instead, they were considered as simply a protection against the “default” of payment on a financial security. And that's where the gambling part enters the picture: only 10 percent of CDS are genuine insurance contracts held by investors who really own asset-backed securities (these are covered CDS); 90 percent of them are rather held by speculators who trade CDS, while not owning any asset-backed securities to be protected (these are naked CDS). To picture the situation, we can consider such “naked” CDS as a form of high valued casino chips that one can buy to bet on the likely future value of a financial security, just as someone could bet on the issue of a horse race. Except that in this kind of unregulated financial gambling, as we will see, the owner of the chips can influence the outcome of the race by intervening in the race itself. In other words, the game is rigged.
The Financial Sector as a Vast Casino
To repeat, and contrary to ordinary regulated insurance contracts, Credit Default Swaps (CDS) can be bought and sold by speculators who are not directly involved in the mortgage business. They deal in “naked” CDS. As a comparison, for example, it is illegal to buy ordinary life insurance on the life of someone with whom a buyer is not related, in order to avoid evident abuses. — Not so with CDS, as it is the case with "naked" CDS. And because of the 2000 Commodity Futures Modernization Act passed by Congress, no state has the power to regulate this new form of sophisticated gambling. The result is astounding: it is estimated that the notional value of credit default swaps outstanding today is about $62 trillion (4 times the size of the US economy). This, in itself, is an indication of how popular the "naked" CDS innovation was as a way to bet on the collapse of the entire asset-backed securities construction. This is also a clear sign that, in a crisis, it would be all but financially impossible for the issuers of CDS to meet their obligations. In other words, disaster was just around the corner. — This is an event that any regulatory agency should have seen coming.
Indeed, when housing prices hit the expected top of their cycle, in the spring of 2005, and began falling, especially in 2006, the price for CDSs was still relatively low. So, some astute speculators undertook to buy CDSs and simultaneously began selling short the ABS that had been issued by investment banks, such as Lehman Brothers, in the correct expectation that mortgage-backed securities were bound to lose value with the expected rise in home foreclosures and mortgage defaults. For instance, one large speculator is reported having reaped, in 2007, an estimated $3 billion-plus for himself, which made it the largest one-year gain in Wall Street history, for a single individual. Many speculative hedge funds played the same game and raked in billions of dollars in easy-made gambling profits.
Who Pays for the Excesses?
Where did all this money came from? It came from the loses suffered by investors in investment banks and in some large insurance companies, and it came from taxpayers who had to advance a lot of money to prevent these financial firms from failing. The first losers, initially, were the very financial firms which had initially engaged, very profitably we must say, in the new risky finance, i.e. insurance companies, such as American International Group (AIG), (which was reported to have $400 billion CDS outstanding on its books when it failed), or from highly leveraged investment banks such as Bear Stearns, Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch and others which specialized in buying primary subprime mortgages and in issuing asset-backed securities (ABS) in their place. They have suffered huge losses on their ABS and CDS. So much so that some of these financial firms saw their capital base nearly completely disappear, making them de facto insolvent and creating the credit crisis that we know.
The Government at the Rescue
To prevent a complete collapse of the financial system, the U.S. government (Fed, U.S. Treasury and FDIC) had to step in to prevent these large financial institutions from filing for bankruptcy, with multiple rescue and bail-out plans, with the notable exception of Lehman Brothers, which was left to fail on September 15, (2008). The U.S. Treasury also had to inject some $200 billion in the government sponsored Fannie Mae and Freddie Mac in preferred shares, in order to solidify their mortgage lending operations and their $5.3 trillion joint debt.
Consequently, large amounts of public money, in excess of $2 trillion, are now being used to settle the risky bets that large banks took over the years and which went bad. Public money is also being used to subsidize large banks to acquire smaller banks, in an unprecedented restructuration of the entire American banking sector. Such a government intervention will likely contribute to shore up the U.S. financial sector by strengthening its consolidated balance sheet. It remains to be seen, however, if some of the money will trickle down to the real economy.
The U.S.-based financial crisis has now become worldwide and is spreading.
The root cause of this financial mess is due to the fact that the lessons of the far away past with its financial crises, and those of a more immediate past, have not been learned. Indeed, one would have hoped that lessons would have been learned from the 1980s Savings & Loans crisis and from the demise of the huge hedge fund, Long Term Capital Management, in the 1990s. But greed and corruption seem to have overtaken wisdom and to have prevented proper governmental oversight.
In the United States, over the last two decades, two parallel banking systems have co-existed, sometime even within the same institution. While one, the traditional banking system, was regulated, the other one, the investment banks and hedge funds and the credit derivatives market, was a shadow system that was hardly regulated at all. Not surprisingly, it is in this unregulated sector that the worst excesses have taken place, as one ever more risky financial innovation led to another. These excesses have resulted in creating a shaky pyramid of fictitious financial debt that has no, or little, relation to the underlying real economy of production of goods and services. How these excesses are going to be unwound will dictate how the world economy is going to fare in the coming years.
At the very least, the return to reality risks being painful and every effort should be deployed to mitigate its consequences for the greatest number.

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