The Financial Tsunami Part V: The Predators had a Ball
By F. William Engdahl, 22 February 2008
Colossal Collateral Damage
The multi-trillion dollar US-centered securitization debacle began to
unravel in June 2007 with the liquidity crisis in two hedge funds owned by Bear
Stearns, one of the world’s largest and most successful investment banks. The
funds were heavily invested in sub-prime mortgage securities. The damage soon
spread across the Atlantic to a little-known German state-owned bank, IKB. In
July 2007, IKB’s wholly-owned conduit, Rhineland Funding, had approximately €20
billion of Asset Backed Commercial Paper (ABCP). In mid-July, investors refused
to rollover part of Rhineland Funding’s ABCP. That forced the European Central
Bank to inject record volumes of liquidity into the market to keep the banking
system liquid.
Rhineland Funding asked IKB to provide a credit line. IKB revealed it
didn’t have enough cash or liquid assets to meet the request of its conduit,
and was only saved by an emergency €8 billion credit facility provided by its
state-owned major shareholder bank, the Kreditanstalt für Wiederaufbau,
ironically the bank which led the Marshall Plan reconstruction of war-torn
Germany in the late 1940’s. It was soon to become evident to the world that a
new Marshall Plan, or some financial equivalent, was urgently needed for the
United States economy; however, there were no likely donors stepping up to the
plate this time.
The intervention of KfW, rather than stopping the panic, led to reserve
hoarding and to a run on all commercial paper issued by international banks’
off-books Structured Investment Vehicles (SIVs).
Asset Backed Commercial Paper was one of the big products of the asset
securitization revolution fostered by Greenspan and the US financial
establishment. They were the stand-alone creations of the major banks, set up
to get risk off the bank’s balance sheet.
The SIV would typically issue Commercial Paper securities backed by a
flow of payments from the cash collections received from the conduit’s
underlying asset portfolio. The ABCP was a short-term debt, generally no more
than 270 days. Crucially, they were exempt from the registration requirements
of the US Securities Act of 1933. ABCPs
were typically issued from pools of trade receivables, credit card
receivables, auto and equipment loans and leases, and collateralized debt
obligations.
In the case of IKB in Germany, the cash flow was supposed to come from
its portfolio of sub-prime US home mortgages, mortgage backed Collateralized
Debt Obligations (CDOs). The main risk faced by ABCP investors was asset
deterioration—that the individual loans making up the security
default—precisely what began to cascade through the US mortgage markets during
the summer of 2007.
The problem with CDOs was that once issued, they were rarely traded.
Their value, rather than being market-driven, were based on complicated
theoretical models.
When CDO holders around the world last summer suddenly and urgently
needed liquidity to face the market sell-off, they found the market value of
their CDOs was far below book value. So, instead of generating liquidity by
selling CDOs, they sold high-quality liquid blue chip stocks, government bonds,
precious metals.
That simply meant the CDO crisis led to a loss of value in both CDOs
and stocks. The drop in price of equities triggered contagion to hedge funds.
That dramatic price collapse wasn’t predicted by the theoretical models built
into quantitative hedge funds and led to large losses in that part of the
market, led by Bear Stearns’ two in-house hedge funds. Major losses by leading
hedge funds further fed increasing uncertainty and amplified the crisis.
That was the beginning of colossal collateral damage. The models all
broke down.
Lack of transparency was at the root of the crisis that had finally and
inevitably erupted in mid-2007. That lack of transparency was due to the fact
that instead of spreading risk in a transparent way as foreseen by accepted
economic theory, market operators chose ways to “securitize” risky assets by
promoting high-yielding, high-risk assets, without clearly marking their risk.
Additionally, credit-rating agencies turned a blind eye to the inherent risks
of the products. The fact that they were rarely traded meant even the
approximate value of these structured financial products was not known. [1]
Ignoring lessons from LTCM
With that collapse of confidence among banks in the international
inter-bank market, the heart of global banking and which trades in Asset Backed
Commercial Paper, the banking system stared a systemic crisis in the face. A
crisis now threatened of a domino collapse of banks akin to that in Europe in
1931, when the French banks for political reasons pulled the plug on the
Austrian Creditanstalt. Greenspan’s New Finance was at the heart of the new
instability. It was his Age of Turbulence, to parody the title of his
ghost-written autobiography.[2]
The world financial system had faced a systemic crisis threat as
recently as the September 1998 collapse of the Long-Term Capital Management
(LTCM) hedge fund in Greenwich, Connecticut. Only extraordinary coordinated
central bank intervention then, led by Greenspan’s US Federal Reserve,
prevented a global meltdown.
That LTCM crisis contained the seed crystal of all that is going wrong
with the multi-trillion dollar asset securitization markets today. Curiously,
Greenspan and others in positions of responsibility systematically refused to
take those lessons to heart.
The nominal trigger of the LTCM crisis was an event not foreseen in the
hedge fund’s risk model. Its investment strategies were based on what they felt
was a predictable mild range of volatility in foreign currencies and bonds
based on data from historical trading experience. When Russia declared it was
devaluing its rouble currency and defaulting on its Russian state bonds, the
risk parameters of LTCM’s risk models were literally blown out of the water,
and LTCM with it. Sovereign debt default was an event that was not “normal.”
Unlike the risk assumptions of every risk model used by Wall Street,
the real world was also not normal, but rather highly unpredictable.
To cover their losses LTCM and its banks began a panic sell-off of
anything it could liquidate, triggering panic selling by other hedge funds and
banks to cover exposed positions. In response, the US stock market dropped 20%,
while European markets fell 35%. Investors sought safety in US Treasury bonds,
causing interest rates to drop by over a full point. As a result, LTCM’s highly
leveraged investments started to crumble. By the end of August 1998, it lost
50% of the value of its capital investments.
In the summer of 1997 amid the hedge fund-led attacks on the vulnerable
currencies of Thailand, Indonesia, Malaysia and other Asian high-growth “Tiger”
economies, Malaysia’s Prime Minister Mahathir Mohamad openly called for greater
international control on the murky speculation of hedge funds. He named the
name of one of the largest involved in the Asian attacks, George Soros’ Quantum
Fund. Because of US pressure from the Treasury Department by Secretary Robert
Rubin, the former head of Goldman Sachs, and from the Greenspan Fed, no
oversight of opaque offshore hedge funds was ever undertaken. Instead they were
let to grow into funds holding more than $1.4 trillion in assets by 2007.
Fatally flawed risk models
The point about that LTCM crisis that rocked the foundations of the
global finance system, was who was involved and what economic assumptions they
used—the very same fundamental assumptions used to construct the deadly-flawed
risk models of the asset securitization debacle.
At the beginning of 1998, LTCM had capital of $4.8 billion, a portfolio
of $200 billion, built from its borrowing capacity or credit lines loaned from
all the major US and European banks hungry for untold gains from the successful
fund. LTCM held derivatives with a notional value of $1,250 billion. That is
one unregulated, offshore hedge fund held a portfolio of options and other
financial derivatives nominally worth one and a quarter trillion dollars.
Nothing of that scale had ever before been dreamed of. The dream rapidly turned
into a nightmare.
In the argot of Wall Street, LTCM was a highly geared fund,
unbelievably high. One of its investors was the Italian central bank, so
awesome was the fund’s reputation. The major global banks who had poured their
money into LTCM hoping to coattail the success and staggering profits included
Bankers Trust, Barclays, Chase, Deutsche Bank, Union Bank of Switzerland,
Salomon Smith Barney, J.P.Morgan, Goldman Sachs, Merrill Lynch, Crédit Suisse,
First Boston, Morgan Stanley Dean Witter; Société Générale; Crédit Agricole;
Paribas, Lehman Brothers. Those were the very banks that were to emerge less
than a decade later at the heart of the securitization crisis in 2007.
Speaking to press at the time, US Treasury Secretary Rubin declared,
“LTCM was a single isolated instance in which the judgment was made by the
Federal Reserve Bank of New York that there were possible systemic implications
of a failure, and what they did was to organize or bring together a group of
private sector institutions which then made a judgment of what was in their
economic self interest."
The source of the awe over LTCM was the “dream team” who ran it. The
fund’s CEO and founder was John Meriwether, a legendary trader who had left
Salomon Brothers following a scandal over purchase of US Treasury bonds. That
hadn’t dented his confidence. Asked whether he believed in efficient markets,
he once modestly replied, "I MAKE them efficient." The fund’s
principal shareholders included the two eminent experts in the
"science" of risk, Myron Scholes and Robert Merton. Scholes and
Merton had been awarded the Nobel Prize for economics in 1997 for their work on
derivatives by the Swedish Academy of Sciences. LTCM also had a dazzling array
of professors of finance, doctors of mathematics and physics and other
"rocket scientists" capable of inventing extremely complex, daring
and profitable financial schemes.
Black-Scholes, fundamental flaws and risk models
There was only one flaw. Scholes’ and Mertons’ fundamental axioms of
risk, the assumptions on which all their models were built, were wrong. They
had been built on sand, fundamentally and catastrophically wrong. Their mathematical
options pricing model assumed that there were Perfect Markets, markets so
extremely deep that traders' actions could not affect prices. They assumed that
markets and players were rational. Reality suggested the opposite—markets were
fundamentally irrational in the long-term. But the risk pricing models of
Black, Scholes and others over the past two or more decades had allowed banks
and financial institutions to argue that traditional lending prudence was old
fashioned. With suitable options insurance, risk was no longer a worry. Eat,
drink and be merry...
That, of course, ignored actual market conditions in every major market
panic since Black-Scholes model was introduced on the Chicago Board Options
Exchange. It ignored the fundamental role of options and ‘portfolio insurance’
in the Crash of 1987; it ignored the causes of the panic that in 1998 brought
down Long Term Capital Management – of which Scholes and Merton were both
partners. Wall Street blissfully ignored the obvious along with the economists
and governors in the Greenspan Fed.
Financial markets, contrary to the religious dogma taught at every
business school since decades, were not smooth, well-behaved models following
the Gaussian Bell-shaped Curve as if it were a law of the universe. The fact
that the main architects of modern theories of financial engineering—now given
the serious-sounding name ‘financial economics’—all got Nobel prizes, gave the
flawed models the aura of Papal infallibility. Only three years after the 1987
crash the Nobel Committee in Sweden gave Harry Markowitz and Merton Miller the
prize. In 1997 amid the Asia crisis, it gave the award to Robert Merton and
Myron Scholes. [3]
The most remarkable aspect of the incompetent risk models in use since
the origins of financial derivatives in the 1980’s, through to the explosive
growth of asset securitization in the last decade, was how little they were
questioned.
LTCM had ace Wall Street investment bankers, two Nobel Prize economists
who literally invented the theory of pricing derivatives on everything from
stocks to currencies. To top its all-star LTCM lineup, David Mullins, the
former vice-chairman of the Federal Reserve Board under Alan Greenspan quit his
job with the Maestro to become a partner at LTCM. Despite all this, the traders
at LTCM and those who followed them to the edge of the financial abyss in
August 1998 did not have a hedge against the one thing they now
confronted—systemic risk. Systemic risk was precisely what they confronted once
an “impossible event,” the Russian state default, had occurred.
Despite the clear lessons from the harrowing LTCM debacle—there is no
derivative that insures against systemic risk—Greenspan, Rubin and the New York
banks continued to build their risk models as if nothing had taken place. The
Russian sovereign default was dismissed as a “once in a Century event.” They
were moving on to build the dot.com bubble and, in the aftermath, the greatest
financial bubble in human history—the asset securitization bubble of 2002-2007.
Life is no Bell Curve
Risk and its pricing did not behave like a bell-shaped curve, not in financial
markets any more than in oilfield exploitation. In 1900 an obscure French
mathematician and financial speculator, Louis Bachelier, argued that price
changes in bonds or stocks followed the bell-shaped curve that the German
mathematician, Carl Friedrich Gauss, devised as a model to map statistical
probabilities for various events. Bell curves assumed a mild form of randomness
in price fluctuations, just as the standard I.Q. test by design defines 100 as
“average,” the center of the bell. It was a kind of useful alchemy, but still
alchemy.
That assumption that financial price variations behaved fundamentally
like the bell curve allowed Wall Street Rocket Scientists to roll out an
unending stream of new financial products each more arcane and complex than the
previous. The theories were modified. The “Law of Large Numbers” was added to
say that when the number of events becomes sufficiently large, like flips of a
coin or rolls of die, the value converges on a stable value over the long term.
The Law of Large Numbers, which in reality was no scientific law at all,
allowed banks like Citigroup or Chase to issue hundreds of millions of Visa
cards without so much as a credit check, based on data showing that in “normal”
times defaults on credit cards were so rare as not to be worth considering.[4]
The problems with models based on bell curve distributions or laws of
large numbers arose when times were not normal, such as a steep economic
recession of the sort the United States economy today is beginning to
experience, a recession comparable perhaps only to that of 1931-1939.
The remarkable thing was that America’s academic economists and Wall
Street investment bankers, Federal Reserve governors, Treasury secretaries,
Sweden’s Nobel Economics Prize judges, England’s Chancellors of the Exchequer,
her High Street bankers, her Court of the Bank of England, to name just the
leading names, all were willing to turn a blind eye to the fact that economic
theory, theories of market behavior, theories of derivative risk pricing, were
incapable of predicting, let alone preventing, non-linear surprises. It was
incapable of predicting bursting of speculative bubbles, not in October 1987,
not in February 1994, in March 2002, and most emphatically not since June 2007.
It couldn’t because the very model created the conditions that led to the ever
larger and more destructive bubbles in the first place. Financial Economics was
but another word for unbridled speculative excess.
A theory incapable of explaining such major, defining surprise events,
despite Nobel prizes, was not worth the paper it was written on. Yet the US
Federal Reserve Governors—above all Alan Greenspan, US Treasury secretaries,
above all Robert Rubin and Lawrence Summers and Henry Paulsen—prevailed to make
sure that Congress never lay a legislative or regulatory hand on the exotic
financial instruments that were being created, created based on a theory that
was utterly irrelevant to reality.
On September 29, 1998, Reuters reported, “any attempt to regulate
derivatives, even after the collapse—and rescue—of LTCM have not met with
success. The CFTC (the government agency with nominal oversight over
derivatives trading-w.e.) was barred from expanding its regulation of
derivatives under language approved late on Monday by the US House and Senate
negotiators. Earlier this month the Republican chairmen of the House and Senate
Agriculture Committees asked for the language to limit the CFTC's regulatory
authority over over-the-counter derivatives echoing industry concerns."
Industry of course meant the big banks.
Reuters added that “when the initial subject of regulation was broached
by the CFTC both Fed chairman, Alan Greenspan, and Treasury Secretary Rubin
leapt to the defense of the industry claiming that the industry did not need
regulation and that to do so would drive business overseas.”
The combination of relentless refusal to allow regulatory oversight of
the explosive new financial instruments from Credit Default Swaps to Mortgage
Backed Securities and the myriad of similar exotic “risk-diffusing” financial
innovations and the 1999 final repeal of the Glass-Steagall Act strictly
separating securities dealing banks from commercial lending banks opened the
way for what in June 2007 began as the second Great Depression in less than a
century. It began what future historians will describe as the final demise of
the United States as the dominant global financial power.
Liars’ Loans and NINA: Banks in an orgy of fraud
The lessons of the 1998 Russia default and the LTCM systemic crisis
were forgotten within weeks by the major players of the New York financial
establishment. Flanked by MBA whiz kid ‘rocket scientist’ analysts, bell curve
models and fatally flawed risk models, the financial giants of the US banking
world launched a wave of mega-mergers and began to create ingenious ways of
getting lending risk off their books. That opened the doors to the greatest era
of corporate and financial fraud in world history, the asset securitization
bonanza.
With Glass-Steagall finally repealed in late 1999, at the urgings of
Greenspan and Rubin, banks were now free to snatch up rivals across the
spectrum from insurance companies to consumer credit or finance houses. The
landscape of American banking underwent a drastic change. The asset
securitization revolution was ready to be launched.
With Glass-Steagall gone, now only bank holding companies and
subsidiary pure lending banks were directly monitored by the Federal Reserve.
If Citigroup opted to close its Citibank branch in a sub-prime neighborhood and
instead have a new wholly-owned subsidiary, CitiFinancial, which specialized in
sub-prime lending, work the area, CitiFinancial could operate under entirely
different and lax regulation.
CitiFinancial issued mortgages separately from Citibank. Consumer
groups accused CitiFinancial of specializing in “predator loans” in which
unscrupulous mortgage brokers or salesmen would push a loan on a family or
person far beyond his comprehension or capacity to handle the risks. And
Citigroup was only typical of most big banks.
On January 8, 2008 Citigroup announced with great fanfare publication
of its consolidated “US residential mortgage business,” including mortgage
origination, servicing and securitization. Curiously, the statement omitted
CitiFinancial, the subsidiary with the most risk. [5]
Basle I loopholes
The driver pushing the banks towards securitization and the
proliferation of off-balance-sheet risks including highly leveraged derivatives
positions was the 1987 Basle Bank for International Settlements Capital
Adequacy Accord, known today as Basle I. That agreement among the central banks
of the world’s largest economies required banks to set aside 8% of a normal
commercial loan as reserve against possible future default. The then-new
innovation of financial derivatives were not mentioned in Basle I on US
insistence.
The Accord originally had been intended by Germany’s ultra-conservative
Bundesbank and other European central banks to rein in the more speculative
Japanese and US bank lending which had led to the worst banking crisis since
the 1930’s. The original intent of the Basle Accord was to force banks to
reduce lending risk. The actual effect for US banks was just the opposite. They
soon discovered a gaping loophole—off-balance-sheet transactions, notably
derivatives positions and securitization. Because they were left out of Basle I
banks need not set aside any capital to cover potential losses.
The elegance of securitization of loans such as home mortgages for the
issuing bank was that they could take the loan or mortgage and immediately sell
it on to a securitizer or underwriter who bundled hundreds of such loans into a
new Asset Backed Security. This seemingly genial innovation was far more
dangerous than it sounded. Lending banks no longer needed to carry a mortgage
loan on its books for 20-30 years as was traditional. They sold it on at a
discount and used the cash to turn the next round of credit issuing.
That meant as well that the lending bank now no longer had to worry if
the loan would ever be repaid.
Fraud a la mode
It didn’t take long before lending banks across the United States
realized they were sitting on a bonanza bigger than the California gold rush.
With no worry about whether a borrower of a home mortgage, say, would be able
to service the debt for the next decades, banks realized they made money on
pure loan volume and resell to securitizers.
Soon it became commonplace for banks to outsource their mortgage
lending to free-lance brokers. Instead of doing their own credit checks they
relied, often exclusively, on various online credit questionnaires, similar to
the Visa card application where no follow-up was done. It became common
practice for mortgage lenders to offer brokers bonus incentives to bring in
more signed mortgage loan volume, another opportunity for massive fraud. The
banks got more gain from making high volumes of loans then selling for securitization.
The world of traditional banking was being turned on its head.
As the bank no longer had an incentive to assure the solidity of a
borrower through minimum cash down payments and exhaustive background credit
checks, many US banks, simply to churn loan volume and returns, gave what they
cynically called “Liars’ Loans.” They knew the person was lying about his
credit and income to get that dream home. They simply didn’t care. They sold
the risk once the ink was dry on the mortgage.
A new terminology arose after 2002 for such loans, such as “NINA”
mortgages—No Income, No Assets. “No problem, Mister Jones. Here’s $400,000 for
your new home, enjoy.”
With Glass-Steagall no longer an obstacle, banks could set up myriad
wholly-owned separate entities to process the booming home mortgage business.
The giant of the process was Citigroup, the largest US bank group with over
$2.4 trillion of group assets.
Citigroup included Travelers Insurance, a state-regulated insurer. It
included the old Citibank, a huge retail lending bank. It included the
investment bank, Smith Barney. And it included the aggressive sub-prime lender,
CitiFinancial, according to numerous consumer reports, one of the most
aggressive predatory [6] lenders pushing
sub-prime mortgages on often ignorant or insolvent borrowers, often in poor
black or Hispanic neighborhoods. It included the Universal Financial Corp. one
of the nation’s largest credit card issuers, who used the so-called Law of
Large Numbers to grow its customer base among more and more dodgy credit risks.
Citigroup also included Banamex, Mexico’s second largest bank and Banco
Cuscatlan, El Salvador’s largest bank. Banamex was one of the major indicted
money laundering banks in Mexico. That was nothing foreign to Citigroup. In
1999 the US Congress and GAO investigated Citigroup for illicitly laundering
$100 million in drug money for Raul Salinas, brother of the then-Mexican
President. The investigations also
found the bank had laundered money for corrupt officials from Pakistan to Gabon
to Nigeria.
Citigroup, the financial behemoth was merely typical of what happened
to American banking after 1999. It was a different world entirely from anything
before with the possible exception of the excesses of the Roaring ‘20’s. The degree
of lending fraud and abuse that ensued in the new era of asset securitization
was staggering to the imagination.
The Predators had a ball
One US consumer organization documented some of the most common
predatory lending practices during the real estate boom:
“In the United States in the first decade of the 21st century there are
many storefronts offering such loans. Some are old -- Household Finance and its
sister Beneficial, for example -- and some are newer-fangled, like
CitiFinancial. Both offer credit at rates over thirty percent. The business is
booming: the spreads, Wall Street says, are too good to pass up. Citibank pays
under five percent interest on the deposits it collects. Its affiliated loan
sharks charge four times that rate, even for loans secured by the borrower's
home. It's a can't-miss proposition. Even if the economy goes South they can
take and resell the collateral. The business is global: the Hong Kong &
Shanghai Banking Corporation, now HSBC, wants to export it to the eighty-plus
countries in which it has a retail presence. Institutional investors love the
business model and investment banks securitize the loans. These fancy terms
will be defined as we proceed. The
root, however, the fodder on which the whole pyramid rests, is the solitary
customer at what's called the point of sale… points and fees can be added to
the money that's lent. CitiFinancial and Household Finance both suggest that
insurance is needed. This they serve in a number of flavors -- credit life and
credit disability, credit unemployment and property insurance -- but in almost
all cases, it is included in the loans and interest is charged on it. It's
called "single premium" -- instead of paying each month for coverage,
you pay in advance with money on which you pay interest. If you choose to
refinance, you will not get a refund. It is money down the drain, but at the
point-of-sale it often goes unnoticed.
Take, for example, the purchase of furniture. A bedroom set might cost
two thousand dollars. The sign says Easy Credit, sometimes spelled E-Z. The
furniture man does not manage these accounts. For this he turns to
CitiFinancial, to HFC or perhaps to Wells Fargo. While the Federal Reserve
lends money to banks at below five percent, these bank-affiliates charge twenty
or thirty or forty percent. You will have insurance on your furniture: to
protect you, they say, from having it repossessed if you die or become
unemployed. Before the debt is discharged, dead or alive, you will have paid
more than the list-price of a luxury car or a crypt with a doorman.
Midway you'll be approached with a sweet-sounding offer: if you'll put
up your home as collateral, your rate can be lowered and the term be extended.
A twenty-year mortgage, fixed or adjustable. The rate will be high and the
rules not disclosed. For example: if you satisfy the loan too quickly, you'll
be charged a pre-payment penalty. Or, you'll pay slowly and then be asked to
pay more, in what's called a balloon. If you can't, that's okay: they knew you
couldn't. The goal is to refinance your loan and charge you yet more points and
fees.
In prior centuries, this was called debt peonage. Today it is the fate
of the so-called sub-prime serf. Fully twenty percent of American households
are described as sub-prime. But half of the people who get sub-prime loans
could have paid normal rates, according to Fannie Mae and Beltway authorities.
Outside it's the law of the jungle; the only rule is Buyer Beware. But this is
easier for some people than others.
Why would a person overpay by so much? In the nation's low-income
neighborhoods, sometimes called ghettos or, in a more poetic euphemism, the
inner city, there's a lack of bank branches. In the late 20th century, many
financial institutions left the 'hood in the lurch. They refused to lend money;
they refused to write insurance policies. [7]
In the 1980’s this author interviewed a senior Wall Street banker, at
the time recovering from some kind of burnout. I asked about his bank’s
business in Cali, Colombia during the heyday of the Cali cocaine cartel.
Speaking not for attribution, he related, “Banks would literally kill to get a
slice of this business, it’s so lucrative.” Clearly they moved on to sub-prime
lending with similar goals in mind, and profits as huge as in money laundering
drug gains.
Alan Greenspan openly backed the extension of bank lending to the
poorest ghetto residents. Edward M. Gramlich, a Federal Reserve governor who
died in September 2007, warned nearly seven years ago that a fast-growing new
breed of lenders was luring many people into risky mortgages they could not
afford. When Gramlich privately urged Fed examiners to investigate mortgage
lenders affiliated with national banks, he was rebuffed by Alan Greenspan. Greenspan ruled the Fed with nearly the power
of an absolute monarch. [8]
Revealing what was most certainly the tip of a very extensive iceberg
of fraud, the FBI recently announced it was investigating 14 companies for
possible accounting fraud, insider trading or other violations in connection
with home loans made to risky borrowers. The FBI announced that the probe
involved companies across the financial services industry, from mortgage
lenders to investment banks that bundle home loans into securities sold to
investors.
At the same time, authorities in New York and Connecticut were
investigating whether Wall Street banks hid crucial information about high-risk
loans bundled into securities sold to investors. Connecticut Attorney General
Richard Blumenthal said he and New York Attorney General Andrew Cuomo were
looking whether banks properly disclosed the high risk of default on so-called
"exception" loans — considered even riskier than sub-prime loans —
when selling those securities to investors. Last November, Cuomo issued
subpoenas to government-sponsored mortgage companies, Fannie Mae and Freddie
Mac, in his investigation into what he claimed were conflicts of interest in
the mortgage industry. He said he wanted to know about billions of dollars of
home loans they bought from banks, including the largest US savings and loan,
Washington Mutual Inc., and how appraisals were handled.
The FBI said it was looking into the practices of sub-prime lenders, as
well as potential accounting fraud committed by financial firms that hold these
loans on their books or securitize them and sell them to other investors.
Morgan Stanley, Goldman Sachs Group Inc. and Bear Stearns Cos. all disclosed in
regulatory filings that they were cooperating with requests for information
from various unspecified, regulatory and government agencies. [9]
One former real estate broker from the Pacific Northwest, who quit the
business in disgust at the pressures to push mortgages on unqualified
borrowers, described some of the more typical practices of predatory brokers in
a memo to this author:
The sub-prime fiasco is a nightmare alright, but the prime ARMs hold
potential for overwhelming disaster.
The first “hiccup” occurred in July/August 2007 - this was the
“Sub-prime Fiasco,” but in November 2007 the hiccup was more than that. It was in November 2007, that the prime ARMs
adjusted upwards.
What this means is that upon the “anniversary date of the loan” the
Adjustable Rate Mortgage adjusts up into a higher payment. This happens because
the ARM was “purchased” at a teaser rate, usually one or one and one half
percent. Payments made at that rate, while very attractive, do nothing to
reduce principal and even generate some unpaid interest which is tacked onto
the loan. Borrowers are permitted to make the teaser rate payments for the entire
first year, even though the rate is good only for the first month.
Concerns about “negative amortization,” whereby the indebtedness on the
loan becomes more than the market value of the property, were allayed by
reference to the growth in property values due to the bank-created bubble,
which it was said was normal and could be relied upon to continue. All that was
promoted by the lenders who sent armies of account executives, i.e., salesmen,
around to the mortgage brokers to explain how it would work.
Adjustable interest rates on home loans were the sum of the bank’s
profit - the margin - and some objective predictor of the cost of the borrowed
funds to the bank, known as the index. Indexes generated by various economic
activities - what the banks around the country were paying for 90 day CD’s or
what the banks in the London Interbank Exchange (LIBOR) were paying for dollars
- were used. Adding the margin to the index produces the true interest rate on
the loan - the rate at which, after 30 years of payments, the loan will be
completely paid off (“amortized”). It
is called the “fully indexed rate.”
I am going to pick an arbitrary 6% as the “real” interest rate (3%
margin + 3% index). With a loan amount of $250,000.00 the monthly payment at 1%
would be $804.10; that is the “teaser rate” payment, exclusive of taxes and
insurance. This would adjust with changes in the index, but the margin remains
static for the life of the loan.
This loan is structured so that payment adjustments only occur once per
year and are capped at 7.5 % of the previous year’s payment. That can go
on, stair stepping, for a period of 5 years (or 10 years in the case of one
lender) without regard to what is happening in the real world. Then, at the end of the 5 years, the caps
come off and everything adjusts to payments under the “fully indexed
rate.”
If the borrower has been making only the minimum required payments the
whole time, this can result in a payment shock in the thousands. If the value
of the home has decreased twenty-five percent, the borrower, this time someone
with stellar credit, is encouraged to give it back to the bank, which devalues
it at least another twenty-five percent and that spreads to the surrounding
properties. [10]
According to a Chicago banking insider, during the first week of
February 2008, bankers in the U.S. were made aware of the following:
Chase Manhattan Bank (“CMB”) has sent out an unlimited number of statements to
its customers about Lines of Credit (“LOC’s”. The terms of its LOC’s, which,
have been popular in the past, are now being manipulated and the values of the properties securing
them are being unilaterally adjusted down, sometimes as much as 50 percent.
This means homeowners are faced with making payments on a loan to buy an asset
that is apparently worth half of the principal amount of the loan and paying
interest on top of that. The only sensible thing to do in many cases is walk
away, which results in a major loss in equity, reducing the value of all
surrounding properties and adding to the avalanche of foreclosures.
This is especially aggravated in cases of “Creative Financing” LOCs -
those that were drawn on equal to between ninety and one hundred percent of the
value of the property before the
bubble burst…
CMB has automatically closed credit lines that have “open” credit on
them - meaning that the borrower left some money in the LOC for the future -
over an 80% ratio of the amount of the loan to the value (“LTV”) of the
property. This has been done on a mass
basis without any reference to the “property owners.”
Loan to Value limits mean that the amount of money which the lender is
willing to loan cannot exceed the stated percentage of the property value. In common practice, an appraiser would be
hired to assess the value of the property. The appraisal is informed by
comparable sales of other properties which have sold in an area that, with a
few exceptions, must be no more than one mile away from the subject
property. That was merely the tip of
the mortgage fraud bonanza that preceded the present unfolding Tsunami.
The Tsumani is only beginning
The nature of the fatally flawed risk models used by Wall Street, by
Moody’s, by the securities Monoline insurers and by the economists of the US
Government and Federal Reserve was such that they all assumed recessions were
no longer possible, as risk could be indefinitely diffused and spread across
the globe.
All the securitized assets, the trillions of dollars worth, were priced
on such flawed assumption. All the trillions of dollars of Credit Default
Swaps—the illusion that loan default could be cheaply insured against with
derivatives—all these were set to explode in a cascading series of domino-like
crises as the crisis in the US housing market unraveled. The more home prices
fell, the more mortgages facing sharply higher interest rate resets, the more
unemployment spread across America from Ohio to Michigan to California to
Pennsylvania to Colorado and Arizona. That process set off a vicious
self-feeding spiral of asset price deflation.
The sub-prime sector was merely the first manifestation of what was to
unravel. The process will take years to wind down. The damaged products of
Asset Backed Securities were used in turn as collateral for yet further bank
loans, for leveraged buyouts by private equity firms, by corporations, even by
municipalities. The pyramid of debt built on assets securitized began to go
into reverse leverage as reality dawned in global markets that no one knew the
worth of the securitized paper they held.
In what would be a laughable admission were the consequences of their
criminal negligence not so tragic for millions of Americans, Standard &
Poors, the second largest rating agency in the world stated in October 2007
that they “underestimated the extent of fraud in the US mortgage industry.”
Alan Greenspan feebly tried to exonerate himself by claiming that lending to
sub-prime borrowers was not wrong, only the later securitization of the loans.
The very system they worked over decades to create was premised on fraud and
non-transparency.
Credit Default Swap crisis next
As of this writing, the next ratchet down in the US financial Tsunami
was the monocline insurers where, short of a US government nationalization, no
solution was feasible as the unknown risks were so staggering. That problem was
discussed in the previous Part IV.
Next to explode will be the imminent probability of meltdown in the $45
trillion market in Over-the-Counter Credit Default Swaps (CDS), the brainchild
of J.P. Morgan.
As Greenspan made certain, the CDS market remained unregulated and
opaque, so that no one knew what the scale of the risks in a falling economy
were. Because it is unregulated it often was the case that one party to a CDS
resold to another financial institution without informing the original
counterparty. That means it is not obvious that were an investor to try to cash
in his CDS he could track down its payer of the claim. The CDS market was
overwhelmingly concentrated in New York banks who held swaps at the end of 2007
worth nominally $14 trillion. The most exposed were J.P. Morgan Chase with $7.8
trillion and Citigroup and Bank of America with $3 trillion each.
The problem had been exacerbated by the fact that of the $45 trillions
of credit default swaps, some 16% or $7.2 trillion worth were written to
protect holders of Collateralized Debt Obligations where the mortgage
collateral problems were concentrated. The CDS market was a ticking time bomb
with an atomic detonator. As the credit
crisis spreads in coming months, corporations will be forced to default on
their bonds and writers of CDS insurance will face exploding claims and
non-transparent rules. A claims settlement procedure for a market nominally
worth $45 trillion did not exist as of February 2008.
As hundreds of thousands of Americans over the coming months find their
monthly mortgage payments dramatically reset according to their Adjustable Rate
Mortgage terms, another $690 billion in home mortgage debt will become prime
candidates for default. That in turn will lead to a snowball effect in terms of
job losses, credit card defaults and another wave of securitization crisis in
the huge market for securitized credit card debt. The remarkable thing about
this crisis is that so much of the sinews of the entire American financial
system were tied in to it. There has never been a crisis of this magnitude in
American history.
At the end of February the Financial
Times of London revealed that US banks had “quietly” borrowed $50 billion
in funds from a special new Fed credit facility to ease their cash crisis.
Losses at all the major banks from Citigroup to J.P.Morgan Chase to most other
major US bank groups continued to mount as the economy sank deeper into a
recession that clearly would turn in coming months into a genuine depression.
No Presidential candidate had dared utter a serious word about their proposals
to deal with what was becoming the greatest financial and economic meltdown in
American history.
By the early days of 2008 it was becoming clear that Financial
Securitization would be the Last Tango for the United States as the global
financial superpower.
The question now was posed what new center or centers of financial
power could conceivably replace New York as the global nexus. That we will
examine in Part VI.
Endnotes:
[1]
UNCTAD Secretariat, Recent developments
on global financial markets: Note by the UNCTAD secretariat,
TD/B/54/CRP.2, Geneva, 28 September 2007.
[2]
For a treatment of the little-known political background to the 1931
Creditanstalt crisis that led to a domino collapse of German banks, see
Engdahl, F. William, A Century of War:
Anglo-American Oil Politics and the New World Order, 2004, London, Pluto
Press, Chapter 6.
[3]
Schroy, John Oswin, Fallacies of the
Nobel Gods: Essay on Financial Economics and Nobel Laureates, in http://www.capital-flow-analysis.com/investment-essays/nobel_gods.html.
[4]
For a fascinating treatment of the fundamental theoretical flaws of economic
and financial market models used today, and what he calls the high odds of
catastrophic price changes, I recommend the book by the Yale mathematician and
inventor of fractal geometry, Benoit Mandelbrot, in Mandelbrot, Benoit and
Hudson, Richard L., The (mis) Behavior of
Markets: A Fractal View of Risk, Ruin and Reward, Profile Books Ltd,
London, 2004.
[5]
Cited by Inner City Press, The Citigroup
Watch, January 28, 2008, in www.innercitypress.org.citi.html.
[6]
Rainforest Action Network, Citigroup
Becomes Mexico’s Largest Bank after Banamex Merger, August 10, 2001,
in
http://forests.org/archive/samerica/cibemexi.htm.
[7]
Lee, Matthew, Predatory Lending: Toxic
Credit in the Inner City, 2003, InnerCityPress.org.
[8]
Andrews, Edmund L., Fed Shrugged as
Sub-prime Crisis Spread, The New York Times, Dec.18, 2007.
[9]
Zibel, Alan, FBI Probes 14 Companies Over Home Loans, AP, January 29, 2008.
[10]
Private communication to the
author from a former mortgage broker with a large US mortgage lender.