by admin » Sat Oct 18, 2008 4:29 pm
Financial Meltdown 101
By Arun Gupta,
Indypendent.
October 13, 2008.
Everything you ever wanted to know about the biggest economic meltdown since the Depression, but were afraid to ask.
From 1982 to 2000, the U.S. stock market went on the longest bull run ever, as share prices rose to dizzying heights. In the late 1990s, a combination of factors, which included the Federal Reserve lowering interest rates, created a huge price bubble in Internet stocks.
A speculative bubble occurs when price far outstrips the fundamental worth of the asset. Bubbles have occurred in everything from real estate, stocks and railroads to tulips, beanie babies and comic books. As with all bubbles, it took more and more money to make a return*. This led to the Internet bubble popping in March 2000.
During this market mania, the Fed gutted the Glass-Steagall Act, enacted during the Depression to prevent the type of banking activity that led to the 1929 stock market crash.
In 1996, the Fed allowed regular banks to become heavily involved in investment banking, which opens the door to conflicts of interest in banks pushing sketchy financial products on customers who poorly understood the risks. [like ABCP in Canada]
In 1999, under intense pressure from financial firms, Congress overturned Glass-Steagall, allowing banks to engage in any sort of activity from underwriting insurance to investment banking to commercial banking (such as holding deposits).
*For instance, if you purchased 100 shares of Apple at $10 a share and it rose to $20, it cost $1,000 to make $1,000 profit (a 100 percent return), but if the shares were $100 each and rose to $110, it would cost $10,000 to make $1,000 profit (a 10 percent return -- and the loss potential would be much greater, too.
Many Americans joined the stock mania literally in the last days and lost considerable wealth, and some, such as Enron employees, lost their life savings. When the stock market bubble erupted, turbulence rippled through the larger economy, causing investment and corporate spending to sink and unemployment to rise.
Then came the Sept. 11, 2001, attacks, generating a shock wave of fear and a drop in consumer spending. Burned by the stock market, many people shifted to real estate as a more secure way to build wealth.
By 2002, with the economy already limping along, former Federal Reserve Chairman Alan Greenspan and the Fed slashed interest rates to historic lows of near 1 percent to avoid a severe economic downturn. Low interest rates make borrowed money cheap for everyone from homebuyers to banks. This ocean of credit was one factor that led to a major shift in the home-lending industry -- from originate to own to originate to distribute. Low interest rates also meant that homebuyers could take on larger mortgages, which supported rising prices.
In the originate-to-own model, the mortgage lender -- a bank, private mortgage company or credit union -- holds the mortgage to term, usually 30 years. Every month the bank originating the mortgage receives a payment -principal and interest - from the homeowner.
If the buyer defaults on the mortgage, the bank can seize and sell the house. Given strict borrowing standards and the long life of the loan, it's like the homebuyer is getting married to the bank.
In the originate-to-distribute model, banks sell the mortgage to third parties, turning the loans into a commodity like widgets on a conveyor belt. By selling the loan, the bank frees up its capital so it can turn around and finance a new mortgage. Thus, the banks have an incentive to distribute mortgages fast so they can recoup the funds plus fees and interest (no 30 year wait) and sell more mortgages. By selling the loan, the bank also distributes the risk of default. In effect they loan someone else's money - an investor's.
Because in the last decade they have sold the loan, in just a few days, they had no concern that a buyer might default. It was not their money at stake. They began using high-pressure tactics to mass-produce mortgages [and credit cards, car loans, lines of credit, business loans, etc] because the profit was in volume--how many loans could be approved how fast. This was complemented by alleged fraud throughout the real estate industry, credit card and car loan industries - and some banks. Appraisers over-valued homes and mortgage brokers approved anyone with a pulse, gave out credit card and car loans in the same way - not verifying assets, job status or income.
And the mushrooming housing industry, and consumer spending [debt] distorted the whole economy. Net job growth from 2002 to 2007, over 40% was for mortgage brokers, appraisers, real-estate agents, call-center employees, loan officers, construction, retail and auto sales workers, etc.
Rating agencies did the rest. Credit bundles that would never return principle plus interest were rated Triple A. Any federal agency involvement was seen as an implicit guarantee: While there was no explicit guarantee, all parties believed bundled loans were solid or kept their mouth shut!
This allowed people to borrow huge sums of money at low rates. Average people were allowed to (encouraged to) swamp themselves in debt. In Canada, there was another sweetener, having helped create the problem, banks were allowed to simply walk away - no wonder they are still strong.
Banks sold their new mortgages and other loans to "bundlers", such as investment banks, hedge funds, etc. Bundlers pooled many types of credit of different quality with the intention of selling the payment rights to others, first to other institutions - pension funds, companies, governments, etc.) so someone paid to get your monthly payments - if you paid. They paid for nothing if you defaulted!
The next step was to securitize the bundle as a tradable asset. Much of the financial black magic of Wall Street/Bay Street and the Rating Agencies involved turning debt into assets.
Say you're a Bank and you sell 200 mortgages a day, give out 500 low-interest credit cards, 50 lines of credit, and 100 car loans. Bundlers bought those and sliced and diced them into an asset-backed security (MBS).
This, like ABCP in Canada, is a financial product that was supposed to pay a yield to the purchaser, such as a hedge fund, pension fund, investment bank, central bank and finally private investors.
The yield, essentially an interest payment, was to come from the payments made on the original loan....if they were made...sadly, the ABCP/MDS were sold to mature within days; the loans on which they were based were for years and to many people who never had a hope in hell of being able to pay --- especially if interest rates rose.
How does it work? The borrower is supposed to keep making payments which makes money for everyone down stream - fees from the original deal, an outfit that gets a cut for servicing the payments and passing them on to the bundlers and the underwriters of the asset-backed security that results and is sold by them to their clients.
The purchaser of the asset-backed security is supposed to get paid directly by whomever sold them the bundle or part of it as a secure (or appropriately rated) investment. If anything goes wrong, the originator may take a hit. In Canada, banks and their accomplices play Pontius Pilot and take a powder.
To the extent that they can't, they give the worthless debt to the bank of Canada and get "Cash for Trash". If it does get stuck in the bank, the accounting profession changed the rules - even though it is worthless because nobody anywhere will now buy these bundles, instead of the bank stating on it books that it has toxic assets, it can estimate what they think this stuff might be worth if things were normal, and plug this imaginary number into its financial statements.
If I could do that, my 02 Maxima would be worth $1,000,000.00 - hey, it's a great car! I'm rich. And I can borrow another million or ten using the Maxi as collateral!
Easy credit fed investors' appetites (fueled in turn by mass marketing campaigns) for more and more credit - not just for mortgages - as most people seem to forget.
Many loans were adjustable-rate with teaser rates to start - credit cards at 1 or 2% that automatically flipped to the regular rate after 364 days, for example. Miss that deadline, and your debt load and monthly payment might give you heart failure!!!
Even fixed rate mortgages are usually only for 5-10 years --- then???? Result, at some point - sooner or later - monthly payments leap sometimes to two or three times the original amount. But demand for everything increased, and that caused housing bubbles and stock bubbles all over the place. People overpaid and if they were caught short or will be, it will be a slaughter.
Bill paying became hard to impossible for many almost immediately, making it more likely that payments would be late or missed, driving down credit ratings and adding charges to the borrower's debt load. Much of that is sunk money - it will never be collected. Principle and interest to those who bought it bundled may never be paid, at least in full. Others may not see this happen to them for some time, but the years go by so quickly....
With mortgage brokers and lenders pushing loans on anyone and everyone, even those who knew better could often not resist the temptation. And, the elderly -- who fell for re-financing their homes - and others in debt - found or soon will find, themselves in over their heads.
Some got it from both ends - as they or their Pension Plans or CPP, bought worthless bundles, they lost there too....they lost coming and going - and some - pensioners, taxpayers and others still don't even realize the peril they face. When the government intervenes, it's YOUR money!
Even if they do get a pension that is not reduced or eliminated, it will be in dollars of lesser value or taxpayers money - you will be paying your own pension - a second time - because the government has increased the money supply - increasing inflation and reducing the value of the dollar against other currencies.
With the surge in mortgage loans, especially around 2004, US financiers started using financial products called collateralized debt obligations (CDOs)....and several other alphabet soup names...that are still around. These were bundles sliced and diced into tranches -- cuts of meat -- in the US that paid a yield according to risk: the best cuts, the filet mignon, had the lowest risk and hence paid the lowest interest. The riskiest, the mystery-meat hotdogs, paid the highest interest, but could default first if people stopped making payments.
This was seen as a way to spread risk - away from the banks - across the market (to you and me). The notion of distributing risk means all market players [even those who don't think they are in the market] take some risk, so if something goes wrong, everyone suffers, but no one is supposed to die.
Tranches were given ratings by agencies like Standard & Poor's, Moody's and Fitch --- none of them would touch Canadian ABCP with a ten foot pole --- but DBRS gave it a Triple A rating anyway.
The highest rating, AAA, is supposed to mean there was virtually no risk of default. The supposed safety of AAA corporate paper meant a wide variety of financial institutions could buy it. And this spurred demand.
There was a conflict of interest, however, because the rating services earned huge fees from the bundlers (investment banks). Moody's earned nearly $850 million from structured finance products in 2006 alone. We'll likely never know the whole story in Canada. You can thank the Purdy Crawford Committee, the Finance Minister, the Regulators, the Bank of Canada and the government of the day for that - and you just re-elected them???
The 'Piggies in the middle" also bundled lower-rated securities, BBB-rated, and then created new tranches -from AAA to Junk. In Canada, we skipped a step and just rated junk AAA from the get go - turning the hotdogs into steaks, lead into gold - until it hit the fan last August.
Furthermore, the tranches could be hedged and leveraged, another way of distributing risk, using paper called credit default swaps (CDSs) or similar names, sold by near banks, investments houses or whatever you want to call them. I have a name - but I don't want to be sued.
The swaps were seen as a way to make tranches more secure and hence higher rated. For instance, say a US investor, pension fund, etc (I know of one elderly Canadian woman who had $20 million in ABCP) had $10 million in AAA tranches. You/they might find someone to insure it - the premium based on the rating. If the tranche defaulted, the company was supposed to pay $10 million in the US.
But CDSs started being brought and sold all over the world - based on advertised low risk. The market grew so large that the underlying debt insured in the US was $45 trillion -- nearly the same size as the annual global economy! Tell me that does not defy common sense!
Around 2004, things began to get trickier when investment banks set up structured investment vehicles (SIVs). The SIVs would purchase poorly rated subprime mortgages from banks. But to purchase them, the structured investment vehicles needed funds of their own. So the SIVs created asset-backed commercial paper (short-term debt of 1 to 90 days) backed by credit from the sponsoring bank in the US - in Canada - by NOBODY.
The SIVs then sold the paper, mainly to money market (institutional - and mutual) funds. So the SIVs generated money to buy MORE mortgage-backed securities from their banks. They made money by getting high yields (returns/profits) from the subprime MBSs, while paying out low yields (interest/returns) to whomever bought this stuff as commercial paper (profiting from a spread like this is known as arbitrage).
Confused yet? Believe me - you were and are meant to be.
Wall Street's/Bay Street's goal was to create ways to make money while not incurring liability....they had seen the Canadian Banks do it. They started moving everything off-book to the SIVs to get around rules about leveraging.
In Canada there are no rules - rules that exist are not enforced - same difference. We then have the nerve to call every problem we have had US-based. We have been the testing ground for every scam that has played out in my lifetime.
Banks, hedge funds and others "leverage" by taking their capital reserves and other assets -- cash or assets that can be easily turned into cash -- and borrowing over and over against them - using the original assets as collateral. Every dollar can make you at least ten as long as the game goes on; but if someone yells "Wait just a minute!", the reverse is true. And you can't pay. You're done.
Now in Vegas, you get you legs broken (if you're lucky) for that kind of stuff; in the US, you go broke and the top dogs can go to jail; in Canada, nothing. Here, the last person or organization holding the junk, for the most part, takes the hit and the Banks walk away whistling.
At worst, they bring in some body like Purdy and the boys and tell you, you won't see your money for a decade, if at all. Then they launch a PR campaign to cover up the truth - and it works!
In the US, Merrill Lynch had a leverage ratio of 45.8 on Sept. 26. That means if they had $10 billion in hand, they were playing around with $458 billion.
The Federal Reserve is supposed to regulate reserves to limit credit, but the SIVs were a way to get around that rule. More leverage meant more risk because that $458 could disappear in a flash if the music stopped.
This is part of what Americans call the Shadow Banking System, meaning it gets around regulations.
In Canada, it's just the way it is. Don't take my word for it - take a look around.
It was deregulation (self-regulation in Canada) that led to the huge growth of the shadow(y) banking system.
In 2004, Wall Street lobbied the SEC to loosen regulations on how much they could leverage their reserves. This opened the flood gates "to the opaque world of asset-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments," according to the New York Times.
The only oversight left in place was self-policing by the industry itself to determine if they were putting investors at risk. We don't allow drivers to self-regulate speed limits, but.......
The whole process worked as long as everyone believed housing prices would go up and the economy would grow forever; that they would always have jobs with high pay; that people believed they were entitled to nothing but the best, NOW.
This is perceptual economics, one principle of which is that any widely held belief in the market tends to become a self-fulfilling prophecy. In the case of housing, homeowners took on ever-larger mortgages in the belief that prices would keep rising. In the case of debt - credit card or other - I don't know what the hell people were thinking....that there was always UI and welfare???
Lenders now claim they thought the loans were safe because even if a homeowner defaulted, the mortgage holder would be left with a house that was increasing in value. And what they don't admit is that it was easy for the banks to lend someone else's money. I remember the days when the only people they would loans were those who didn't need them - because banks knew it was their depositor's money and their responsibility to use caution - due diligence.
Once they came up with these little schemes, nobody on the inside cared about anything. In Canada, the banks could not lose, no matter what. If they did take a write down, it was a cost of doing business, and now - thanks to the accountants - they can make up an imaginary number even for that. Plus they can pawn their worthless paper to the Bank of Canada for real money. Of course - that creates all kinds of problems down the road, but what the hell, let'er roll.
Either these people were such nutjobs that their confidence in rising prices led the creators and purchasers of mortgage-backed securities to think these investments were virtually risk-free - including the over-leveraged -- as long as there was easy credit and quick returns, and investors clamoured for more. And this applied to money market funds that brought the paper from structured investment vehicles.
As long as the money market funds had confidence in the system, they didn't cash out when their investments matured, they rolled them over at the same interest rates. This allowed the SIVs to mint money without posting liabilities.
They were either out of their minds - or they were shysters - either/or/both? Now they are being painted as deluded innocents. And the government/s have had to step in to cover the butts of these confirmed free-enterprisers - to restore faith in either the crookedest or stupidest group of people to every come down the pike.
But for most of us outside the club - well too bad so sad - no pension, higher taxes, inflation, job loss, devalued dollar, resources dropping like a stone, investments evaporating, governments doing what they always do - the wrong things, and the finance people - well they were handed a ton of money to play with and are back to their old tricks - helped by "improved" accounting standards - good golly Miss Molly!
This system kept the U.S./Canadian economy chugging along for 35 years; of course, real wages have been stagnant, but house values skyrocketed, so many homeowners refinanced and cashed out equity -- turning their homes into ATMs -- they used the money to pay credit card debts and car loan debt and to consume.
If you owed $200,000 on a mortgage, but the house rose in value to $300,000, you could turn the $100,000 difference (or a portion of it) into cash by refinancing (at rates that ultimately would break the back of a camel - but who cares?).
By 2004, Americans were using home equity to finance as much $310 billion a year in personal consumption. This debt-driven consumption was the engine of growth. And this is the engine all the government interventions in the economy are trying to re-start there and here???
Over-consumption here was balanced by over-production in many poorer countries like China, India, Taiwan and South Korea - they now have large trade surpluses with the West, which is speeding their economic development - but they invested in our junk paper. That way they get much less for what they produce - if/when they figure that out, and pull their money, or ask for gold or other assets, where will we be - with our de-valued dollars?
It's what some economists call a virtuous cycle: we buy their goods, helping them develop, while they use the profits to buy our credit, allowing us to purchase more of their goods. But it's also unsustainable. We cannot over-consume forever.
In the final stage of the housing bubble, fewer buyers could afford traditional mortgages. Rising house prices required ever-larger down payments so all kinds of "strategies were brought to bear - because everyone has a right to decent housing. They do - but mansions?
Mortgages multiplied, and often required little or no money down and ran for 40 years. From 2004 to 2006, nearly 20 percent of all mortgage loans were "subprime" in the US; Canadians simply overpaid. A vast supply of adjustable-rate mortgages (ARMs) created a time bomb. The minute interest rates went up, the mortgage rates reset, and homeowners with ARMs were saddled with larger monthly payments. Even 5-10 years in, there would be trouble, and with everything else that was going on (job loss, other ballooning debt, etc), people should have known better.
Various factors combined and continue to lower real-estate and stock prices and to deflate the bubbles. Oversupply of houses in the wrong places, ever-accelerating prices/indexes (and P-E ratios) meant smaller returns and, again, government interventions were either stupid or ethically wrong- headed.
Once the bubbles started to leak in the US, Canada started plugging the holes until the election was over, telling us that US problems (even though they are our largest customers across the board) and was looking at mania turning into panic, would leave us high and dry. Pas de Sweat!
It was a lie, but people wanted desperately to believe it. In just days the dollar and the resource sector have tanked, plus the TSX looks like it's having a nervous breakdown. Some steps taken by our government and its henchmen to ward off the inevitable border on the criminal.
In the US, first, structured debt instruments like collateralized debt obligations and mortgage-backed securities failed. Securitization spread across the entire financial system -- putting everyone at risk. Because the finance sector had lobbied aggressively for decades to slash regulation, lack of oversight magnified the problem.
ABCP froze over a year ago and now the whole system could go belly-up. Recession, depression, stag-flation, government intervention, a failure in confidence - every body calls it anything but what it was - at best total systemic corruption; at worse widespread criminality.
As panic is setting in, asset backed commercial paper -- is locked in for a decade -- except for less than $2 of over $32 billion paid to individuals and a few side deals cuts with key players.
In Canada, some of the agencies hit have turned right around and are selling their own commercial paper; banks don't have to accurately reflect it on their financials; and the central bank, in addition to flooding the market with cash, has to buy this trash for cash on demand. Those responsible have been indemnified.
While the US was in a liquidation trap, our banks and government were tap dancing until the election was out of the way. Nobody even knows the true size of the losses, because of the leveraging, and banks began to hoard funds which caused credit markets to dry up. That was seen as bad - I'm not so sure it was. Some pain now or a lot more later - your call.
Over the last year, the U.S. has taken increasingly drastic measures -- lowering interest rates, pumping cash into the banking sector, allowing investment banks to borrow funds while putting up low-valued securities as collateral. This evolved to financing takeovers, then to nationalization; followed by the federal takeover of AIG. Wall Street banks disappeared in a fortnight -- bankrupt -- acquired or converted into bank holding companies. But the contagion has not been contained. Whether the bailout plan can succeed is questionable. It can only do so depending on just how dumb people are.
Can government bailouts "restore confidence" in a corrupt system in which the players don't even trust one another enough to thaw the frozen money and credit markets? Even if the bailouts revive the banking sector in the US and Canadian Banks can still play innocent, few economists think state intervention will jumpstart the consumer credit machine. It never has in the past.
Over-leveraged, money-strapped banks will eagerly dump worthless securities on taxpayers in exchange for cash to bulk up their reserves - you bet! Plus, with working hours and wages declining and unemployment increasing in "real" jobs, home foreclosures and inflation surging, banks are in no mood to give consumers credit, so consumption -- and hence the economy -- will continue to contract. Call me hard-hearted, but I think people have enough debt already.
There are better options: avoiding the poisonous corporate paper (some isn't - by the way); the state can buy equity stakes directly in troubled banks and near banks, re-regulate the industry, send in teams of government (not contract) auditors to decide the real worth of financial companies - which should live and which should die; allow the government to buy troubled mortgages directly, allow local governments to seize foreclosed homes and turn them into subsidized housing, public works programs, alternative energy investments.
But these are political strategies and they depend on an ethical government organizing political power to propose, legislate, fund and enact sensible strategies, and not run around under the radar covering the backs of their friends, thereby perpetuating the cycle of corruption and irresponsibility that landed us here in the first place.
That's what will determine if there is a 21st-century New Deal or if Wall Street/Bay Street will get away with the biggest financial crime in world history. Most people are clueless - led astray by masterful mass advertising campaigns and our political leaders.
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This article relied on many sources, including "The Subprime Debacle" by Karl Beitel, Monthly Review, May 2008. This essay was printed in the Oct. 3, 2008, issue of The Indypendent, and the November 2008 issue of Z Magazine. I also took my crack at it to try to make it relevant and to show that as goes the US, so goes Canada to a greater degree than we have so far been told.
Arun Gupta is an editor of the Indypendent. He's writing a book about the decline of American Empire to be published by Haymarket Books.