- 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
- 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
- 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
- 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
- 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
- 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.
- 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
- 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
- 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
- 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
- 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
- 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
- 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
- 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
- * 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
- 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.