Fraud, chicnery and bankrpty: The wall street crash of 2008

Prof. Dr. Desmond McForan

Introduction.

The two basic reasons for the melt-down on Wall Street, can be traced as far back as 1994. In that year, Federal Reserve Chairman Alan Greenspan refused to regulate questionable lending practices by the major investment banks, despite having been given explicit Congressional authority to do so. Once again the words of Senator Proxmire echoed throughout the establishment. When Greenspan was the head of President Ford’s Council of Economic Advisers, his own forecasts were so “downright awful” that during Congressional hearings, Proxmire opined to Greenspan:

“…I hope … when you get to the Federal
Reserve Board everything will come up roses.
You can’t always be wrong.” [1].

The second reason concerns the Chief Executive Officer (CEO) of Freddie Mac. As early as 2004, Richard Syron was being constantly warned, that Freddie Mac’s continual financing of questionable loans threatened not only the financial health of Freddie Mac, but also that of the entire US. [2] These two basic factors produced results which confirmed that the basic policies of US financial institutions, centred around institutional greed, coupled with an almost total lack of individual responsibility on the part of the Federal Reserve and the CEO’s of financial institutions. [3]

From the beginning of this decade, financial institutions which dealt primarily with consumer credit, began packaging credit-lines aimed not at their best customers, but at their worst. This was done by spending millions of dollars to create sophisticated computer models which emphasized those potential clients who would run up the largest credit balances. Effectively, this fell into the purview of ‘predatory lending’, which is supposedly illegal, but extremely difficult to either prove or to prosecute.

The Influence of Foreign Investors.

However, so successful were these policies – particularly in the recent boom market – that these financial institutions began to attract huge amounts of foreign investment money. This excess capital was the result of enormous trade surpluses combined with oil wealth. The major international investors, therefore, were sovereign funds and governments ranging from China, Dubai, Saudi Arabia and Russia, all of which had enormous amounts of foreign reserves which they directed, principally at Western financial institutions. For example, China invested US$29.2 billion in acquiring stakes in foreign companies or, buying them outright, since October 2007. During the same period, Western investment in Chinese companies amounted to only US$21.5 billion. This means that for the first time in economic and financial history, more western assets were bought than the West acquired. Since October 2007, investors from the Middle East and Asia have invested US$22 billion in acquiring stakes in Bear Stearns, Citigroup, Morgan Stanley and UBS.

In particular, Asian investment during this same period, concentrated on the following banks:
– US$5.2 billion invested in Standard Bank;
– US$5 billion in Morgan Stanley Bank;
– US$5 billion in Merrill Lynch Bank;
– US$2.98 billion in Barclays Bank;
– US$2.67 in Fortis Bank;
– US$1 billion in Bear Stearns.
These are just an example.

Middle East investors were similarly active in the banking and financial sectors during the same period.
– US$7.5 billion was invested by Abu Dhabi for a stake in Citigroup;
– US$11.5 billion was invested by an anonymous investor who joined together with the Government of Singapore Investment Corporation, for a stake in the Swiss UBS bank.

The amount of foreign currency reserve surpluses around the globe is, indeed, staggering. The United Arab Emirates possesses an estimated US$710 billion available for investment, while Abu Dhabi has around US$875 billion and Kuwait almost US$215 billion. It is also estimated that Singapore controls US$325 billion available for investment. Other oil producers such as Norway have US$330 billion, while Russia has around US$300 billion. [4]

Most of this foreign investment was directed at Wall Street and, in particular, at the five New York-based securities firms which have dominated the US markets for at least the last sixty years. Witness the fact that Bear Stearns was sold in March 2008 to JP Morgan Chase & Co., together with a Federal underwriting of US$29 billion in order to cover its assets. With Lehman Brothers’ Holding seeking bankruptcy in September 2008, in order to avoid total liquidation, this became the biggest bankruptcy claim in history, when it specified in its Chapter 11 petition, that it had debts (mostly illiquid) in excess of US$613 billion. Merrill Lynch agreed to itself being sold to Bank of America Corporation for US$50 billion in order to stave off similar certain bankruptcy itself.

These were large enough blows to the US financial sector. However, American International Group (AIG), the US insurance giant, being bailed out by the Federal Reserve to the tune of US$85 billion, heightened the situation into a crisis. Merrill and Lehman are both investment banks. However, traditionally Merrill has focused on the brokerage aspect of the business, while Lehman traditionally kept its activities confined to the institutional slice of the market. However, in an ill-fated move, both banks began to make significant forays into real estate-related investments.

There now remains only two financial institutions currently left, relatively unscathed, on Wall Street. They are Goldman Sachs Group Inc., and JP Morgan Stanley. These are the only two firms in the entire sector which have demonstrated profitability throughout the entire year, but both of them will, in all likelihood, post a serious decline in profits as the year moves towards its close. It was, however, significant that in late September 2008, both banks announced that they would relinquish their investment bank status and voluntarily revert to being deposit-collecting banks i.e. normal commercial banks and would, therefore, need to submit themselves to much tighter regulation. However, even Goldman Sachs was forced to market additional asset securities to the value of US$5 billion, which were then bought by the billionaire, Warren Buffet’ company Berkshire Hathaway, on 24 September 2008. At the same time, Goldman Sachs announced that it would seek to sell additional assets upwards of US$2.5 billion. One day later, Washington Mutual (WaMu), the giant Savings & Loan operator, was sold in a fire-sale to JP Morgan Chase, for a mere US$1.9 billion. Had WaMu been allowed to file for bankruptcy, this would have exceeded the bankruptcy of Lehman Brother’s Holding. It would, in effect, have been the biggest bankruptcy in history.

Coupled with this scenario, and concurrent with it, the Federal Reserve, this time in conjunction with the US Treasury Department, were forced to take government control of both Fannie Mae and Freddie Mac. This was nothing short of the nationalization of the two mortgage-based institutions. The simple fact is, that more than US$1.3 trillion of Fannie Mae and Freddie Mac debt is currently held by the Central Banks of China, Japan, Europe, the Middle East and Russia. These two government bodies had hoped to stave off such a move, which had already become an apparent necessity earlier in 2008. In May of that year, after the collapse of Bear Stearns, the Federal Reserve permitted the remaining investment banks to swap their toxic and contaminated assets for Treasury Bonds at par value. Such assets included mortgage-backed securities (MBS), asset-backed securities (ABS) and collateralized loan obligations (CLO). However, none of these bank’s shareholders were being protected from losses due to these contaminated securities. [5]

The move by the US Government was inevitable. Foreign bond-holders had informed the US that if no drastic action was taken in order to protect their investments, then they would no longer buy US-based bonds. Chinese and other Asian investors, joined by Middle East investors led the way in this move. It should be clear from the investments which they have made since October 2007, that the current banking crisis in the US has left them all openly exposed to potential catastrophic losses. Only by taking control of Fannie Mae and Freddy Mac, could the US Government allay the fears of these billion-dollar investors, that their money would be safe. Similarly, it should be remembered that if foreign investors, central banks and sovereign wealth funds had halted their purchase of Fannie and Freddie debt, then the entire US mortgage market would have been unable to function at all, and would have collapsed, since these two institutions either own or guarantee more than 50% of the US mortgage market of US$12 trillion. Already, by September 2008, the world’s largest banks had written-down more than US$510 billion in bad debt.[6]

Thus, it was the US$5.2 trillion in Fannie and Freddie debt that was the cornerstone behind the bailout. China, with its US$1.8 trillion in foreign reserves, keeps more than 70% in US dollars. China also holds at least US$ 376 billion worth of the debt of US Government-sponsored enterprises. It is therefore not surprising to note that China is the single largest foreign investor holding Fannie and Freddie debt. However, by guaranteeing the Fannie/Freddie debt, the US Government has just doubled at one fell stroke, its public debt load. As Brad Setser, Geo-Economics Fellow at the Council of Foreign Relations recently stated,

“… this is the first case where foreign central
banks exercised their leverage as creditors to
push the US government to make a policy
decision that protected their interests”.[7]

The Origins of the Debacle: Faulty Risk Management and Excessive Leverage.

Since the summer of 2007 when the real estate crisis first loomed in the United States, most people in the financial sphere had expected some sort of crisis. However, not the full-scale “melt down” which has occurred. In trying to analyze the origins of this crisis, focus must concentrate on how these companies interpreted their investment risk.

In early September 2008, Lehman Brothers announced a loss for the Third Quarter of US$3.9 billion. As one US financial and market commentator observed:

“Just where were all the risk-management experts
Who should have assessed the pitfalls these companies
Faced, and how could they have faced the massive
risks that are now threatening to take this entire
sector down?” [8]

It is now quite clear that that is exactly what happened to Lehman.

In the 2008 Annual Report, Lehman Brothers waxed lyrical about having

“… a culture of risk management at every level
of the firm.”[9]

If this was true, despite the fact during the second half of 2007, when global markets were already in turmoil, how could the bank allow its leverage ratio to rise from 26.2:1 in 2006, to 30.7:1 by November 2007? [10] Similarly, during the same time, there were no losses reported and, indeed, shareholders equity increased by more than US$3 billion. This has to be understood in the context that investment bankers ‘love’ assets, because the more assets a bank has, the more money can be made from them. And this had been the picture since March 1995, when Alan Greenspan, the then Chairman of the Federal Reserve began to push more liquidity into the US financial markets.

One reason for the emergence of this situation, is the way in which banks treat their economists as opposed to their accountants. It would seem that the riskier the markets and the deals become, the more banks need and value their accountants as opposed to their economists who are, more usually, a relatively conservative breed. Hans de Jong, the Chief Economist of ABN-AMRO Bank, puts this in the following way:

“I find…that the role of serious economists in
financial institutions is very limited to-day.
We are little more than clowns, whose purpose
is to entertain clients”. [11]

Perhaps this is at the root of the problem. For the investment banking sector it certainly appears to be the case.

In the early 1990s, JP Morgan Chase & Co. devised a new system of risk management. This system is known as the “Value-At-Risk” (VAR) system and, it is based on the extrapolation of a number of mathematical assumptions which, patently, have absolutely no bearing on real life.

“VAR appears to have been designed to let the
traders get on with the business of making real
money, while at the same time keeping the top
brass from worrying too much about the risks
traders were taking.”[12]

These mathematical assumptions are based on the Gaussian function. This function produces a graph which is a characteristic symmetric “bell-shaped” curve. This curve falls quickly to either plus or minus infinity. Gaussian functions are extensively used in statistics where they describe normal distributions. JP Morgan’s risk management ‘inventors’, assessed the “99% confidence limit” of a loss which may be incurred by each trading position, at most, 1% of the time. The way that this is done, is to model the price behaviour of any particular security as a Gaussian normal curve. Then, the point 2.36 is taken as the standard deviation of the mean.

This is all well and good. However, even if we accept the 99% confidence limit, VAR still cannot tell us what can happen during the other 1% of the time. Nevertheless, the investment bank’s top management strata believed that this 1% did not matter, because it was ‘only’ a 1% possibility!! The problem was, however, that VAR was being calculated on a daily basis, which, in fact, made the 1% acutely important.

The other major problem with VAR, is that it depends on some assessment of the volatility of a given security. Volatility, is simply how much a security rises or falls in market trading over a given period of time. The problem is, that the volatility of any security in a quiet market is usually low, whereas volatility is extremely high in turbulent markets. This means that the assessment of risk is low when the markets are quiet, allowing traders to materially increase their positions. However, when the market becomes turbulent, there is no way for traders to extract themselves from their already traded positions.

Therefore, using such inapplicable functions to assess risk, is a major factor in the demise of many of these banking institutions. So, too, is leverage.

In Wall Street, the acceptable leverage ratio has, traditionally, been accepted as being 20:1. Such a ratio is usually acceptable when assets consist of commercial paper, bonds or shares, all of which can be easily valued because they are relatively liquid and are traded on a daily basis. However, when “assets” include investments in real estate, private equity stakes, hedge-fund positions, credit default swaps and countless other derivatives, which do not appear on the balance sheet, then scaling up the leverage ratio to 30:1 is a recipe for disaster.

At a leverage ratio of 30:1, an institution needs to see a decline of only 3% in its assets, for its capital to be totally wiped out. Such a decline can happen extremely swiftly particularly in a global credit crisis, where such an institution only has to see the value of one-third of its assets decline by only 10% to find itself facing bankruptcy. By May-June 2008, Lehman’s had reduced its leverage ratio to 23.3:1 due to the sale of some assets. During the same period, however, Morgan Stanley’s was still at 30:1, Goldman Sachs had a ratio of 24.3:1 and Merrill Lynch a staggering 44.1:1. [13]

Essentially, when bankers divorce risk from investments, a much greater opportunity window opens up for fraudulent dealing, and this, over time, fairly and squarely rested on the shoulders of bank accountants. [14]

Accounting Methodology: Exacerbating the Crisis.

The Federal Reserve and the US Treasury Department are currently trying to give banks and investment banks time to clean up their balance sheets. This they will try to do, by using spurious accounting techniques, many of which, only just fall short of being fraudulent. The net result of such a policy will be simply that

“…transparency will be thin, liabilities will be
buried, losses will surprise investors, and capital
will be both inadequate and expensive.”[15].

One method often used by management, is simply to lengthen the measure of time by which a financial institution considers a loan to be either ‘troubled’ or ‘non-performing’. This is particularly apposite when mortgage-related lending is concerned. A bank, for example, can restructure its definition of a ‘troubled’ loan, by altering the time-frame from two months to three moths without payments received. A ‘non-performing’ loan can be categorized as ‘anticipated borrower default’ after 180 days instead of the more normal 120 days.

The Basel Accords of 1988 concerning the valuation of Tier 1 assets, were agreed under the auspices of the Bank of International Settlements (BIS). This was known as Basel 1, and was updated in 2004. The modified accord is known as Basel II. The accord requires that accounting rules ensure that financial entities price their assets on their balance sheets at a ‘fair value. Tier 1 assets are those which are totally liquid and are, therefore, easy to price.

However, there are additional problems with the implementation of the Basel Accords. Commercial banks in the US, which are regulated by the Federal Reserve, follow the Basel I guidelines for Tier I calculations. Financial institutions such as investment banks, are controlled and regulated by the Securities & Exchange Commission (SEC). These institutions calculate their Tier I ratios on the basis of the Basel II guidelines. Basel II requirements, permit much greater management flexibility in risk-weighting and, also permits for the utilization of both ratings and internal modeling into the bank’s calculations of their asset values.

Another of the finer points of the Basel Accords, is that they make a distinction between banks holding mortgages on their balance sheets and those holding mortgage-backed securities on their balance sheets. The difference lies in the amount of capital which banks have to hold against the differing assets. Holding mortgages requires banks to hold more capital, because mortgages, as a banking instrument, are less liquid than securities which can be traded. Once this became apparent, investment banks in particular, left the direct mortgage market and began to deal almost solely in mortgage-backed securities.

A bank’s Tier 1 capital ratio is the ratio of the bank’s equity capital to its risk-weighted assets. The problem with these valuations, however, is the potential for manipulation in the calculation of ‘risk-weighting’. This very much depends on how the banks themselves weight the risk factor of its assets. This reflects the fact that banks literally manage their own capital. As Gilani states:

“Determine what capital is required and then
manage the books to meet that measure.”[16].

And, Sheila C. Bair, Commissioner of the Federal Deposit Insurance Corporation has publicly stated that Basel II essentially lets

“banks set their own capital requirements.”.[17]

Under Tier 1 asset valuation, these are assets which are labeled “held-to-maturity”. These are accounted for at cost. If such an asset either appreciates or depreciates, it is not shown on the balance sheet.Nor are they reflected in the Profit and Loss account. The only reason for such assets to be accounted for differently from others, is if any change in their value is considered to be either ‘more permanent’ or ‘other than temporary’. Therefore, banks are able to manipulate their asset valuations concerning Tier 1 assets, simply by the way in which they define what ismore permanent or other than temporary.

A similar story is true for Tier II assets. These are assets that can be priced with the benefit of ‘comparable assets’. Another way of describing these assets is to refer to them as assets which are ‘available-for-sale’. Such definitions give the management of banks the option to account for assets as though they might be sold now – and therefore priced concurrently – or, whether such assets will be held to maturity. If it is the second option, then they would not need to be priced at their present current value.

Sometimes, Tier II assets are regarded as being “held-for-trading”. These assets are mark-to market and their value is published on a quarterly basis. Their ‘fair value’ is usually regarded as being the last time that they were marked-to-market. Marked-to-market, means that the asset’s value is based on the last sale price on the day it is being accounted for. However, if a particular asset or asset type, does not trade frequently, then it is very difficult to value it accurately. Similarly, internally-produced mathematical models are then produced to give an indication of an asset’s value on a given date.

Tier III assets are defined as those assets which are almost totally illiquid and, therefore, are impossible to price. Sometimes this classification of assets is referred to as ‘accumulated other comprehensive income’. This is the category where most losses are to be found. However, they do not encroach on Tier I calculations. Neither can they be valued on a ‘mark-to-market’ basis. Therefore boosting their value can “staunch a bleeding balance sheet.”[18] The reason for doing this, is that by boosting the value of Tier III assets, they can then secure highly-liquid US Treasury bonds and loans.

Sometimes, these Tier III, assets are also referred to as “available-for-sale”. This means that although such assets could be sold, they are more likely to be retained. Neither gains nor losses in the value of these assets are accounted for either on the balance sheet, nor on the Profit and Loss statement. More usually they are accounted for under “equity”. Usually, therefore, when changes in value occur with such assets, they are placed in the balance sheet under “shareholder’s equity”. Once there, they are further removed to “accumulated other comprehensive income”. Such practices are referred to as “managed earnings”. Therefore, such assets are not counted in either Tier 1 capital, nor are they accounted for in the determination of capital ratios.

What now seems to have been clear, is that investment banks reclassified their Tier II assets as Tier III assets. At the same time, they inflated the value of their Tier III assets. The point is, that if there is no market in which banks can trade or sell their Tier III assets, then they do not have to write-down the value of the asset and, theoretically, can price them at any value they want.

The whole philosophy from the point of view of the banks, has always been to free up capital. This means that they have always sought to free capital in order to leverage it elsewhere. Banks did this by creating Structured Investment Vehicles (SIV’s). These were created in order for the banks to make their capital-reserve-holding requirements disappear. The SIV’s were usually offshore entities which were set up to warehouse assets for which the banks would normally have to hold capital against. Usually the SIVs were a conduit for buying back asset-backed securities (ASB’s) previously sold into the capital markets by the banks. The idea was for the banks to fund SIVs by issuing short-term commercial paper. At the same time, the banks massively leveraged their borrowed capital and bought huge amounts of ABS instruments. SIVs are not banks and therefore there are no capital reserve requirements for them to adhere to. There was so much growth of ‘structured commercial paper’, that such paper amounted in value to more than half of the value of all the US money markets combined. When the markets realized that these SIVs were contaminated with sub-prime mortgage paper, they ceased investing in them and demanded their money back. [19]

In the end, the banks will have to repatriate all the SIV assets back onto their balance sheets. They will also have to absorb their losses. Because the situation is so massive, both the Federal Reserve and the US Treasury Department have given the banks until 2010 to account for these off-balance sheet liabilities in a transparent manner. To give just one example of the enormity of the problem, it is estimated that Citicorp has in excess of US$650 billion of SIV assets to repatriate. Once this is done, however, these same banks will continue to manipulate their accounts in order for them to maintain capital adequacy. [20] As Prof. Stephen Ryan of New York University’s Stern School of Business has pointed out,

“…all forms of intent-based accounting are
problematic, as intent does not change the
risk or the value of a position while you hold it”.[21]

The upshot of all this, is that it leaves the potential investor and the analyst with no real means of judging the viability or otherwise of any of these banks. [22]

It is not just in the issuance of questionable securities and the utilization of almost-fraudulent accounting techniques for which banks are to blame. They are, also, untruthful towards the regulatory authorities. Many banks have been found to have given false LIBOR quotations regarding the true rates at which they accept deposits. [23] They do this in order to prevent them being thought of as a credit risk. However, the real problem behind untruthful LIBOR reporting is the effect which trillions of dollars of derivative contracts are having on this aspect of the sector. Most of these derivative contracts LIBOR, particularly those which are concerned with Interest-Rate Swaps – US$382.3 trillion in 2007. This is the second time in twelve months that LIBOR irregularities have resulted in global investigations of the veracity of the international banking world. [24]

The LIBOR rate is the net result of data on loan duration, calculations ranging from overnight funds to as much as a year in 10 different countries. This data is submitted by the major international banks and, the rate is then published each morning by Reuters. These LIBOR rates, drive global financial calculations which involve trillions of dollars of corporate debt, mortgages, financial derivatives and other financial instruments. These LIBOR interest rates are, therefore, regarded as being an assessment of risk, because the higher the LIBOR rate, the greater the escalation of risk.

The data submitted to LIBOR is supposed to be submitted honestly and without bias. This means that LIBOR rates are intended to reflect true borrowing costs. Because LIBOR has always trusted the participating banks to report both accurately and truthfully and, for this reason there has never been a regulatory body overseeing LIBOR. It is therefore, more than ironic,that the very banks and the very bankers responsible for the current global credit crisis, were the same people and institutions responsible for the self-policing of their LIBOR submissions. [25]

No bank wants to submit data which would show that it is having trouble borrowing money or making loans. If this were to be the case, then the result would be a barrage of questions about the particular institution and its liquidity, bank-loan trends and, levels of off-balance sheet derivatives exposure.

Rising LIBOR rates indicate that banks are wary of trusting one another and, are, therefore, charging a premium to other banks for their money. The British Banker’s Association (BBA) has already launched an investigation into LIBOR-related machinations. When the BBA announced an acceleration of its probe, the results were that the LIBOR rates jumped, as did the dollar!

Contaminated and Toxic Securities: The Denial of Counter-Party Risk.

Counter-party risk is the chance that the person with whom one is making a deal, will not pay up. Simply put, if one is selling a house, the counter-party risk is that on the assigned day for the sale and purche, the buyer will not turn up. When banks make a deal to either buy or sell securities, normally they refer to the credit-rating of the counter party. If the credit-rating is not acceptable, then more guarantees or collateral may be required. If not, they will refuse to deal with the party concerned. Fundamentally, this is what happened to Lehman Brothers, causing them to file for Chapter 11 bankruptcy.

АIG, on the other hand, as an insurance company expanded into the market of selling insurance against bond defaults. This insurance was provided through derivative contracts, called “Credit Default Swaps”. AIG’s problems began when a wave of defaults began to surface, as the sub-prime mortgage market collapsed. At the same time, Fannie Mae and Freddie Mac also began to renege on their obligations, as did Lehman Brothers. The most conservative estimates are, that AIG is facing US$25 billion losses on its credit default swaps insurance.

A ‘credit default swap’ insurance is an insurance policy against one or other of the parties not making good on its debts. Currently, according to the Bank of International Settlements, it is estimated that there are US$62 trillion credit default swaps outstanding. However, because these swaps are not openly traded in exchanges, but are sold over-the-counter” they are not regulated and, therefore, this figure could be an extremely conservative one.

When AIG’s credit rating was down-graded, it meant that counter-parties could demand that AIG provide extra collateral, thus ensuring that it could pay any and all claims on bond defaults which it had insured. The amount of extra collateral required by AIG amounted to US$13 billion. The only way out for AIG was to raise more money on the market, which, in the current climate proved to be impossible. Hence, the US government bailed out AIG.

The fact that the bailout was a necessity for the global financial markets is clear. AIG was a ‘giant’ player in the world insurance markets. However, the problem was and remains, its risk exposure based on its credit default swap contracts. In the case of Lehman Brothers, the bank was both a buyer and a seller of such swaps, therefore reducing its net overall exposure, despite the fact that it had grossly inflated the value of those which it held. AIG, on the other hand, is a seller of credit default swaps. This means that many large global banking institutions are depending on AIG to fulfill its obligations to them. The greatest mistake which AIG made was to enter such a market, in the belief that it was not that much different from selling life or home insurance. Once again, risk management failed. However, it is anticipated that AIG will be able to repay the government bailout of US$85 billion by selling of about US$115 billion of its assets. Time will tell. [26]

As far back as the Spring of 2008, many financial commentators came to be concerned about the market in credit default swaps. These swaps emerged during the boom years after 2000. Essentially, one bank would issue a loan to a company which was its client. It would then ask a second bank to cover the credit-risk of the loan by agreeing to make payment to the first bank if the company were to default on its loan. The first bank would pay the second bank a relatively small insurance premium for assuming the risk of the loan.

In the initial stages of this market, there was little perceived risk to either bank. The first bank knew its corporate customer and lent money in the belief that it would be returned. By taking out insurance over the loan, however, it meant that the loan was fully-covered and therefore was not accounted for as a liability on the balance sheet. Similarly, the second bank received annual cash for its insurance premiums. In essence, it seemed to be a ‘win-win’ situation. And it was, until banks began to see additional profits which could be made by entering into the credit boom and the sub-prime market.

In the year 2000, the volume of credit default swaps has been estimated as being US$2 trillion. By 2007, however, this market had exploded to the volume of US$50 trillion. It is now estimated to be in excess of US$65 trillion. With these swaps, there are now two possibilities of default, whereas at its inception, the market only considered that there was one. The first type of default is where the original company defaults. This has always been the accepted risk. However, it bears no relation to the risks involved in packaged securities based on sub-prime mortgages and other questionable securities. This leads to the second type of default – one which was never considered to be a realistic option when the market in these securities first emerged. There is now, as has become patently obvious, the very real risk that both banks and other financial institutions which bought or insured these swaps might also default on their obligations. [27]

The whole debacle began in mid-2007 when the biggest financial players in the world (primarily the investment and commercial banks), found that they were in possession of US$1.3 trillion of illiquid and worthless assets. These were bonds which were backed by US homebuyers with either low or no income. [28] The results were spectacular:

– the first run on a British bank, Northern Rock, in 130
years;
– the collapse of US interest rates;
– the bargain-basement sale of Bear Stearns investment bank for US$0.16c/share on the dollar;
– the astronomic rise in the price of gold to over USD1000/ounce;
– the rise of oil to almost US$150/barrel.

The problems regarding the US housing and mortgage markets should have been seen earlier than they were. Credit and mortgage finance were showered at people with low incomes, whose ability to repay was seriously impaired. If only those concerned had taken the time to analyze the market, then much could have been salvaged. In early January 2008, Alexander Green, a well-known Wall Street commentator, argued that any rudimentary analysis of the price-to-rent ratio would reveal how deep the housing crisis in the US was. [29] He argued that if house prices get too high, then many people will choose to rent instead of buying. On the other hand, if rents get too high, then people will prefer to buy. He further ascertained that the price-to-rent ratio is the most accurate gauge of ‘fair house value’. Between 1960 and 1995, annual rents fluctuated at about 5% of house prices. In 1996, house prices more than doubled to an average of US$282, 000. During the same year, rents increased by only 48% to an average of US$818. This meant that the annual price-to-rent ratio fell to 3.48% – a massive one-third below its long-term average.

In order to reach equilibrium, house prices would need to fall on an annual average of 3% for at least 10 years – and this would be true, even if rents were to rise by an annual rate of 4% over the same period. Therefore, the faster the fall in house prices, the sooner the market will, once again be in equilibrium. What this means for US homeowners and, particularly those having mortgages bearing variable interest rates, is dire. Houses bought at inflated prices have lost almost 20% of their inherent equity, and there is little that can be done to help these people. Foreclosure rates in the US are currently standing at upwards of 50, 000 per calendar month, and are set to rise further.

Conclusion.

As Marc Cenedella has put it, it’s very rare for such a great trouble to end with such a quick fix. [30]
Ben Bernanke, Chairman of the Federal Reserve, made the following statement in Congressional Hearings on 23 September 2008:

“… the Federal Reserve supports the Treasury’s
proposal to buy illiquid assets from financial
institutions.” [31].

It should be noted, that he uses the word illiquid. Here, for the first time at least, financiers are now beginning to admit that they have been part of the conspiracy to deal internationally in contaminated and therefore illiquid assets. It is these structured financial products, which are still on the balance sheets of banks, bankrupt investment banks, insurance companies, as well as the almost US$65 trillion credit default swaps market, which are the real reason behind this melt down. And this is because they are impossible to value and they are impossible to guarantee. [32]. Had it not been for the Clinton Administration’s policy to make mortgages available to low income families, then this crisis would never have arisen. During President Clinton’s second term, the Federal Reserve demanded that ALL banks treat welfare payments and unemployment benefits as valid income sources for people to qualify for a mortgage. The Administration even insisted that Fannie Mae and Fannie allocate at least 50% of their motgage capacity for low income families by 2001. [33]

The Federal Bureau of Investigation (FBI) began conducting investigations into possible fraud in late September 2008. The objects of these investigations were Fannie Mae and Freddie Mac, as well as AIG and Lehman Brothers’ Holding. The results will be interesting.

NOTES AND REFERENCES.

1. Quoted in Fred Sheehan “Clowning Around” in Whiskey & Gunpowder 14 May 2008.
2. See Keith Fitz-Gerald “When the Thundering Herd Comes up Lame” in Money Morning 30 September 2008.
3. Ibid.
4. See Keith Fitz-Gerald “The $3.1 Trillion ‘Money Bomb’” in The Money Map Report(2008) pp. 2-4.
5. Dan Amoss “The Worst Is Not Over” in Whiskey & Gunpowder 28 May 2008.
6.William Patalon III “With Buyout of Merrill, Bankruptcy for Lehman, Wall Street plays ‘Let’s Make a Deal’” in Money Morning 16 September 2008.
7. Cited in William Patalon III “Foreign Bondholders – and not the US Mortgage Market – Drove the Fannie/Freddie Bailout” in Money Morning 11 September 2008.
8. Martin Hutchinson “How Lehman Brothers’ Own Risk Management Strategy, May Cause it to Fail” in Money Morning 12 September 2008.
9. Lehman Brothers’ Annual Report (2008).
10. For the uninitiated, the leverage ratio is calculated as being the ratio when total assets are divided by shareholders’ equity.
11. Hans de Jong in Financial Times 21 February 2008.
12 See Hutchinson Op cit.
13. Shah Gilani “Inside Wall Street: Why Hocus-Pocus Accounting Will Perpetuate the Capital Markets Credit Crisis” in Money Morning 10 September 2008.
14. See Floyd G. Brown “Forget the Bailout, Buy Like Buffett.” In Investment U 24 September 2009.
15.See Gilani, 10 September 2008.
16. cited in Ibid.
17. Jennifer Yousfi “Rising Tide of Level Three Assets: A Disaster Waiting to Happen.” in Money Morning 21 April 2008.
18. Shah Gilani “Inside Wall Street: The Hocus-Pocus Accounting Tricks That Will Perpetuate the Capital Markets” in Money Morning 11 September 2008.
19. Horacio Marquez“The Dumbest Money in the World” in Money Morning 6-7 December 2007.
20. Gilani Op cit. n.18.
21. Op cit. Shah Gilani 11 September 2008.
22. Floyd G. Brown “Three Ways to Beat Analysts at their Own Job.” in Investment U 23 July 2008.
23. The London Inter-bank Borrowing Rate is the authority which controls inter-bank borrowing.
24. Martin Hutchinson “LIBOR Sends Another Shaky Signal to the Global Financial Markets” in Money Morning 18 April 2008.
25. Keith Fitz-Gerald “A Currency Conundrum: Beware of the US Dollar’s ‘Head Fake’ Rally” in Money Morning 08 May 2008.
26. Boyd Erman “Counterparty Risk And Credit Default Swaps.” in Report on Business 17 September 2008; also William Patalon III “AIG Could Repay US$85 Billion Government Loan With US$115 Billion in Asset Sales, Analyst Says” in Money Morning 24 September 2008.
27. Martin Hutchinson “Credit Default Swaps: A US$50 Trillion Problem” in Money Morning 02 April 2008.
28. Adrian Ash “A Valuable Backstop for Wealthy Investors” in Whiskey & Gunpowder 13 May 2008; Shah Gilani “How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused A Near Meltdown of the US Banking System” in Money Morning 24 September 2008.
29. Alexander Green “Why the Price-to-Rent Ratio is Signaling More Pain Ahead” in Investment U 08 January 2008.
30. Marc Cenedella, “Financial Turmoil and Your Job Prospects” in UpLadders.com 22 September 2008.
31. See also Jennifer Yousfi “Paulson and Bernanke Testify Before Congress in Favor of US$700 Billion Government Banking Bailout.” in Money Morning 23 September 2008.
32. See Shah Gilani “Dear Hank: Here’s How to End the Credit Crisis at No Cost to Taxpayers” in Money Morning 25 September 2008.
33. See Ann Coulter in Human Events 24 September 2008.