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A financial system under siege
Rodrigue Tremblay
Online
Journal
Friday November 16, 2007
"If these items [promised benefits in Social Security,
Medicare, Veterans Administration and other entitlement programs]
are factored in, the total [debt] burden in present value dollars
is estimated to be about $53 trillion. Stated differently, the
estimated current total burden for every American is nearly
$175,000; and every day that burden becomes larger." David
Walker, comptroller general of the United States
"The economic forces driving the global saving-investment
balance have been unfolding over the course of the past decade,
so the steepness of the recent decline in long-term dollar yields
and the associated distant forward rates suggests that something
more may have been at work." --Alan Greenspan, former Fed
Chairman, July 20, 2005
“The subprime black hole is appearing deeper, darker
and scarier than they [the banks] thought. They’ve worked
through . . . about 40 percent of the backlog of the leveraged
loan side, and there’s definitely some signs of thaw there.”
--Tony James, president and CEO of Blackstone Group LP
The global dollar-based financial system is in crisis and is
threatening the prosperity and stability of many economies. Financial
excesses of all kinds have undermined its legitimacy and its efficiency.
The U.S. dollar is losing its preeminence as the main international
reserve currency while many banks are caught in the turmoil of
the subprime credit crisis.
The overall background is the unprecedented real estate bubble
that took place worldwide, from 1995 to 2005. In the United States,
for example, owner-occupied home prices increased annually by
an average of about 9 percent. The market value of the stock of
owner-occupied homes in the U.S. rose from slightly less than
$8 trillion in 1995 to slightly more than $18 trillion in 2005.
It has been contracting ever since, confirming the working of
the 18-year Kuznets real estate cycle, which spans the beginning
of 1987 to the beginning of 2005.
(Article continues below)
What makes this period especially dangerous is the fact that
the average 54-year long inflation-disinflation-deflation Kondratieff
cycle is also at play, having begun in 1949 after prices were
unfrozen. World inflation then rose for 20 years, until 1980,
which was followed by a period of disinflation under the Volcker
Fed. The entry of China into the World Trade Organization (WTO)
on December 11, 2001, with its abundant labor and low wages, unleashed
strong deflationary forces worldwide. This in turn led to lower
inflation expectations paving the way for the Greenspan Fed to
keep interest rates abnormally low.
Persistent low interest rates and low inflation expectations
led to a binge in borrowing and to a vast increase in market valuation,
not only in real estate but also in stocks and bonds. Banks and
other mortgage lending institutions took advantage of the opportunity
to introduce some financial innovations in order to finance the
exploding mortgage market. These innovations resulted in the severing
of the traditional direct link between borrower and lender and
the reduction in the lending risk normally associated with mortgage
loans.
Thus, with the connivance of the rating agencies and of the Federal
Reserve System, large banks invented new financial products under
various names such as "Collateralized Bond Obligations"
(CBOs), "Collateralized Debt Obligations" (CDOs), also
called "Structured Investment Vehicles" (SIVs), which
had the characteristics of unfunded short-term commercial paper.
In the residential mortgage market, for example, mortgage brokers
and retail lenders would sell their mortgage loans to banks, which
in turn would package them together and slice them into different
classes of mortgage-backed securities (RMBS), carrying different
levels of risk and return, before selling them to investors.
Indeed, these new financial instruments were the end result of
a process of "asset securitization" and were slices
of bundles of loans, not only of mortgage loans but also of credit
cards debts, car loans, student loans and other receivables. Each
slice carried a different risk load and a different yield. With
the blessing of rating agencies, banks went even one step further,
and they began pooling the more risky financial slices into more
risky bundles and divided them again to be sold to investors in
search of high yields.
By selling these new debt instruments to investors in search
of high yields and higher yields, including hedge funds and pension
funds, banks were doubly rewarded. First, they collected handsome
managing fees for their efforts. But second, and more importantly,
they unloaded the risk of lending to the unsuspected buyer of
such securities, because in case of default on the original loans,
the banks would be scot-free. They had already been paid and had
been released from the risk of default and foreclosure on the
original loans.
The banks' residual role was to collect and distribute interest,
as long as borrowers made their interest payments. But if payments
stopped, the capital losses incurred because of the decline in
the value of unperforming loans would instead be carried by the
investors in CBOs and CDOs. The banks themselves would suffer
no losses and would be free to use their capital bases to engage
in additional profitable lending. In fact, the end of the line
investors became the real mortgage lenders (without reaping all
the rewards of such risky loans) and the banks could reuse their
capital to pyramid upward their loan operations. These were the
best of times for banks and they gorged themselves without restraint.
Some of them paid their employees tens of billions of dollars
in year-end bonuses.
Indeed, and it is here that the Fed and other regulatory agencies
failed, first line mortgage lenders became more and more aggressive
in their lending, with the full knowledge that they could profitably
unload the risk downstream. This explains the expansion of the
"subprime" mortgage market where borrowing was done
with no down payments, no interest payments for a while and no
questions asked as to the income and creditworthiness of the borrower.
These were not normal lending practices. Such Ponzi schemes could
not last forever. And when housing prices started to decline,
foreclosures also increased, thus shaking the new financial house
of cards to its foundations. Banks became the reluctant owners
of some of the foreclosed properties at very discounted values.
Why then are so many banks in financial difficulties, if the
lending risk was transferred to unsuspecting investors? Essentially,
because when the housing boom burst, the banks' inventory of unsold
"asset-backed securities" was unusually high. When the
piper stopped playing and investors stopped buying the newly created
risky investments, their value plummeted overnight and banks were
left with huge losses still not fully reflected in their financial
balance sheets. Indeed, banks that did not unload their stocks
of packaged mortgages were forced to accept ownership of foreclosed
properties at very discounted values. With little or no collateral
behind the loans, bad-debt losses became unavoidable.
Since noboby knows for sure the value of something which is not
traded, it will take months before banks come to terms with the
total losses they have suffered in their stocks of unsold pre-packaged
"asset-based securities." It is more than a normal "liquidity
crisis" or "credit crunch" (which results when
banks borrow short-term and invest in illiquid long-term assets);
it is more like a "solvency crisis" if the banks' capital
base is overtaken by the disclosure of huge financial losses incurred
when the banks are forced to sell mortgaged assets in a depressed
real estate market.
This is this financial and banking mess which is unfolding under
our very eyes and which is threatening the American and international
financial system. There are four classes of losers. First, the
homebuyers who bought properties at inflated prices with little
or no down payment and who now face foreclosure. Second, the investors
who bought illiquid mortgage-backed commercial paper and who stand
to lose part or all of their investments. Third, the holders of
bank stocks who profited when the system worked smoothly but who
now face declining stock values. And, finally, anybody who stands
to fall victim, directly or indirectly, to the coming economic
slowdown.
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INFOWARS:
BECAUSE THERE'S A WAR ON FOR YOUR MIND
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