The Financial Tsunami
Part IV: Asset Securitization -- The Last Tango
F. William Engdahl
Feb 8, 2008
Endgame: Unregulated Private Money
What had emerged going into
the new millennium after the 1999 repeal of Glass-Steagall was
an awesome transformation of American credit markets into what
was soon to become the world's greatest unregulated private money
The New Finance was built on
an incestuous, interlocking, if informal, cartel of players,
all reading from the script written by Alan Greenspan and his
friends at J.P. Morgan, Citigroup, Goldman Sachs, and the other
major financial houses of New York. Securitization was going
to secure a "new" American Century and its financial
domination, as its creators clearly believed on the eve of the
Key to the revolution in finance
in addition to the unabashed backing of the Greenspan Fed, was
the complicity of the Executive, Legislative and Judicial branches
of the US Government right to the Supreme Court. In addition,
to make the game work seamlessly, it required the active complicity
of the two leading credit agencies in the world - Moody's and
Standard & Poors.
It required a Congress and
Executive branch that would repeatedly reject rational appeals
to regulate over-the-counter financial derivatives, bank-owned
or financed hedge funds or any of the myriad steps to remove
supervision, control, transparency that had been painstakingly
built up over the previous century or more. It required that
the major government-certified rating agencies give their credit
AAA imprimatur to a tiny handful of poorly regulated insurance
companies called Monolines, all based in New York. The monolines
were another essential part of the New Finance.
The interlinks and consensus
behind the massive expansion of securitization among all these
institutional players was so clear and pervasive it might have
been incorporated as America New Finance Inc. and its shares
sold over NASDAQ.
Alan Greenspan anticipated
and encouraged the process of asset securitization for years
before his actual nurturing of the phenomenal real estate bubble
in the beginning of the first decade of the new Century. In a
pathetic attempt to deny his central role after the fall, Greenspan
last year claimed that the problem was not mortgage lending to
sub-prime customers but the securitization of the sub-prime credits.
In April 2005, he sung a quite different hymn to sub-prime securitization.
Addressing the Federal Reserve System's Fourth Annual Community
Affairs Research Conference, the Fed chairman declared,
brought about a multitude of new products, such as subprime loans
and niche credit programs for immigrants. Such developments are representative
of the market responses that have driven the financial services
industry throughout the history of our country. With these advances
in technology, lenders have taken advantage of credit-scoring
models and other techniques for efficiently extending credit
to a broader spectrum of consumers...The mortgage-backed security
helped create a national and even an international market for
mortgages, and market support for a wider variety of home mortgage
loan products became commonplace. This
led to securitization of a variety of other consumer loan products,
such as auto and credit card loans." 
That 2005 speech was about
the time he later claimed to have suddenly realized securitization
was getting out of hand. In September 2007 once the crisis was
full force, CBS' Leslie Stahl asked why he did nothing to stop
"illegal or shady practices you knew were taking place in
sub-prime lending." Greenspan replied, "Err, I had
no notion of how significant these practices had become until
very late. I didn't really get it until late 2005 and
2006..."  (emphasis added-w.e.)
As far back as November 1998,
only weeks after the near-meltdown of the global financial system
through the collapse of the LTCM hedge fund, Greenspan had told
an annual meeting of the US Securities Industry Association,
"Dramatic advances in computer and telecommunications technologies
in recent years have enabled a broad unbundling of risks through
innovative financial engineering. The financial instruments
of a bygone era, common stocks and debt obligations, have been
augmented by a vast array of complex hybrid financial products,
which allow risks to be isolated, but which, in many cases, seemingly
challenge human understanding." 
That speech was the clear signal
to Wall Street to move into asset-backed securitization in a
big way. After all, hadn't Greenspan just demonstrated through
the harrowing Asia crises of 1997-98 and the systemic crisis
triggered by the August 1998 sovereign debt default that the
Federal Reserve and its liquidity spigot stood more than ready
to bailout the banks in event of any major mishap? The big banks
were, after all, clearly now, Too Big To Fail - TBTF.
The Federal Reserve, the world's
largest and most powerful central bank with what was arguably
the world's most liberal market-friendly Chairman, Greenspan,
would back its major banks in the bold new securitization undertaking.
When Greenspan said risks "which seemingly challenge human
understanding," he signaled that he understood at least
in a crude way that this was a whole new domain of financial
obfuscation and complication. Central bankers traditionally were
known for their pursuit of transparency among banks and conservative
lending and risk management practices by member banks.
Not 'ole Alan Greenspan.
Most significantly, Greenspan
reassured his Wall Street securities underwriting friends in
the Securities Industry Association audience that November of
1998 that he would do all possible to ensure that in the New
Finance, the securitization of assets would remain for the banks
alone to self-regulate.
Under the Greenspan Fed, the
foxes would be trusted to guard the henhouse. He stated:
"The consequence (of
the banks' innovative financial engineering-w.e.) doubtless has
been a far more efficient financial system...The new international
financial system that has evolved as a consequence has been,
despite recent setbacks, a major factor in the marked increase
in living standards for those economies that have chosen to participate
It is important to remember--when
we contemplate the regulatory interface with the new international
financial system--the system that is relevant is not solely the
one we confront today. There is no evidence of which I am aware
that suggests that the transition to the new advanced technology-based
international financial system is now complete. Doubtless, tomorrow's
complexities will dwarf even today's.
It is, thus, all the more
important to recognize that twenty-first century financial regulation is
going to increasingly have to rely on private counterparty surveillance
to achieve safety and soundness. There is no credible
way to envision most government financial regulation being other
than oversight of process. As the complexity of financial
intermediation on a worldwide scale continues to increase, the
conventional regulatory examination process will become progressively
obsolescent--at least for the more complex banking systems.
One might naively ask, why
then surrender all those powers like Glass-Steagall to the private
banks far beyond possible official regulatory purview?
Again in October 1999, amid
the frenzy of the dot.com IT stock market bubble mania, a bubble
which Greenspan repeatedly and stubbornly insisted he could not
confirm as a bubble, he once again praised the role of financial
derivatives and "new financial instruments...reallocating
risk in a manner that makes risk more tolerable. Insurance, of
course, is the purest form of this service. All the new financial
products that have been created in recent years, financial derivatives
being in the forefront, contribute economic value by unbundling
risks and reallocating them in a highly calibrated manner. He
was speaking of securitization on the eve of the all-but certain
repeal of the Glass-Steagall Act. 
The Fed's "private counterparty
surveillance" brought the entire international inter-bank
trading system to a screeching halt in August 2007, as panic
spread over the value of the trillions of dollars in securitized
Asset Backed Commercial Paper and in fact most securitized bonds.
The effects of the shock have only begun, as banks and investors
slash values across the US and international financial system.
But that's getting ahead of our story.
Deregulation, TBTF and Gigantomania
In the United States, between
1980 and 1994 more than 1,600 banks insured by the Federal Deposit
Insurance Corporation (FDIC) were closed or received FDIC financial
assistance. That was far more than in any other period since
the advent of federal deposit insurance in the 1930s. It was
part of a process of concentration into giant banking groups
that would go into the next century.
In 1984 the largest bank insolvency
in US history threatened, the failure of Chicago's Continental
Illinois National Bank, the nation's seventh largest, and one
of the world's largest banks. To prevent that large failure,
the Government through the Federal Deposit Insurance Corporation
stepped in to bailout Continental Illinois by announcing 100%
deposit guarantee instead of the limited guarantee FDIC insurance
provided. This came to be called the doctrine of "Too Big
to Fail" (TBTF). The argument was that certain very large
banks, because they were so large, must not be allowed to fail
for fear of the chain-reaction consequences it would have across
the economy. It didn't take long before the large banks realized
that the bigger they became through mergers and takeovers, the
more sure they were to qualify for TBTF treatment. So-called
"Moral Hazard" was becoming a prime feature of US big
That TBTF doctrine was to be
extended during Greenspan's Fed tenure to cover very large hedge
funds (LTCM), very large stock markets (NYSE) and virtually every
large financial entity in which the US had a strategic stake.
Its consequences were to be devastating. Few outside the elite
insider circles of the very large institutions of the financial
community even realized the doctrine had been established.
Once the TBTF principle was
made clear, the biggest banks scrambled to get even bigger. The
traditional separation of banking into local S&L mortgage
lenders, large international money center banks like Citibank
or J.P. Morgan or Bank of America, the prohibition on banking
in more than one state, one by one were dismantled. It was a
sort of "level playing field" but level for the biggest
banks to bulldoze over and swallow up the smaller and create
cartels of finance of unprecedented scope.
By 1996 the number of independent
banks had shrunk by more than one-third from the late 1970s,
from more than 12,000 to fewer than 8,000. The percentage of
banking assets controlled by banks with more than $100 billion
doubled to one-fifth of all US banking assets. The trend was
just beginning. The banks' consolidation was a direct outgrowth
of the removal of geographic restrictions on bank branching and
holding company acquisitions by the individual states, formalized
in the 1994 Interstate Banking and Branch Efficiency Act. Under
the rubric of "more efficient banking" a Darwinian
survival of the biggest ensued. They were by no means the fittest.
The consolidation was to have significant consequences a decade
or so later as securitization exploded in scale beyond the banks'
J.P.Morgan blazes the trail
In 1995, well into the Clinton-Rubin
era, Alan Greenspan's former bank, J.P. Morgan, introduced an
innovation that was to revolutionize banking over the next decade.
Blythe Masters, a 34-year old Cambridge University graduate hired
by the bank, developed the first Credit Default Swaps, a financial
derivative instrument that ostensibly let a bank insure against
loan default; and Collateralized Debt Obligations, bonds issued
against a mixed pool of assets, a kind of credit derivative giving
exposure to a large number of companies in a single instrument.
Their attraction was that it
was all off the bank's own books, hence away from the Basle Accord's
8% capital rules. The goal was to increase bank returns while
eliminating the risk, a kind of "having your cake and eating
it too," something which in the real world can only be very
J.P.Morgan thereby paved the
way to transform US banking away from traditional commercial
lenders to traders of credit, in effect, into securitizers. The
new idea was to enable the banks to shift risks off their balance
sheets by pooling their loans and remarketing them as securities,
while buying default insurance, Credit Default Swaps, after syndicating
the loans for their clients. It was to prove a staggering development,
soon to hit volumes measured in the trillions for the banks.
By the end of 2007 there were an estimated $45,000 billion worth
of Credit Default Swap contracts out there, giving bondholders
the illusion of security. That illusion, however, was built on
bank risk models of default assumptions which are not public
and, if like other such risk models, were wildly optimistic.
Yet the mere existence of the illusion was sufficient to lead
the major banks of the world, lemming-like, into buying mortgage
bonds collateralized or backed by streams of mortgage payments
from unknown credit quality, and to accept at face value a Moody's
or Standard & Poors AAA rating.
Just as Greenspan as new Fed
chairman turned to his old cronies at J.P. Morgan when he wanted
to grant a loophole to the strict Glass-Steagall Act in 1987,
and as he turned to J.P. Morgan to covertly work with the Fed
to buy derivatives on the Chicago MMI stock index to artificially
manipulate a recovery from the October 1987 crash, so the Greenspan
Fed worked with J.P. Morgan and a handful of other trusted friends
on Wall Street to support the launch of securitization in the
1990's, as it became clear what the staggering potentials were
for the banks who were first and who could shape the rules of
the new game, the New Finance.
It was J.P. Morgan & Co.
that led the march of the big money center banks beginning 1995
away from traditional customer bank lending towards the pure
trading of credit and of credit risk. The goal was to amass huge
fortunes for the bank's balance sheet without having to carry
the risk on the bank's books, an open invitation to greed, fraud
and ultimate financial disaster. Almost every major bank in the
world, from Deutsche Bank to UBS to Barclays to Royal Bank of
Scotland to Societe Generale soon followed like eager blind lemmings.
None however came close to
the handful of US banks which came to create and dominate the
new world of securitization after 1995, as well as of derivatives
issuance. The banks, led by J.P. Morgan, first began to shift
credit risk off the bank balance sheets by pooling credits and
remarketing portfolios, buying default protection after syndicating
loans for clients. The era of New Finance had begun. Like every
major "innovation" in finance, it began slowly.
Very soon after, the new securitizing
banks such as J.P. Morgan began to create portfolios of debt
securities, then to package and sell off tranches based on default
probabilities. "Slice and dice" was the name of the
new game, to generate revenue for the issuing underwriting bank,
and to give "customized risk to return" results for
investors. Soon Asset Backed Securities, Collateralized Debt
Securities, even emerging market debt were being bundled and
sold off in tranches.
On November 2, 1999, only ten
days before Bill Clinton signed the Act repealing Glass-Steagall,
thereby opening the doors for money center banks to acquire brokerage
business, investment banks, insurance companies and a variety
of other financial institutions without restriction, Alan Greenspan
turned his attention to encouraging the process of bank securitization
of home mortgages.
In an address to America's
Community Bankers, a regional banking organization, at a conference
on mortgage markets, the Fed chairman stated:
The recent rise in the homeownership
rate to over 67 percent in the third quarter of this year owes,
in part, to the healthy economic expansion with its robust job
growth. But part of the gains have also come about because innovative
lenders, like you, have created a far broader spectrum of mortgage
products and have increased the efficiency of loan originations
and underwriting. Ongoing progress in streamlining the loan application
and origination process and in tailoring mortgages to individual
homebuyers is needed to continue these gains in homeownership...Community
banking epitomizes the flexibility and resourcefulness required
to adjust to, and exploit, demographic changes and technological
breakthroughs, and to create new forms of mortgage finance
that promote homeownership. As for the Federal Reserve, we are
striving to assist you by providing a stable platform for business
generally and for housing and mortgage activity. (emphasis mine - w.e.) 
Already on March 8 of that
same year, 1999, Greenspan addressed the Mortgage Bankers' Association
where he strongly pushed real estate mortgage backed securitization
as the wave of the future. He told the bankers there,
in the supply of mortgage credit has been accompanied by the
unbundling of the various aspects of the mortgage process.
Some institutions act as mortgage bankers, screening applicants
and originating loans. Other parties service mortgage loans,
a function for which efficiencies seem to be gained by large-scale
operations. Still others, mostly with stable funding bases, provide
the permanent financing of mortgages through participation in
mortgage pools. Beyond this, some others slice cash flows from
mortgage pools into special tranches that appeal to a wider group
of investors. In the process, mortgage-backed securities outstanding
have grown to a staggering $2.4 trillion..., automated underwriting
software is being increasingly employed to process a rapidly
rising share of mortgage applications. Not only does this
technology reduce the time it takes to approve a mortgage application,
it also offers a consistent way of evaluating applications across
a number of different attributes, and helps to ensure that the
down-payment and income requirements and interest rates charged
more accurately reflect credit risks. These developments enabled
the industry to handle the extraordinary volume of mortgages
last year with ease, especially compared to the strains that
had been experienced during refinancing waves in the past. One
key benefit of the new technology has been an increased ability
to manage risk (sic). Looking forward, the increased use
of automated underwriting and credit scoring creates the potential
for low-cost, customized mortgages with risk-adjusted pricing.
By tailoring mortgages to the needs of individual borrowers,
the mortgage banking industry of tomorrow will be better positioned
to serve all corners of the diverse mortgage market. (emphasis mine-w-e-)."
But only after the Fed punctured
the dot.com stock bubble in 2000 and after the Greenspan Fed
dropped Fed funds interest rates drastically to lows not seen
on such a scale since the 1930's Great Depression, did asset
securitization literally explode into a multi-trillion dollar
Securitization - the Un-Real Deal
Because the very subject of
securitization was embedded with such complexity no one, not
even its creators fully understood the diffusion of risk, let
alone the simultaneous concentration of systemic risk.
Securitization was a process in which assets were acquired by
some entity, sometimes called a Special Purpose Vehicle (SPV)
or Special Investment Vehicle (SIV).
At the SIV the diverse home
mortgages, let's say, were assembled into pools or bundles as
they were termed. A specific pool, say, of home mortgage receivables,
now took life in the new form of a bond, an asset backed bond,
in this case a mortgage backed security. The securitized bond
was backed by the cash flow or value of the underlying assets.
That little step involved a
complex leap of faith to grasp. It was based on illusory collateral
backing whose real worth, as is now dramatically clear to all
banks everywhere, was unknown and unknowable. Already at this
stage of the process the legal title to the home mortgage of
a specific home in the pool is legally ambiguous, as I pointed
out in Part I. Who in the chain actually has in his or her physical
possession the real, "wet signature" mortgage deed
to the hundreds and thousands of homes in collateral? Now lawyers
will have a field day for years to come sorting out Wall Street's
Securitization usually applied
to assets that were illiquid, that is ones that were not easily
sold, hence it became common in real estate. And US real estate
today is one of the world's most illiquid markets. Everyone wants
out and few want in, at least not at these prices.
Securitization was applied
to pools of leased property, to residential mortgages, home equity
loans, on student loans, credit card or other debts. In theory
all assets could be securitized as long as they were associated
with a steady and predictable cash flow. That was the theory.
In practice, it allowed US banks to skirt tougher new Basle Capital
Adequacy Rules, Basle II, designed explicitly in part to close
the loophole in Basle I that let US and other banks shove loans
wholesale into off-the-books special entities called Special
Investment Vehicles or SIVs.
Financial Alchemy: Where the fly hits
Securitization, thus, converted
illiquid assets into liquid assets. It did this, in theory, by
pooling, underwriting and selling the ownership claims to the
payment flows, as asset-backed securities (ABS). Mortgage-backed
securities were one form of ABS, the largest by far since 2001.
Here's where the fly hit the
With the US housing market
beginning back in 2006 in sharp downturn and rates on Adjustable
Rate Mortgages (ARMs) moving sharply higher across the United
States, hundreds of thousands of homeowners were being forced
to simply "walk away" from their now un-payable mortgages,
or be foreclosed on by one or another party in the complex securitization
chain, very often illegally, as an Ohio judge recently ruled.
Home foreclosures for 2007 were 75% higher than in 2006 and the
process is just beginning, in what will be a real estate disaster
to rival or likely exceed that of the Great Depression. In California
foreclosures were up an eye-popping 421% over the year before.
That growing process of mortgage
defaults in turn left gaping holes in the underlying cash payment
stream intended to back up the newly issued Mortgage Backed Securities.
Because the entire system was totally opaque, no one, least of
all the banks holding this paper, knew what was really the case,
what asset backed security was good, or what bad. As nature abhors
a vacuum, bankers and investors, especially global investors,
abhor uncertainty in financial assets they hold. They treat it
like toxic waste.
The architects of this New
Finance, based on the securitization of home mortgages, however,
found that bundling hundreds of disparate mortgages of varying
credit quality from across the USA into a big MBS bond wasn't
enough. If the Wall Street MBS underwriters were to be able to
sell their new MBS bonds to the well-endowed pension funds of
the world, they needed some extra juice. Most pension funds are
restricted to buying only bonds rated AAA, highest quality.
But how could a rating agency
rate a bond which was composed of a putative spream of mortgage
payments from 1,000 different home mortgages across the USA?
They couldn't send an examiner into every city to look at the
home and interview its occupant. Who could stand behind the bond?
Not the mortgage issuing bank. They sold the mortgage immediately,
at a discount, to get it off their books. Not the Special Purpose
Vehicle, they were just there to keep the transactions separate
from the mortgage underwriting bank. No something else was needed.
Deux Maxima! in stepped the dauntless Big Three (actually Big
Two) Credit Raters, the rating agencies.
The ABS Rating Game
Never ones to despair when
confronted by new obstacles, clever minds at J.P. Morgan, Morgan
Stanley, Goldman Sachs, Citigroup, Merrill Lynch, Bear Stearns
and a myriad of others in the game of securitizing the exploding
volumes of home mortgages after 2002, turned to the Big Three
rating agencies to get their prized AAA. This was necessary because,
unlike issuance of a traditional corporate bond, say by GE or
Ford, where a known, physical bricks 'n mortar blue-chip company
with a long-term credit history stood behind the bond, with Asset
Backed Securities no corporation stood behind an ABS. Just a
lot of promises on mortgage contracts across America.
The ABS or bond was, if you
will, a "stand alone" artificial creation, whose legality
under US law has been called into question. That meant a rating
by a credit rating agency was essential to make the bond credible,
or at least give it the "appearance of credibility,"
as we now realize from the unraveling of the present securitization
At the very heart of the new
financial architecture that was facilitated by the Greenspan
Fed and successive US Administrations over the past two decades
and more, was a semi-monopoly held by three de facto unregulated
private companies who operated to provide credit ratings for
all securitized assets, of course for very nice fees.
Three rating agencies dominated
the global business of credit ratings, the largest in the world
being Moody's Investors Service. In the boom years of securitization,
Moody's regularly reported well over a 50% profit on gross rating
revenues. The other two in the global rating cartel were Standard
& Poor's and Fitch Ratings. All three were American companies
intimately tied into the financial sinews of Wall Street and
US finance. The fact that the world's rating business was a de
facto US monopoly was no accident. It was planned that way, as
a main pillar of the financial domination of New York. The control
of the credit rating world was for the US global power projection
almost tantamount to US domination in nuclear weapons as a power
Former Secretary of Labor,
economist Robert Reich, identified a core issue of the raters,
their built-in conflict of interest. Reich noted, "Credit-rating
agencies are paid by the same institutions that package and sell
the securities the agencies are rating. If an investment bank
doesn't like the rating, it doesn't have to pay for it. And even
if it likes the rating, it pays only after the security is sold.
Get it? It's as if movie studios hired film critics to review
their movies, and paid them only if the reviews were positive
enough to get lots of people to see the movie."
Reich went on, "Until
the collapse, the result was great for credit-rating agencies.
Profits at Moody's more than doubled between 2002 and 2006. And
it was a great ride for the issuers of mortgage-backed securities.
Demand soared because the high ratings had expanded the market.
Traders didn't examine anything except the ratings...a multibillion-dollar
game of musical chairs. And then the music stopped." 
That put three global rating
agencies - Moody's, S&P, and Fitch - directly under the investigative
spotlight. They were de facto the only ones in the business of
rating the collateralized securities - Collateralized Mortgage
Obligations, Collateralized Debt Obligations, Student Loan-backed
Securities, Lottery Winning-backed Securities and a myriad of
others - for Wall Street and other banks.
According to an industry publication,
Inside Mortgage Finance, some 25% of the $900 billion
in sub-prime mortgages issued over the past two years were given
top AAA marks by the rating agencies. That comes to more than
$220 billion of sub-prime mortgage securities carrying the highest
AAA rating by either Moody's, Fitch or Standard & Poors.
That is now coming unwound as home mortgage defaults snowball
across the land.
Here the scene got ugly. Their
model assumptions on which they gave their desired AAA seal of
approval was a proprietary secret. "Trust us..."
According to an economist working
within the US rating business, who had access to the actual model
assumptions used by Moody's, S&P and Fitch to determine whether
a mortgage pool with sub-prime mortgages got a AAA or not, they
used historical default rates from a period of the lowest interest
rates since the Great Depression, in other words a period with
abnormally low default rates, to declare by extrapolation that
the sub-prime paper was and would be into the distant future
of AAA quality.
The risk of default on even
a sub-prime mortgage, so went the argument, "was historically
almost infinitesimal." That AAA rating from Moody's in turn
allowed the Wall Street investment houses to sell the CMOs to
pension funds, or just about anybody seeking "yield enhancement"
but with no risk. That was the theory.
As Oliver von Schweinitz pointed
out in a very timely book, Rating Agencies: Their Business,
Regulation and Liability, "Securitizations without ratings
are unthinkable." And because of the special nature of asset
backed securitizations of mortgage loans, von Schweinitz points
out, those ABS, "although being standardized, are one-time
events, whereas other issuances (corporate bonds, government
bonds) generally affect repeat players. Repeat players have less
incentive to cheat than 'one time issuers.'" 
Put the other way, there is
more incentive to cheat, to commit fraud with asset backed securities
than with traditional bond issuance, a lot more.
Moody's, S&P's unique status
The top three rating agencies
under US law enjoy an almost unique status. They are recognized
by the Government's Securities and Exchange Commission (SEC)
as Nationally Recognized Statistical Rating Organizations (NRSROs).
There exist only four in the USA today. The fourth, a far smaller
Canadian rater, is Dominion Bond Rating Service Ltd. Essentially,
the top three hold a quasi monopoly on the credit rating business,
and that, worldwide.
The only US law regulating
rating agencies, the Credit Agency Reform Act of 2006 is a toothless
law, passed in the wake of the Enron collapse. Four days before
the collapse of Enron, the rating agencies gave Enron an "investment
grade" rating, and a shocked public called for some scrutiny
of the raters. The effect of the Credit Agency Reform Act of
2006 was null on the de facto rating monopoly of S&P, Moody's
The European Union, also reacting
to Enron and to the similar fraud of the Italian company Parmalat,
called for an investigation of whether the US rating agencies
rating Parmalat has conflicts of interest, how transparent their
methodologies were (not at all) and the lack of competition.
After several years of "study"
and presumably a lot of behind-the-scenes from big EU banks involved
in the securitization game, the EU Commission announced in 2006
it would only "continue scrutiny" (sic) of the rating
agencies. Moody's and S&P and Fitch dominate EU ratings as
well. There are no competitors.
It's a free country, ain't it?
The raters under US law were
not liable for their ratings despite the fact that investors
worldwide depend often exclusively on the AAA or other rating
by Moody's or S&P as validation of creditworthiness, most
especially in securitized assets. The Credit Agency Reform Act
of 2006 in no way dealt with liability of the rating agencies.
It was in this regard a worthless paper. It was the only law
dealing with the raters at all.
As von Schweinitz pointed out,
"Rule 10b-5 of the Securities and Exchange Act of 1934 is
probably the most important basis for suing on the grounds of
capital market fraud." That rule stated "It shall be
unlawful for any person...to make any untrue statement of a material
fact." That sounded like something concrete. But then the
Supreme Court affirmed in a 2005 ruling, Dura Pharmaceuticals,
ratings are not "statements of a material fact" as
required under Rule 10b-5. The ratings given by Moody's or S&P
or Fitch are rather, "merely an opinion." They are
thereby protected as "privileged free speech," under
the US Constitution's First Amendment.
Moody's or S&P could say
any damn thing about Enron or Parmalat or sub-prime securities
it wanted to. It's a free country ain't it? Doesn't everyone
have a right to their opinion?
US courts have ruled in ruling
after ruling that financial markets are "efficient"
and hence, markets will detect any fraud in a company or security
and price it accordingly...eventually. No need to worry about
the raters then... 
That was the "self-regulation"
that Alan Greenspan apparently had in mind when he repeatedly
intervened to oppose any regulation of the emerging asset securitization
The securitization revolution was all underwritten by a kind
of "hear no evil, see no evil" US government policy
that said, what is "good for the Money Trust is good for
the nation." It was a perverse twist on the already perverse
saying from the 1950's of then General Motors chief, Charles
E. Wilson, "what's good for General Motors is good for America."
Monoline insurance: Viagra for securitization?
For those CMO sub-prime securities
that fell short of AAA quality, there was also another crucial
fix needed. The minds on Wall Street came up with an ingenious
The issuer of the Mortgage
Backed Security could take out what was known as Monoline insurance.
Monoline insurance for guaranteeing against default in asset
backed securities was another spin-off of the Greenspan securitization
Although monoline insurance
had begun back in the early 1970's as a guarantee for municipal
bonds, it was the Greenspan securitization revolution which gave
it its leap into prominence.
As their industry association
stated, "The monoline structure ensures that our full attention
is given to adding value to our capital market customers."
Add value they definitely did. As of December 2007, it was reliably
estimated that the monoline insurers, who call themselves "financial
guarantors," eleven poorly capitalized, loosely regulated
monoline insurers, all based in New York and regulated by that
state's insurance regulator, had given their insurance guarantee
to enable the AAA rated securitization of over $2.4 trillion
worth of Asset Backed Securities. (emphasis mine - f.w.e.).
Monoline insurance became a
very essential element in the fraud-ridden Wall Street scam known
as securitization. By paying a certain fee, a specialized (hence
the term monoline) insurance company would insure or guarantee
a pool of sub-prime mortgages in event of an economic downturn
or recession in which the poor sub-prime homeowner could not
service his monthly mortgage payments.
To quote from the official
website of the monoline trade association, "The Association
of Financial Guaranty Insurers, AFGI, is the trade association
of the insurers and re-insurers of municipal bonds and asset-backed
securities. A bond or other security insured by an AFGI member
has the unconditional and irrevocable guarantee that interest
and principal will be paid on time and in full in the event of
a default." Now they regret ever having promised that as
sub-prime mortgage resets, growing recession and mortgage defaults
are presenting hyperbolic insurance demands on the tiny, poorly
The main monoline insurers
were hardly household names: ACA Financial Guaranty Corp., Ambac
Assurance, Assured Guaranty Corp. BluePoint Re Limited, CIFG,
Financial Guaranty Insurance Company, Financial Security Assurance,
MBIA Insurance Corporation, PMI Guaranty Co., Radian Asset Assurance
Inc., RAM Reinsurance Company and XL Capital Assurance.
A cautious reader might ask
the question, "Who insures these eleven monoline insurers
who have guaranteed billions indeed trillions in payment flows
over the past five or so years of the ABS financial revolution?"
No one, yet, was the short
answer. They state, "Eight AFGI member firms carry a Triple-A
claims paying ability rating and two member firms carry a Double-A
claims paying ability rating." Moody's, Standard & Poors
and Fitch gave the AAA or AA ratings.
By having a guarantee from
a bond insurer with an AAA credit rating, the cost of borrowing
was less than it would normally be and the number of investors
willing to buy such bonds was greater.
For the monolines, guaranteeing
such bonds seemed risk-free, with average default rates running
at a fraction of 1 per cent in 2003-2006. As a result, monolines
leveraged their assets to build their books, and it was not being
uncommon for a monoline to have insured risks 100 to 150 times
the size of its capital base. Until recently, Ambac had capital
of $5.7 billion against guarantees of $550 billion.
In 1998, the NY State Insurance
Superintendent's office, the only regulator of monolines, agreed
to allow monolines to sell credit-default swaps (CDSs) on asset-backed
securities such as mortgage backed securities. Separate shell
companies would be established, through which CDSs could be issued
to banks for mortgage backed securities.
The move into insuring securitized
bonds was spectacularly lucrative for the monolines. MBIA's premiums
rose from $235m in 1998 to $998m in 2007. Year on year premiums
last year increased 140%. Then along came the US sub-prime mortgage
crisis, and the music stopped dead for the monolines, dead.
As the mortgages within bonds
from the banks defaulted - sub-prime mortgages written in 2006
were already defaulting at a rate of 20 per cent by January 2008
- the monolines were forced to step in and cover the payments.
On February 3, MBIA revealed
$3.5 billion in writedowns and other charges in three months
alone, leading to a quarterly loss of $2.3 billion. That was
likely just the tip of a very cold iceberg. Insurance analyst
Donald Light remarked, "The answer is no one knows,"
when asked what the potential downside loss was. "I don't
think we will know to perhaps the third or fourth quarter of
Credit ratings agencies have
begun downgrading the monolines, taking away their prized AAA
ratings, which means a monoline could no longer write new business,
and the bonds it guarantees no longer would hold a AAA rating.
To date, the only monoline
to receive downgrades from two agencies - usually required for
such a move to impact on a company - is FGIC, cut by both Fitch
and S&P. Ambac, the second largest monoline, has been cut
to AA by Fitch, with the other monolines on a variety of different
The rating agencies did "computer
simulated stress tests" to decide if the monolines could
"pay claims at a default level comparable to that of the
Great Depression." How much could the monoline insurers
handle in a real crisis? They claimed, "Our claims-paying
resources available to back members' guarantees...totals more
than $34 billion." 
That $34 billion was a drop
in what will rapidly over the course of 2008 appear to be a bottomless
bucket. It was estimated that in the Asset Backed Securities
market roughly one-third of all transactions were "wrapped"
or insured by AAA monolines. Investors demanded surety wraps
for volatile collateral or that without a long performance history.
According to the Securities
Industry and Financial Markets Association, a US trade group,
at the end of 2006 there was a total of some $3.6 trillion worth
of Asset Backed Securities in the United States, including of
home mortgages, prime and sub-prime, of home equity loans, credit
cards, student loans, car loans, equipment leasing and the like.
Fortunately not all $3.6 trillion of securitizations are likely
to default, and not all at once. But the AGFI monoline insurers
had insured $2.4 trillion of that mountain of asset backed securities
over the past several years. Private analysts estimated by early
February 2008 that the potential insurer payout risks, under
optimistic assumptions, could exceed $200 billions. A taxpayer
bailout of that scale in an election year would be an interesting
Off the books
The entire securitization revolution
allowed banks to move assets off their books into unregulated
opaque vehicles. They sold the mortgages at a discount to underwriters
such as Merrill Lynch, Bear Stearns, Citigroup, and similar financial
securitizers. They then in turn sold the mortgage collateral
to their own separate Special Investment Vehicle or SIV as they
were known. The attraction of a stand-alone SIV was that they
and their potential losses were theoretically at least, isolated
from the main underwriting bank. Should things ever, God forbid,
run amok with the various Asset Backed Securities held by the
SIV, only the SIV would suffer, not Citigroup or Merrill Lynch.
The dubious revenue streams
from sub-prime mortgages and similar low quality loans, once
bundled into the new Collateralized Mortgage Obligations or similar
securities, then often got an injection of Monoline insurance,
a kind of financial Viagra for junk quality mortgages such as
the NINA (No Income, No Assets) or "Liars' Loans,"
or so-called stated-income loans, that were commonplace during
the colossal Greenspan Real Estate economy up until July 2007.
According to the Mortgage Brokers'
Association for Responsible Lending, a consumer protection group,
by 2006 Liars' Loans were a staggering 62% of all USA mortgage
originations. In one independent sampling audit of stated-income
mortgage loans in Virginia in 2006, the auditors found, based
on IRS records that almost 60% of the stated-income loans were
exaggerated by more than 50%. Those stated-income chickens are
now coming home to roost or far worse. The default rates on those
Liars' Loans, which is now sweeping across the entire US real
estate market, makes the waste problems of Tyson Foods factory
chicken farms look like a wonderland. 
None of that would have been
possible without securitization, without the full backing of
the Greenspan Fed, without the repeal of Glass-Steagall, without
monoline insurance, without the collusion of the major rating
agencies, and the selling on of that risk by the mortgage-originating
banks to underwriters who bundled them, rated and insured them
as all AAA.
In fact the Greenspan New Finance
revolution literally opened the floodgates to fraud on every
level from home mortgage brokers to lending agencies to Wall
Street and London securitization banks to the credit rating agencies.
Leaving oversight of the new securitized assets, hundreds of
billions of dollars worth of them, to private "self-regulation"
between issuing banks like Bear Stearns, Merrill Lynch or Citigroup
and their rating agencies, was tantamount to pouring water on
a drowning man. In Part V we discuss the consequences of the
grand design in New Finance.
Alan, Consumer Finance, Remarks at the Federal Reserve
System's Fourth Annual Community Affairs Research Conference,
Washington, D.C., April 8, 2005, in www.federalreserve.gov/BoardDocs/speeches/2005/20050408/default.htm
Greenspan Defends Low Interest Rates Interview CBS 60
Minutes, September 16, 2007, in www.cbsnews.com/stories/2007/09/13/60minutes/main3257567.shtml
The Markets, Excerpts From Greenspan Speech on Global Turmoil,
reprinted in The New York Times, November 6, 1998.
Alan, Remarks by Chairman Alan Greenspan:The structure of
the international financial system, at the Annual Meeting of the Securities Industry
Association, Boca Raton, Florida, November 5, 1998.
Alan, Measuring Financial Risk in the Twenty-first Century,
Remarks Before a conference sponsored by the Office of the Comptroller
of the Currency, Washington, D.C., October 14, 1999, in www.federalreserve.gov/boarddocs/speeches/1999/19991014.htm.
Here Greenspan states, "...to date, economists have been
unable to anticipate sharp reversals in confidence. Collapsing
confidence is generally described as a bursting bubble, an
event incontrovertibly evident only in retrospect. To anticipate
a bubble about to burst requires the forecast of a plunge in
the prices of assets previously set by the judgments of millions
of investors, many of whom are highly knowledgeable about the
prospects for the specific investments that make up our broad
price indexes of stocks and other assets.
Deposit Insurance Corporation, History of the 80s, Volume
I: An Examination of the Banking Crises of the 1980s and Early
1990s, in www.fdic.gov/bank/historical/history/vol1.html,
Alan, Mortgage markets and economic activity, Remarks
before a conference on Mortgage Markets and Economic Activity,
sponsored by America's Community Bankers, Washington, D.C., November
2, 1999, in www.federalreserve.gov/boarddocs/speeches/1999/19991102.htm.
Alan, Remarks to Mortgage Bankers' Association, Washington,
D.C., March 8, 1999.
Robert, Why Credit-rating Agencies Blew It: Mystery Solved,
October 23, 2007, Robert Reich's Blog, in robertreich.blogspot.com/2007/10/they-mystery-of-why-credit-rating.html.
 Von Schweinitz,
Oliver, Rating Agencies Their Business, Regulation and Liability,
Unlimited Publishing LLC, Bloomington, Ind., 2007, pp. 35-36.
of Financial Guaranty Insurers, Our Claims-Paying Ability,
James P., Monoline Insurance & Financial Guaranty Reserving,
Dan, Liars' Loans Could Make Many Moan, The New York Sun,
Dec. 20, 2006.
Feb 8, 2008
F. William Engdahl
Part 1: Deutsche
Bank's painful lesson
Part II: The Financial Foundations
of the American Century
Part III: Greenspan's
F. William Engdahl
is the author of Seeds
The Hidden Agenda of Genetic Manipulation. Publication Launch:
23 November 2007.
He also authored
Century of War:
Anglo-American Oil Politics,'
Pluto Press Ltd.
He may be contacted
at his website, www.engdahl.oilgeopolitics.net.