The Financial Tsunami
Part V: The Predators had a ball
F. William Engdahl
Feb 25, 2008
Colossal Collateral Damage
The multi-trillion dollar US-centered
securitization debacle began to unravel in June 2007 with the
liquidity crisis in two hedge funds owned by Bear Stearns, one
of the world's largest and most successful investment banks.
The funds were heavily invested in sub-prime mortgage securities.
The damage soon spread across the Atlantic to a little-known
German state-owned bank, IKB. In July 2007, IKB's wholly-owned
conduit, Rhineland Funding, had approximately €20 billion
of Asset Backed Commercial Paper (ABCP). In mid-July, investors
refused to rollover part of Rhineland Funding's ABCP. That forced
the European Central Bank to inject record volumes of liquidity
into the market to keep the banking system liquid.
Rhineland Funding asked IKB
to provide a credit line. IKB revealed it didn't have enough
cash or liquid assets to meet the request of its conduit, and
was only saved by an emergency €8 billion credit facility
provided by its state-owned major shareholder bank, the Kreditanstalt
für Wiederaufbau, ironically the bank which led the Marshall
Plan reconstruction of war-torn Germany in the late 1940's. It
was soon to become evident to the world that a new Marshall Plan,
or some financial equivalent, was urgently needed for the United
States economy; however, there were no likely donors stepping
up to the plate this time.
The intervention of KfW, rather
than stopping the panic, led to reserve hoarding and to a run
on all commercial paper issued by international banks' off-books
Structured Investment Vehicles (SIVs).
Asset Backed Commercial Paper
was one of the big products of the asset securitization revolution
fostered by Greenspan and the US financial establishment. They
were the stand-alone creations of the major banks, set up to
get risk off the bank's balance sheet.
The SIV would typically issue
Commercial Paper securities backed by a flow of payments from
the cash collections received from the conduit's underlying asset
portfolio. The ABCP was a short-term debt, generally no more
than 270 days. Crucially, they were exempt from the registration
requirements of the US Securities Act of 1933. ABCPs were typically
issued from pools of trade receivables, credit card receivables,
auto and equipment loans and leases, and collateralized debt
In the case of IKB in Germany,
the cash flow was supposed to come from its portfolio of sub-prime
US home mortgages, mortgage backed Collateralized Debt Obligations
(CDOs). The main risk faced by ABCP investors was asset deterioration-that
the individual loans making up the security default-precisely
what began to cascade through the US mortgage markets during
the summer of 2007.
The problem with CDOs was that
once issued, they were rarely traded. Their value, rather than
being market-driven, were based on complicated theoretical models.
When CDO holders around the
world last summer suddenly and urgently needed liquidity to face
the market sell-off, they found the market value of their CDOs
was far below book value. So, instead of generating liquidity
by selling CDOs, they sold high-quality liquid blue chip stocks,
government bonds, precious metals.
That simply meant the CDO crisis
led to a loss of value in both CDOs and stocks. The drop in price
of equities triggered contagion to hedge funds. That dramatic
price collapse wasn't predicted by the theoretical models built
into quantitative hedge funds and led to large losses in that
part of the market, led by Bear Stearns' two in-house hedge funds.
Major losses by leading hedge funds further fed increasing uncertainty
and amplified the crisis.
That was the beginning of colossal
collateral damage. The models all broke down.
Lack of transparency was at
the root of the crisis that had finally and inevitably erupted
in mid-2007. That lack of transparency was due to the fact that
instead of spreading risk in a transparent way as foreseen by
accepted economic theory, market operators chose ways to "securitize"
risky assets by promoting high-yielding, high-risk assets, without
clearly marking their risk. Additionally, credit-rating agencies
turned a blind eye to the inherent risks of the products. The
fact that they were rarely traded meant even the approximate
value of these structured financial products was not known. 
Ignoring lessons from LTCM
With that collapse of confidence
among banks in the international inter-bank market, the heart
of global banking and which trades in Asset Backed Commercial
Paper, the banking system stared a systemic crisis in the face.
A crisis now threatened of a domino collapse of banks akin to
that in Europe in 1931, when the French banks for political reasons
pulled the plug on the Austrian Creditanstalt. Greenspan's New
Finance was at the heart of the new instability. It was his Age
of Turbulence, to parody the title of his ghost-written autobiography.
The world financial system
had faced a systemic crisis threat as recently as the September
1998 collapse of the Long-Term Capital Management (LTCM) hedge
fund in Greenwich, Connecticut. Only extraordinary coordinated
central bank intervention then, led by Greenspan's US Federal
Reserve, prevented a global meltdown.
That LTCM crisis contained
the seed crystal of all that is going wrong with the multi-trillion
dollar asset securitization markets today. Curiously, Greenspan
and others in positions of responsibility systematically refused
to take those lessons to heart.
The nominal trigger of the
LTCM crisis was an event not foreseen in the hedge fund's risk
model. Its investment strategies were based on what they felt
was a predictable mild range of volatility in foreign currencies
and bonds based on data from historical trading experience. When
Russia declared it was devaluing its rouble currency and defaulting
on its Russian state bonds, the risk parameters of LTCM's risk
models were literally blown out of the water, and LTCM with it.
Sovereign debt default was an event that was not "normal."
Unlike the risk assumptions
of every risk model used by Wall Street, the real world was also
not normal, but rather highly unpredictable.
To cover their losses LTCM
and its banks began a panic sell-off of anything it could liquidate,
triggering panic selling by other hedge funds and banks to cover
exposed positions. In response, the US stock market dropped 20%,
while European markets fell 35%. Investors sought safety in US
Treasury bonds, causing interest rates to drop by over a full
point. As a result, LTCM's highly leveraged investments started
to crumble. By the end of August 1998, it lost 50% of the value
of its capital investments.
In the summer of 1997 amid
the hedge fund-led attacks on the vulnerable currencies of Thailand,
Indonesia, Malaysia and other Asian high-growth "Tiger"
economies, Malaysia's Prime Minister Mahathir Mohamad openly
called for greater international control on the murky speculation
of hedge funds. He named the name of one of the largest involved
in the Asian attacks, George Soros' Quantum Fund. Because of
US pressure from the Treasury Department by Secretary Robert
Rubin, the former head of Goldman Sachs, and from the Greenspan
Fed, no oversight of opaque offshore hedge funds was ever undertaken.
Instead they were let to grow into funds holding more than $1.4
trillion in assets by 2007.
Fatally flawed risk models
The point about that LTCM crisis
that rocked the foundations of the global finance system, was
who was involved and what economic assumptions they used-the
very same fundamental assumptions used to construct the deadly-flawed
risk models of the asset securitization debacle.
At the beginning of 1998, LTCM
had capital of $4.8 billion, a portfolio of $200 billion, built
from its borrowing capacity or credit lines loaned from all the
major US and European banks hungry for untold gains from the
successful fund. LTCM held derivatives with a notional value
of $1,250 billion. That is one unregulated, offshore hedge fund
held a portfolio of options and other financial derivatives nominally
worth one and a quarter trillion dollars. Nothing of that scale
had ever before been dreamed of. The dream rapidly turned into
In the argot of Wall Street,
LTCM was a highly geared fund, unbelievably high. One of its
investors was the Italian central bank, so awesome was the fund's
reputation. The major global banks who had poured their money
into LTCM hoping to coattail the success and staggering profits
included Bankers Trust, Barclays, Chase, Deutsche Bank, Union
Bank of Switzerland, Salomon Smith Barney, J.P.Morgan, Goldman
Sachs, Merrill Lynch, Crédit Suisse, First Boston, Morgan
Stanley Dean Witter; Société Générale;
Crédit Agricole; Paribas, Lehman Brothers. Those were
the very banks that were to emerge less than a decade later at
the heart of the securitization crisis in 2007.
Speaking to press at the time,
US Treasury Secretary Rubin declared, "LTCM was a single
isolated instance in which the judgment was made by the Federal
Reserve Bank of New York that there were possible systemic implications
of a failure, and what they did was to organize or bring together
a group of private sector institutions which then made a judgment
of what was in their economic self interest."
The source of the awe over
LTCM was the "dream team" who ran it. The fund's CEO
and founder was John Meriwether, a legendary trader who had left
Salomon Brothers following a scandal over purchase of US Treasury
bonds. That hadn't dented his confidence. Asked whether he believed
in efficient markets, he once modestly replied, "I MAKE
them efficient." The fund's principal shareholders included
the two eminent experts in the "science" of risk, Myron
Scholes and Robert Merton. Scholes and Merton had been awarded
the Nobel Prize for economics in 1997 for their work on derivatives
by the Swedish Academy of Sciences. LTCM also had a dazzling
array of professors of finance, doctors of mathematics and physics
and other "rocket scientists" capable of inventing
extremely complex, daring and profitable financial schemes.
Black-Scholes, fundamental flaws and
There was only one flaw. Scholes'
and Mertons' fundamental axioms of risk, the assumptions on which
all their models were built, were wrong. They had been built
on sand, fundamentally and catastrophically wrong. Their mathematical
options pricing model assumed that there were Perfect Markets,
markets so extremely deep that traders' actions could not affect
prices. They assumed that markets and players were rational.
Reality suggested the opposite-markets were fundamentally irrational
in the long-term. But the risk pricing models of Black, Scholes
and others over the past two or more decades had allowed banks
and financial institutions to argue that traditional lending
prudence was old fashioned. With suitable options insurance,
risk was no longer a worry. Eat, drink and be merry...
That, of course, ignored actual
market conditions in every major market panic since Black-Scholes
model was introduced on the Chicago Board Options Exchange. It
ignored the fundamental role of options and 'portfolio insurance'
in the Crash of 1987; it ignored the causes of the panic that
in 1998 brought down Long Term Capital Management - of which
Scholes and Merton were both partners. Wall Street blissfully
ignored the obvious along with the economists and governors in
the Greenspan Fed.
Financial markets, contrary
to the religious dogma taught at every business school since
decades, were not smooth, well-behaved models following the Gaussian
Bell-shaped Curve as if it were a law of the universe. The fact
that the main architects of modern theories of financial engineering-now
given the serious-sounding name 'financial economics'-all got
Nobel prizes, gave the flawed models the aura of Papal infallibility.
Only three years after the 1987 crash the Nobel Committee in
Sweden gave Harry Markowitz and Merton Miller the prize. In 1997
amid the Asia crisis, it gave the award to Robert Merton and
Myron Scholes. 
The most remarkable aspect
of the incompetent risk models in use since the origins of financial
derivatives in the 1980's, through to the explosive growth of
asset securitization in the last decade, was how little they
LTCM had ace Wall Street investment
bankers, two Nobel Prize economists who literally invented the
theory of pricing derivatives on everything from stocks to currencies.
To top its all-star LTCM lineup, David Mullins, the former vice-chairman
of the Federal Reserve Board under Alan Greenspan quit his job
with the Maestro to become a partner at LTCM. Despite all this,
the traders at LTCM and those who followed them to the edge of
the financial abyss in August 1998 did not have a hedge against
the one thing they now confronted-systemic risk. Systemic risk
was precisely what they confronted once an "impossible event,"
the Russian state default, had occurred.
Despite the clear lessons from
the harrowing LTCM debacle-there is no derivative that insures
against systemic risk-Greenspan, Rubin and the New York banks
continued to build their risk models as if nothing had taken
place. The Russian sovereign default was dismissed as a "once
in a Century event." They were moving on to build the dot.com
bubble and, in the aftermath, the greatest financial bubble in
human history-the asset securitization bubble of 2002-2007.
Life is no Bell Curve
Risk and its pricing did not
behave like a bell-shaped curve, not in financial markets any
more than in oilfield exploitation. In 1900 an obscure French
mathematician and financial speculator, Louis Bachelier, argued
that price changes in bonds or stocks followed the bell-shaped
curve that the German mathematician, Carl Friedrich Gauss, devised
as a model to map statistical probabilities for various events.
Bell curves assumed a mild form of randomness in price fluctuations,
just as the standard I.Q. test by design defines 100 as "average,"
the center of the bell. It was a kind of useful alchemy, but
That assumption that financial
price variations behaved fundamentally like the bell curve allowed
Wall Street Rocket Scientists to roll out an unending stream
of new financial products each more arcane and complex than the
previous. The theories were modified. The "Law of Large
Numbers" was added to say that when the number of events
becomes sufficiently large, like flips of a coin or rolls of
die, the value converges on a stable value over the long term.
The Law of Large Numbers, which in reality was no scientific
law at all, allowed banks like Citigroup or Chase to issue hundreds
of millions of Visa cards without so much as a credit check,
based on data showing that in "normal" times defaults
on credit cards were so rare as not to be worth considering.
The problems with models based
on bell curve distributions or laws of large numbers arose when
times were not normal, such as a steep economic recession of
the sort the United States economy today is beginning to experience,
a recession comparable perhaps only to that of 1931-1939.
The remarkable thing was that
America's academic economists and Wall Street investment bankers,
Federal Reserve governors, Treasury secretaries, Sweden's Nobel
Economics Prize judges, England's Chancellors of the Exchequer,
her High Street bankers, her Court of the Bank of England, to
name just the leading names, all were willing to turn a blind
eye to the fact that economic theory, theories of market behavior,
theories of derivative risk pricing, were incapable of predicting,
let alone preventing, non-linear surprises. It was incapable
of predicting bursting of speculative bubbles, not in October
1987, not in February 1994, in March 2002, and most emphatically
not since June 2007. It couldn't because the very model created
the conditions that led to the ever larger and more destructive
bubbles in the first place. Financial Economics was but another
word for unbridled speculative excess.
A theory incapable of explaining
such major, defining surprise events, despite Nobel prizes, was
not worth the paper it was written on. Yet the US Federal Reserve
Governors-above all Alan Greenspan, US Treasury secretaries,
above all Robert Rubin and Lawrence Summers and Henry Paulsen-prevailed
to make sure that Congress never lay a legislative or regulatory
hand on the exotic financial instruments that were being created,
created based on a theory that was utterly irrelevant to reality.
On September 29, 1998, Reuters
reported, "any attempt to regulate derivatives, even after
the collapse-and rescue-of LTCM have not met with success. The
CFTC (the government agency with nominal oversight over derivatives
trading-w.e.) was barred from expanding its regulation of derivatives
under language approved late on Monday by the US House and Senate
negotiators. Earlier this month the Republican chairmen of the
House and Senate Agriculture Committees asked for the language
to limit the CFTC's regulatory authority over over-the-counter
derivatives echoing industry concerns." Industry of course
meant the big banks.
Reuters added that "when
the initial subject of regulation was broached by the CFTC both
Fed chairman, Alan Greenspan, and Treasury Secretary Rubin leapt
to the defense of the industry claiming that the industry did
not need regulation and that to do so would drive business overseas."
The combination of relentless
refusal to allow regulatory oversight of the explosive new financial
instruments from Credit Default Swaps to Mortgage Backed Securities
and the myriad of similar exotic "risk-diffusing" financial
innovations and the 1999 final repeal of the Glass-Steagall Act
strictly separating securities dealing banks from commercial
lending banks opened the way for what in June 2007 began as the
second Great Depression in less than a century. It began what
future historians will describe as the final demise of the United
States as the dominant global financial power.
Liars' Loans and NINA: Banks in an
orgy of fraud
The lessons of the 1998 Russia
default and the LTCM systemic crisis were forgotten within weeks
by the major players of the New York financial establishment.
Flanked by MBA whiz kid 'rocket scientist' analysts, bell curve
models and fatally flawed risk models, the financial giants of
the US banking world launched a wave of mega-mergers and began
to create ingenious ways of getting lending risk off their books.
That opened the doors to the greatest era of corporate and financial
fraud in world history, the asset securitization bonanza.
With Glass-Steagall finally
repealed in late 1999, at the urgings of Greenspan and Rubin,
banks were now free to snatch up rivals across the spectrum from
insurance companies to consumer credit or finance houses. The
landscape of American banking underwent a drastic change. The
asset securitization revolution was ready to be launched.
With Glass-Steagall gone, now
only bank holding companies and subsidiary pure lending banks
were directly monitored by the Federal Reserve. If Citigroup
opted to close its Citibank branch in a sub-prime neighborhood
and instead have a new wholly-owned subsidiary, CitiFinancial,
which specialized in sub-prime lending, work the area, CitiFinancial
could operate under entirely different and lax regulation.
CitiFinancial issued mortgages
separately from Citibank. Consumer groups accused CitiFinancial
of specializing in "predator loans" in which unscrupulous
mortgage brokers or salesmen would push a loan on a family or
person far beyond his comprehension or capacity to handle the
risks. And Citigroup was only typical of most big banks.
On January 8, 2008 Citigroup
announced with great fanfare publication of its consolidated
"US residential mortgage business," including mortgage
origination, servicing and securitization. Curiously, the statement
omitted CitiFinancial, the subsidiary with the most risk. 
Basle I loopholes
The driver pushing the banks
towards securitization and the proliferation of off-balance-sheet
risks including highly leveraged derivatives positions was the
1987 Basle Bank for International Settlements Capital Adequacy
Accord, known today as Basle I. That agreement among the central
banks of the world's largest economies required banks to set
aside 8% of a normal commercial loan as reserve against possible
future default. The then-new innovation of financial derivatives
were not mentioned in Basle I on US insistence.
The Accord originally had been
intended by Germany's ultra-conservative Bundesbank and other
European central banks to rein in the more speculative Japanese
and US bank lending which had led to the worst banking crisis
since the 1930's. The original intent of the Basle Accord was
to force banks to reduce lending risk. The actual effect for
US banks was just the opposite. They soon discovered a gaping
loophole-off-balance-sheet transactions, notably derivatives
positions and securitization. Because they were left out of Basle
I banks need not set aside any capital to cover potential losses.
The elegance of securitization
of loans such as home mortgages for the issuing bank was that
they could take the loan or mortgage and immediately sell it
on to a securitizer or underwriter who bundled hundreds of such
loans into a new Asset Backed Security. This seemingly genial
innovation was far more dangerous than it sounded. Lending banks
no longer needed to carry a mortgage loan on its books for 20-30
years as was traditional. They sold it on at a discount and used
the cash to turn the next round of credit issuing.
That meant as well that the
lending bank now no longer had to worry if the loan would ever
Fraud à la mode
It didn't take long before
lending banks across the United States realized they were sitting
on a bonanza bigger than the California gold rush. With no worry
about whether a borrower of a home mortgage, say, would be able
to service the debt for the next decades, banks realized they
made money on pure loan volume and resell to securitizers.
Soon it became commonplace
for banks to outsource their mortgage lending to free-lance brokers.
Instead of doing their own credit checks they relied, often exclusively,
on various online credit questionnaires, similar to the Visa
card application where no follow-up was done. It became common
practice for mortgage lenders to offer brokers bonus incentives
to bring in more signed mortgage loan volume, another opportunity
for massive fraud. The banks got more gain from making high volumes
of loans then selling for securitization. The world of traditional
banking was being turned on its head.
As the bank no longer had an
incentive to assure the solidity of a borrower through minimum
cash down payments and exhaustive background credit checks, many
US banks, simply to churn loan volume and returns, gave what
they cynically called "Liars' Loans." They knew the
person was lying about his credit and income to get that dream
home. They simply didn't care. They sold the risk once the ink
was dry on the mortgage.
A new terminology arose after
2002 for such loans, such as "NINA" mortgages-No Income,
No Assets. "No problem, Mister Jones. Here's $400,000 for
your new home, enjoy."
With Glass-Steagall no longer
an obstacle, banks could set up myriad wholly-owned separate
entities to process the booming home mortgage business. The giant
of the process was Citigroup, the largest US bank group with
over $2.4 trillion of group assets.
Citigroup included Travelers
Insurance, a state-regulated insurer. It included the old Citibank,
a huge retail lending bank. It included the investment bank,
Smith Barney. And it included the aggressive sub-prime lender,
CitiFinancial, according to numerous consumer reports, one of
the most aggressive predatory  lenders pushing
sub-prime mortgages on often ignorant or insolvent borrowers,
often in poor black or Hispanic neighborhoods. It included the
Universal Financial Corp. one of the nation's largest credit
card issuers, who used the so-called Law of Large Numbers to
grow its customer base among more and more dodgy credit risks.
Citigroup also included Banamex,
Mexico's second largest bank and Banco Cuscatlan, El Salvador's
largest bank. Banamex was one of the major indicted money laundering
banks in Mexico. That was nothing foreign to Citigroup. In 1999
the US Congress and GAO investigated Citigroup for illicitly
laundering $100 million in drug money for Raul Salinas, brother
of the then-Mexican President. The investigations also found
the bank had laundered money for corrupt officials from Pakistan
to Gabon to Nigeria.
Citigroup, the financial behemoth
was merely typical of what happened to American banking after
1999. It was a different world entirely from anything before
with the possible exception of the excesses of the Roaring '20's.
The degree of lending fraud and abuse that ensued in the new
era of asset securitization was staggering to the imagination.
The Predators had a ball
One US consumer organization
documented some of the most common predatory lending practices
during the real estate boom:
"In the United States
in the first decade of the 21st century there are many storefronts
offering such loans. Some are old -- Household Finance and its
sister Beneficial, for example -- and some are newer-fangled,
like CitiFinancial. Both offer credit at rates over thirty percent.
The business is booming: the spreads, Wall Street says, are too
good to pass up. Citibank pays under five percent interest on
the deposits it collects. Its affiliated loan sharks charge four
times that rate, even for loans secured by the borrower's home.
It's a can't-miss proposition. Even if the economy goes South
they can take and resell the collateral. The business is global:
the Hong Kong & Shanghai Banking Corporation, now HSBC, wants
to export it to the eighty-plus countries in which it has a retail
presence. Institutional investors love the business model and
investment banks securitize the loans. These fancy terms will
be defined as we proceed. The root, however, the fodder on which
the whole pyramid rests, is the solitary customer at what's called
the point of sale points and fees can be added to the money that's
lent. CitiFinancial and Household Finance both suggest that insurance
is needed. This they serve in a number of flavors -- credit life
and credit disability, credit unemployment and property insurance
-- but in almost all cases, it is included in the loans and interest
is charged on it. It's called "single premium" -- instead
of paying each month for coverage, you pay in advance with money
on which you pay interest. If you choose to refinance, you will
not get a refund. It is money down the drain, but at the point-of-sale
it often goes unnoticed.
Take, for example, the purchase
of furniture. A bedroom set might cost two thousand dollars.
The sign says Easy Credit, sometimes spelled E-Z. The furniture
man does not manage these accounts. For this he turns to CitiFinancial,
to HFC or perhaps to Wells Fargo. While the Federal Reserve lends
money to banks at below five percent, these bank-affiliates charge
twenty or thirty or forty percent. You will have insurance on
your furniture: to protect you, they say, from having it repossessed
if you die or become unemployed. Before the debt is discharged,
dead or alive, you will have paid more than the list-price of
a luxury car or a crypt with a doorman.
Midway you'll be approached
with a sweet-sounding offer: if you'll put up your home as collateral,
your rate can be lowered and the term be extended. A twenty-year
mortgage, fixed or adjustable. The rate will be high and the
rules not disclosed. For example: if you satisfy the loan too
quickly, you'll be charged a pre-payment penalty. Or, you'll
pay slowly and then be asked to pay more, in what's called a
balloon. If you can't, that's okay: they knew you couldn't. The
goal is to refinance your loan and charge you yet more points
In prior centuries, this
was called debt peonage. Today it is the fate of the so-called
sub-prime serf. Fully twenty percent of American households are
described as sub-prime. But half of the people who get sub-prime
loans could have paid normal rates, according to Fannie Mae and
Beltway authorities. Outside it's the law of the jungle; the
only rule is Buyer Beware. But this is easier for some people
Why would a person overpay
by so much? In the nation's low-income neighborhoods, sometimes
called ghettos or, in a more poetic euphemism, the inner city,
there's a lack of bank branches. In the late 20th century, many
financial institutions left the 'hood in the lurch. They refused
to lend money; they refused to write insurance policies. 
In the 1980's this author interviewed
a senior Wall Street banker, at the time recovering from some
kind of burnout. I asked about his bank's business in Cali, Colombia
during the heyday of the Cali cocaine cartel. Speaking not for
attribution, he related, "Banks would literally kill to
get a slice of this business, it's so lucrative." Clearly
they moved on to sub-prime lending with similar goals in mind,
and profits as huge as in money laundering drug gains.
Alan Greenspan openly backed
the extension of bank lending to the poorest ghetto residents.
Edward M. Gramlich, a Federal Reserve governor who died in September
2007, warned nearly seven years ago that a fast-growing new breed
of lenders was luring many people into risky mortgages they could
not afford. When Gramlich privately urged Fed examiners to investigate
mortgage lenders affiliated with national banks, he was rebuffed
by Alan Greenspan. Greenspan ruled the Fed with nearly the power
of an absolute monarch. 
Revealing what was most certainly
the tip of a very extensive iceberg of fraud, the FBI recently
announced it was investigating 14 companies for possible accounting
fraud, insider trading or other violations in connection with
home loans made to risky borrowers. The FBI announced that the
probe involved companies across the financial services industry,
from mortgage lenders to investment banks that bundle home loans
into securities sold to investors.
At the same time, authorities
in New York and Connecticut were investigating whether Wall Street
banks hid crucial information about high-risk loans bundled into
securities sold to investors. Connecticut Attorney General Richard
Blumenthal said he and New York Attorney General Andrew Cuomo
were looking whether banks properly disclosed the high risk of
default on so-called "exception" loans - considered
even riskier than sub-prime loans - when selling those securities
to investors. Last November, Cuomo issued subpoenas to government-sponsored
mortgage companies, Fannie Mae and Freddie Mac, in his investigation
into what he claimed were conflicts of interest in the mortgage
industry. He said he wanted to know about billions of dollars
of home loans they bought from banks, including the largest US
savings and loan, Washington Mutual Inc., and how appraisals
The FBI said it was looking
into the practices of sub-prime lenders, as well as potential
accounting fraud committed by financial firms that hold these
loans on their books or securitize them and sell them to other
investors. Morgan Stanley, Goldman Sachs Group Inc. and Bear
Stearns Cos. all disclosed in regulatory filings that they were
cooperating with requests for information from various unspecified,
regulatory and government agencies. 
One former real estate broker
from the Pacific Northwest, who quit the business in disgust
at the pressures to push mortgages on unqualified borrowers,
described some of the more typical practices of predatory brokers
in a memo to this author:
The sub-prime fiasco is
a nightmare alright, but the prime ARMs hold potential for overwhelming
disaster. The first "hiccup" occurred in July/August
2007 - this was the "Sub-prime Fiasco," but in November
2007 the hiccup was more than that. It was in November 2007,
that the prime ARMs adjusted upwards.
What this means is that upon the "anniversary date of the
loan" the Adjustable Rate Mortgage adjusts up into a higher
payment. This happens because the ARM was "purchased"
at a teaser rate, usually one or one and one half percent. Payments
made at that rate, while very attractive, do nothing to reduce
principal and even generate some unpaid interest which is tacked
onto the loan. Borrowers are permitted to make the teaser rate
payments for the entire first year, even though the rate is good
only for the first month.
Concerns about "negative amortization," whereby the
indebtedness on the loan becomes more than the market value of
the property, were allayed by reference to the growth in property
values due to the bank-created bubble, which it was said was
normal and could be relied upon to continue. All that was promoted
by the lenders who sent armies of account executives, i.e., salesmen,
around to the mortgage brokers to explain how it would work.
Adjustable interest rates on home loans were the sum of the bank's
profit - the margin - and some objective predictor of the cost
of the borrowed funds to the bank, known as the index. Indexes
generated by various economic activities - what the banks around
the country were paying for 90 day CD's or what the banks in
the London Interbank Exchange (LIBOR) were paying for dollars
- were used. Adding the margin to the index produces the true
interest rate on the loan - the rate at which, after 30 years
of payments, the loan will be completely paid off ("amortized").
It is called the "fully indexed rate."
I am going to pick an arbitrary 6% as the "real" interest
rate (3% margin + 3% index). With a loan amount of $250,000.00
the monthly payment at 1% would be $804.10; that is the "teaser
rate" payment, exclusive of taxes and insurance. This would
adjust with changes in the index, but the margin remains static
for the life of the loan.
This loan is structured so that payment adjustments only occur
once per year and are capped at 7.5 % of the previous year's
payment. That can
go on, stair stepping, for a period of 5 years (or 10 years in
the case of one lender) without regard to what is happening in
the real world. Then, at the end of the 5 years, the caps come
off and everything adjusts to payments under the "fully
If the borrower has been making only the minimum required payments
the whole time, this can result in a payment shock in the thousands.
If the value of the home has decreased twenty-five percent, the
borrower, this time someone with stellar credit, is encouraged
to give it back to the bank, which devalues it at least another
twenty-five percent and that spreads to the surrounding properties.
According to a Chicago banking
insider, during the first week of February 2008, bankers in the
U.S. were made aware of the following:
Chase Manhattan Bank ("CMB")
has sent out an unlimited number of statements to its customers
about Lines of Credit ("LOC's". The terms of its LOC's,
which, have been popular in the past, are now being manipulated
and the values of the properties securing them are being unilaterally
adjusted down, sometimes as much as 50 percent. This means homeowners
are faced with making payments on a loan to buy an asset that
is apparently worth half of the principal amount of the loan
and paying interest on top of that. The only sensible thing to
do in many cases is walk away, which results in a major loss
in equity, reducing the value of all surrounding properties and
adding to the avalanche of foreclosures.
This is especially aggravated in cases of "Creative Financing"
LOCs - those that were drawn on equal to between ninety and one
hundred percent of the value of the property before the bubble
CMB has automatically closed credit lines that have "open"
credit on them - meaning that the borrower left some money in
the LOC for the future - over an 80% ratio of the amount of the
loan to the value ("LTV") of the property. This has
been done on a mass basis without any reference to the "property
Loan to Value limits mean that the amount of money which the
lender is willing to loan cannot exceed the stated percentage
of the property value. In common practice, an appraiser would
be hired to assess the value of the property. The appraisal is
informed by comparable sales of other properties which have sold
in an area that, with a few exceptions, must be no more than
one mile away from the subject property. That was merely the
tip of the mortgage fraud bonanza that preceded the present unfolding
The Tsunami is only beginning
The nature of the fatally flawed
risk models used by Wall Street, by Moody's, by the securities
Monoline insurers and by the economists of the US Government
and Federal Reserve was such that they all assumed recessions
were no longer possible, as risk could be indefinitely diffused
and spread across the globe.
All the securitized assets,
the trillions of dollars worth, were priced on such flawed assumption.
All the trillions of dollars of Credit Default Swaps-the illusion
that loan default could be cheaply insured against with derivatives-all
these were set to explode in a cascading series of domino-like
crises as the crisis in the US housing market unraveled. The
more home prices fell, the more mortgages facing sharply higher
interest rate resets, the more unemployment spread across America
from Ohio to Michigan to California to Pennsylvania to Colorado
and Arizona. That process set off a vicious self-feeding spiral
of asset price deflation.
The sub-prime sector was merely
the first manifestation of what was to unravel. The process will
take years to wind down. The damaged products of Asset Backed
Securities were used in turn as collateral for yet further bank
loans, for leveraged buyouts by private equity firms, by corporations,
even by municipalities. The pyramid of debt built on assets securitized
began to go into reverse leverage as reality dawned in global
markets that no one knew the worth of the securitized paper they
In what would be a laughable
admission were the consequences of their criminal negligence
not so tragic for millions of Americans, Standard & Poors,
the second largest rating agency in the world stated in October
2007 that they "underestimated the extent of fraud in the
US mortgage industry." Alan Greenspan feebly tried to exonerate
himself by claiming that lending to sub-prime borrowers was not
wrong, only the later securitization of the loans. The very system
they worked over decades to create was premised on fraud and
Credit Default Swap crisis next
As of this writing, the next
ratchet down in the US financial Tsunami was the monocline insurers
where, short of a US government nationalization, no solution
was feasible as the unknown risks were so staggering. That problem
was discussed in the previous Part IV.
Next to explode will be the
imminent probability of meltdown in the $45 trillion market in
Over-the-Counter Credit Default Swaps (CDS), the brainchild of
As Greenspan made certain,
the CDS market remained unregulated and opaque, so that no one
knew what the scale of the risks in a falling economy were. Because
it is unregulated it often was the case that one party to a CDS
resold to another financial institution without informing the
original counterparty. That means it is not obvious that were
an investor to try to cash in his CDS he could track down its
payer of the claim. The CDS market was overwhelmingly concentrated
in New York banks who held swaps at the end of 2007 worth nominally
$14 trillion. The most exposed were J.P. Morgan Chase with $7.8
trillion and Citigroup and Bank of America with $3 trillion each.
The problem had been exacerbated
by the fact that of the $45 trillions of credit default swaps,
some 16% or $7.2 trillion worth were written to protect holders
of Collateralized Debt Obligations where the mortgage collateral
problems were concentrated. The CDS market was a ticking time
bomb with an atomic detonator. As the credit crisis spreads in
coming months, corporations will be forced to default on their
bonds and writers of CDS insurance will face exploding claims
and non-transparent rules. A claims settlement procedure for
a market nominally worth $45 trillion did not exist as of February
As hundreds of thousands of
Americans over the coming months find their monthly mortgage
payments dramatically reset according to their Adjustable Rate
Mortgage terms, another $690 billion in home mortgage debt will
become prime candidates for default. That in turn will lead to
a snowball effect in terms of job losses, credit card defaults
and another wave of securitization crisis in the huge market
for securitized credit card debt. The remarkable thing about
this crisis is that so much of the sinews of the entire American
financial system were tied in to it. There has never been a crisis
of this magnitude in American history.
At the end of February the
Financial Times of London revealed that US banks had "quietly"
borrowed $50 billion in funds from a special new Fed credit facility
to ease their cash crisis. Losses at all the major banks from
Citigroup to J.P.Morgan Chase to most other major US bank groups
continued to mount as the economy sank deeper into a recession
that clearly would turn in coming months into a genuine depression.
No Presidential candidate had dared utter a serious word about
their proposals to deal with what was becoming the greatest financial
and economic meltdown in American history.
By the early days of 2008 it
was becoming clear that Financial Securitization would be the
Last Tango for the United States as the global financial superpower.
The question now was posed
what new center or centers of financial power could conceivably
replace New York as the global nexus. That we will examine in
Secretariat, Recent developments on global financial markets:
Note by the UNCTAD secretariat,
TD/B/54/CRP.2, Geneva, 28 September 2007.
a treatment of the little-known political background to the 1931
Creditanstalt crisis that led to a domino collapse of German
banks, see Engdahl, F. William, A
Century of War: Anglo-American Oil Politics and the New World
Order, 2004, London, Pluto Press, Chapter 6.
John Oswin, Fallacies of the Nobel Gods: Essay on Financial
Economics and Nobel Laureates, in http://www.capital-flow-analysis.com/investment-essays/nobel_gods.html.
a fascinating treatment of the fundamental theoretical flaws
of economic and financial market models used today, and what
he calls the high odds of catastrophic price changes, I recommend
the book by the Yale mathematician and inventor of fractal geometry,
Benoit Mandelbrot, in Mandelbrot, Benoit and Hudson, Richard
L., The (mis) Behavior of Markets: A Fractal View of Risk,
Ruin and Reward, Profile Books Ltd, London, 2004.
by Inner City Press, The Citigroup Watch, January 28,
2008, in www.innercitypress.org.citi.html.
Action Network, Citigroup Becomes Mexico's Largest Bank after
Banamex Merger, August 10, 2001, in
Matthew, Predatory Lending: Toxic Credit in the Inner City,
Edmund L., Fed Shrugged as Sub-prime Crisis Spread, The
New York Times, Dec.18, 2007.
Alan, FBI Probes 14 Companies Over Home Loans, AP, January
communication to the author from a former mortgage broker with
a large US mortgage lender.
Feb 25, 2008
F. William Engdahl
Part 1: Deutsche
Bank's painful lesson
Part II: The Financial Foundations
of the American Century
Part III: Greenspan's
Part IV: Asset Securitization
-- The Last Tango
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.