By Walter Sorochan, Emeritus Professor, San Diego State University
Posted March 18, 2009; Updated April 30, 2017.
Purpose of article:
To briefly and simply illustrate the events that lead to the real estate meltdown, Wall Street collapse and global financial depression of 2008. The reference to 2008 meltdown needs an update 2017:
Suggestions for preventing and fixing the 2008 meltdown are displayed below after the causes.
New threat to Global Economy:
Many bankers, lenders, loan companies, insurance companies, wall street and speculators made money at the expense of a naïve public. The public borrowed easy loans they could not pay-off.
By understanding the 17 caustive links of the many meltdowns, we can try to reverse engineer the causes and fix the continuing economic problems.
Step 1 Early symptoms ignored: One of the earliest signs that the economic system had flaws was the mid-1970's shortage of oil. There was no long range energy plan! Then there were several mini-stock market crashes thereafter. All these forecasters of the future were ignored! "Business as usual!"
Step 2 Credit default Swaps created: A financial instrument Credit Default Swaps [CDS or SWAPS ], was created by Blythe Masters of JP Morgan Chase Bank in the early 1980s. [ Teather ] This instrument developed the credit derivatives which were at the heart of the current financial crisis. It exchanged or swapped paper debt for collateral.
In 1997, Masters and her team developed many of the credit derivatives that were intended to remove risk from companies' balance sheets. The idea was to separate the default risk on loans from the loans themselves. The banks argued that by trading credit derivatives of the kind pioneered by Masters, they had spread their risk elsewhere and therefore needed lower reserves to protect against loan defaults. Regulators rolled over and the banks loaned ever more. It was a huge success and the market for credit derivatives grew rapidly.
The new instrument, the Credit Default Swap [ CDS ] was used as an insurance to secure paper notes or loans. SWAPS set the stage for a new form of gamble speculation. It allowed banks and big insurance corporations to make money by not assuming responsibility to have enough collateral or cash on hand to cover their bets.
The economic mess the entire world found itself in 2009 started a long time ago; probably 300 years ago with the free enterprise system. But it started surfacing in 2001 when banks began using a special way of providing collateral for money they were borrowing from investment banks and others. Enron, the energy giant in 2000, exploited special credit notes, called Credit Default Swap, to create a paper money empire [without cash reserves to back up the SWAPS trading ] that collapsed in 2002.
Step 3 Enron 1980s test run for SWAPS: Enron, the defunct energy corporation in Houston, Texas., evolved its own form of an unregulated banking and loan system. Enron borrowed the idea of a new instrument from JPMorgan Chase Bank in the early 1980s; that exchanged or swapped paper debt for collateral. The new instrument was called the Credit Default Swap [ CDS or SWAPS ] and was used as an insurance to secure paper notes or loans and also generate income for Enron. Politicians in Washington bent over backwards to accommodate Enron.
Enron exploited special credit notes, called Credit Default Swap, to create a paper money empire that collapsed in 2002. Enron triggered Wall Street speculation that brought the financial institutions down in 2009.
The tragedy of Enron is that no one did anything about preventing the Enron tragedy from reoccurring! For more information click on: [Enron]
Step 4 1980 - 2000 Allowing Speculative gambling on the stock market started big time in the late 1980’s with Enron. No one understood CDS in the 1980 - 1990's era. Congress gave Enron political and fiscal freedom to use CDS as they wished, without monitoring, accountability or regulation. After all, Wall Street and free enterprise would work to provide an equal playing field for everyone!
CDS opened the door to all future events such as creating sub-prime loans, allowing unsecured securities to be sold by banks, and disposing of unmonitored CDS to foreign investors. Everyone who participated in the "CDS gambling table" had dollar signs in their eyes and greed and power in their hearts. Politicians had a "hands off" policy toward all these shennanigans.
Step 5 Politicians smuggling protective legislation - Gramm's Commodity Futures Modernization Act of 2000 in the dark of night: Credit Default Swaps became exempt from regulation with the Commodity Futures Modernization Act of 2000, which was also responsible for the Enron loophole. U.S. Sen. Phil Gramm (R-TX) introduced the Act on behalf of financial industry lobbyists. The Modernization Act was rushed through Congress as a companion bill to the omnibus spending bill, the last day before the Christmas holiday at 2:00am in the morning when the senate was empty. Not a single politician read the bill. Most did not know what was in the bill.
The bill by-passed the substantive policy committees in both the House and the Senate so that there were neither hearings nor opportunities for recorded committee votes. The omnibus spending bill, which was 11,000 pages long, is the financial plan the government requires for everyday operations. President Clinton signed the bill into Public Law (106-554) o December 21, 2000. This bill spurred the loaning of easy to get loans to home buyers.
The Modernization Act allowed for even more regulatory bypasses. It became difficult to determine the financial strength of the sellers of protection. CDS came to be issued for Structured Investment Vehicles, which did not have a nown entity to follow to determine the strength of a particular bond or loan. The market became rampant with gambling as sellers and buyers of CDS were no longer owners of the underlying asset (bond or loan). Before the Act of 2000, the CDS markets value was 900 billion. By the end of 2007, the CDS market had a notional value of $45 trillion.
Step 6 Money scammers wanting to make money - The real estate boom: Mainstreet was ready to take part in the SWAPS casino. Common folk wanted to live the American dream of owning a home. And banks and loan companies were eager to help them.
"I have a dream ..." "Whooow! No money down!"
Step 7 Weak checks on Prospective Buyers - a Big Housing Market: Quick Loan Funding targeted people who couldn't afford a down payment and had poor credit... so-called "sub-prime borrowers." Mortgage lender Daniel Sadek, head of Quick Loan Funding, drastically reduced borrowers' credit requirements and may have raked in as much as $5 million a month in personal profits.
After cranking out thousands of sub-prime mortgages, credit began to dry up and Quick Loan eventually closed. But the momentum toward easy loans had a jump-start!
Step 8 Weak banking loan scrutiny - Sub-prime loans & more new owners: With rising home values, almost everyone believed they could get rich just by buying a home. A pretty much everyone -- even those with terrible credit histories -- could get a home loan. This was the beginning of " sub-prime loan!"
Buyers were persons who could not afford to buy & who did not have a moderate down payment. Mainstreet usually bought houses with an adjustable rate mortgage. A new loan was created: “the pay option negative amortization adjustable rate mortgage.” It was designed to help first-time homebuyers who couldn’t actually afford the cost of the loan. Those homebuyers would have the option to pay only part of the interest they owed each month. The unpaid interest was added to the total amount of the mortgage. As a result, the mortgage balance increased; instead of the mortgage being paid down, it was getting bigger.
Key motivation for lenders was earning more commission sales.
9 Opening the door to another weak loan - Another loan customer: more refinancing by encouraging small Equity Loans:
Bill Dallas started a new company, Ownit, and offered to sell Wall Street a mortgage for borrowers who weren't quite "prime." It was a 100% home loan for people with good credit who couldn't afford a down payment.
In 2004 homeowners withdrew an estimated $900 billion dollars by refinancing and spent the
money on whatever they could buy. Homes had turned into ATM machines and the economy flourished.
Lenders were more than happy to issue mortgages and Wall Street was more than happy to have a new supply of mortgages to package up and sell to hungry investors around the world. It seemed everyone was spending…and making money.
But, just like many homeowners, a lot of investors didn't quite understand what kind of mortgages they were buying. Major Wall Street banks enlisted lenders to supply them with mortgages banks could sell to investors. Banks eagerly dropped many requirements for the mortgages they were willing to sell: "removing the litmus test ... No income, no asset. Not verifying income... breathe on a mirror and if there's fog you sort of get a loan."
Wall Street bankers pooled together thousands of these mortgages, carved them up into similar packages and profitably sold them as securities.
Credit tranching refers to creating multiple classes (or "tranches") of securities, each of which has a different seniority and value relative to the others.
[ more info on tranches ]
Step 11 No control of Rating Agencies: During the boom, when home prices surged and virtually no borrowers defaulted, the riskier Triple-B rated securities made from mortgages looked as good as the safe Triple-A's. "Eventually the market gets smart and says, let's lower the requirements for Triple-A."
The key to getting investors to buy those mortgage-backed securities was to get them stamped with a seal of "respectable grade" approval. Big institutions like police retirement funds and universities would only invest if the investment rating agencies — Moody’s, Standard & Poor’s, and Fitch — gave the securities an “investment grade” rating. “Investment grade” can range from the safest triple A-rated investments to the lower triple B-rated investments. Because a triple A security is safer, it pays less than a riskier triple B. credit rating
The credit rating agencies had an incentive to award a security the best possible ratings; agencies were paid for their appraisals by the very banks that issued the securities. [Moody loan ratings fiasco ]
Step 12 New way to package loans into poorly worded loans: CDOs – Collateralized Debt Obligations: A CDO is an arrangement that raises money primarily by issuing its own bonds and then invests the proceeds in a portfolio of bonds, loans, or similar assets.
These structured products are highly complicated investments. The debt securities are bundled and re-sold but often buyers don't really know exactly what they are purchasing. Even Alan Greenspan admitted he was befuddled by the CDO. Hence, these have be referred to as "toxic waste." [toxic waste]
CDOs are constructed from a portfolio of fixed-income assets. CDOs are divided by the issuer into different tranches: senior tranches ( rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). For a simple explanation of how CDO work, [ refer to Gagliano and Hirsch: “ …. CDO is an investment that works kind of like a champagne bottle." ]
Step 13 Falsifying records just to continue the scam: CDOs and CDS are different financial cousins: CDO's [ a form of debt-security bond ] were purchased by investors who were told by "creditable" ratings agencies that these securities were "investment grade. Some of these investors obviously didn't believe the credit agencies and decided to seek insurance in the case that their CDO defaulted. They bought insurance protection in the form of Credit Default Swaps or CDS [ often referred to a "swaps" ] so as to insure their investment. Credit default swaps are bought by bond holders to hedge or bet against the default risk of banks.
Credit Default Swap is basically an insurance policy against the failure of CPO's'. Companies - like AIG, Lehman and Fortis (and many others) found these insurance policies to be a very lucrative business. The problem is that AIG didn't foresee that any of these would default - they thought this was a risk free operation. AIG took in a ton of money to insure the CDO's through Credit Default Swaps - but never had enough reserved for losses. When numerous CPO's defaulted and their investors put a call to be compensated, AIG did not have the money in reserves to do so. Hence AIG declared bankruptcy and had to be bailed out; on assumption that "it was too big to fail!"
Step 14 No one paying attention to Fishy odor on Wall Street & Hedge Funds: Credit default swaps were bought by bond holders to hedge or bet against the default risk of banks.
Alert signals were sounded in early 2000's by wall street players like Steve Eisen, Meredith Whitney, Timothy Sykes and Kyle Bass [ Pittman ] that sub-prime lending practices in the housing industry were corrupt and doomed to failure. No one, but no one listened to them! By the spring of 2005, Steve Eisen at FrontPoint, and others, were fairly convinced that something was very screwed up not merely in a handful of companies but in the financial underpinnings of the entire U.S. mortgage market. Eisen refined a betting instrument called hedge fund; which basically bets that a holder [bank lender] of a loan or CDS will not be able to repay the loan in a specific period of time.
Hedge fund speculators began using hedge funds to profit from an anticipated housing meltdown. [ hedge funds, Lewis ] Hedge funds invested in "credit protection," a kind of insurance on various mortgage-backed securities. As those securities decline in value, hedge fund insurance pays off. Kyle Bass' hedge fund made more than a billion dollars in profit.
Step 15 Failure of banks to follow Bank solvency requirements:
Banks [ and insurance corporations like AIG ] need a certain amount of cash on hand to be solvent and be able to cover their banking obligations. Many banks in 2000 to 2009 had capital ratios below the required 10 % liquidity requirement. This allowed them to pay the SWAPS game and speculate on investing in busted market for mortgages, derivatives and especially credit default swaps; an unsecured paper debt. [ Bank Capital Requirement ]
The big lending banks, like JPMorgan Chase, Bear stearns, Wachovia, HSBC, Bank of America, CityGroup, PNC Bank, Lehman Brothers, Suntrust Bank and State Street Bank got into trouble when they made big loans and could not pay off to creditors or when a creditor made a "call" on the bank. Unable to pay off their creditors, they had to declare bankruptcy and ask for a government bailout or sell.
Also involved in this bank gambling fiasco were the big bank insurers like AIG. These firms also created similar financial distresses for themselves.
Step 16 No one stopped bankers from Marketing SWAPS:
Wall Street sold CDO's and CDS's to greedy speculators who wanted to make money.
The business of wall street banker Michael Francis was to pool mortgages and sell them to investors who would then get the monthly payments those mortgages produced. The more mortgages lenders provided to homebuyers, the more “product” Francis would have to sell.
Step 17 Speculator buyers worldwide were greedy for money and lacked smarts:
Example of foreign investor-speculators:
The Housing Bubble bursts in 2008
... the beginning of the economic meltdown. The housing bubble bursts, spreading like a domino effect to the other money institutions. CDOs were packaged into baskets securities and sold worldwide.
Example Narvik, Norway: town far above the Arctic Circle that was convinced it could solve its budget problems by investing in Wall Street's wares... primarily CDOs. In spite of not understanding what it was that they were buying, Town leaders thought it was a safe investment.
But the investment collapsed. Now, the town has closed a school and slashed services for the elderly.
Toxic Poison Today:
Furthermore, SWAPS have been unregulated, sold worldwide; thus difficult to find. [ Toxic Debt ]
Especially alarming is the large growth in credit default swaps in the US Banking system. This chart from contrary investor shows only $16 trillion in exposure, while it is generally estimated (no one really knows) that there are some $60 trillion outstanding worldwide.
Why bailouts may not work:
3. Bailouts are ambiguous & have no accountability. To get more detailed information go to: CNNmoney for total bailout spending
Bailout efforts were designed to stimulate the economy, avoid a housing bust, restore public confidence, contain the credit crunch, reduce the danger of a global debt collapse, and shore up sinking banks. There is no evidence that all these efforts are working! Indeed, President Obama is trying to restore confidence in the banking, loan and insurance system as a way of rebuilding confidence in the capitalistic system. Instead, he should be passing solid legislation to regulate wall street and the policies that lead to outsourcing jobs, gambling on wall street and fix the broken federal bank and printing of money.
4. Not identifying the real problem(s):
Abuse of credit: what is this, anyway?
Andrews Ken, “Secured Mortgage Lending explained,” February 18, 2007. Lending explained
Attwood, Mathew, “Which credits are covered by the CDS market?” Credit,April, 2008. Website
Balber Carmen, "One decade, $5 Billion, bought Wall Street freedom from oversight," Consumer Watcgdog, March 06, 2009. causes of meltdown
Bank Capital Requirement: Bank regulations require that a bank have a specific amount of cash as liquidity to cover bank obligations. The capital requirement is a capital ratio , or the percentage of a bank's capital to its risk-weighted assets.
To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. A 10 % capitalization has been a general requirement.
Bond:is a loan; the issuer is the borrower, the bond holder is the lender, and the coupon is the interest. It is a formal contract to repay borrowed money with interest at fixed intervals.what is a bond
Briefing, “What went wrong,“ The Economist, March 19, 2008. [ shadow nking system ] Website
Brock James W.. “The real issue behind saving Bear Stearns: size,” The Christian Science Monitor, April 7, 2008. Website
Brodrick Sean, "Financial Terrorism and You," Money &
Markets, April 01, 2009.Financial terrorism
____, “ Concerns rise of US bank failure,” The Sidney Morning Herald, March 7, 2008. credit rating
Dauenhauser Scott, "MBS, CDO's and CDS in Layman's Terms," The meridian, September 29, 2008.CDOs & CDS relationship
Pretend that you have a mortgage (okay, most of us aren't pretending) and you make principal and interest payments each month - these payments are made to your loan servicer and then split up as follows:
Deeter Karl, Missed mortgage payment? Bad debt? How a bad debt caused a crisis,” March 11, 2008. bad debt caused a crisis
Editorial, “Facing up to debt contagion“ Wall Street Journal, March 17, 2008. Website
Enron is a classic and famous example of a CDS gone wrong.
Envon used CDS as a scheme to finance itself. In 1999, Citigroup had a huge exposure, almost $1.7 billion, to Enron. This amount was four times the bank’s internal limit on such an exposure, so Citigroup used the CDS mechanism to spread their risk. In a deal known as Yosemite, the bank underwrote and sold their Enron corporate bonds as “senior unsecured notes.” Enron stayed in business as long as it could generator investors to provide cash.
Evans, David, “ The poison in your pension,” Bloomberg Magazine, July, 2007. Pension poison
Ferguson James “Credit default swaps: How to spot riskiest banks,” MoneyWeek, 03/17/2008. Website
Gaffen David, “ Worry Seeps Into Financials (Again),” Wall Street Journal, April 10, 2008. Website
Gagliano Rico & Hatley Mike, “Financial Crisis 101: CDOs explained,” Market Place, October 03, 2008. Financial Crisis 101: CDOs explained
Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949.[Steve Eisen took this insturment to a another level about 2005 ]
_____, "House of Cards - Origins of the Financial Crisis''Then and Now,'' Slideshow. House of Cards: Origins of crisis Slideshow
Kyle Bass was convinced the booming housing market was really one big house of cards and began to find ways to profit from it. He invested in "credit protection," a kind of insurance on various mortgage-backed securities. As those securities declined in value, his insurance paid off. Kyle Bass' hedge fund made more than a billion dollars in profit.
Hull, John, et la, “ The relationship between credit default swap spreads, bond yields, and credit rating announcements, “ University of Toronto, January, 2004. Website
International Swaps and Derivatives Association, Inc., “Contract CDS Syndicated-Secured-Loan CDS-Standard Terms Supplement,” May 22, 2007. website Jacoby James and Jill Landes, "House of Crisis 2009," CNBC, Feb. 13, 2009. webvideo
Jung, Alexander and Pauly, Christoph, “ Iceland's Credit Crunch Blues,” Business Week, April 11, 2008. website
Longstaff, francis, et la, The Credit Default Swap market,” UBC Seminar, October 24, 2003. Website
Market size for CDS: The market for the credit default swaps has been enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market. Also in sharp contrast to traditional insurance, the swaps are totally unregulated. Cyclic Economist March 07, 2009 [ The New Yourk Tmes October 26th, 2008]
Martin Eric, “ U.S. Stocks Fall on Profit Concern; “Bloomberg, Apr 08, 2008. website
Mason, Joseph R., and Rosner, Joshua, “
Non-Ratings cause mortgage backed securities and collateralized debt
obligation market disruptions, “ May 2007.
Momura, "CDOs in Plain English," Nomura Fixed Income Research, September 13, 2004. Nomura Securities International, Inc.,Two World Financial Center Building B New York, NY. 10281-1198.
Moody loan ratings fiasco: Bajaj Vikas,"Security ratings rules breached, Moody's admits" International Herald tribune, July 1, 2008. Moody loan ratings fiasco
Morrissey Janet, “Credit Default Swaps: The Next Crisis?” Time, March 17, 2008. Credit Default Swaps
Moses Abigail and Harrington Shannon D., “Company Bond Risk Rises on Emergency Fed Cut, Bear Stearns Sale,” March 17, 2008. Website
Newman, Rich, “ A beginner’s Guide to Credit Default Swaps,” December 09, 2007. website
Neidenberg Milt, “ What lurks behind Bear Stearns bailout? “Worker’s World, April 10, 2008. Website
Nolan Gavin, “Back to basics “ Credit, December, 2007. Website
Partnoy, Frank and Skeel, David A., “The Promise and Perils of Credit Derivatives,”
Pittman Mark, "God I Hope You're Wrong' Wall Street," Bloomberg magazine, December 19, 2007. Hedge fund & Bass prediction of housing bubble
Pittman, Mark, Katz Alan and David Mildenberg, “Citigroup, Wells Fargo May Loan Less After Downgrades (Update3),“ Bloomberg, April 8, 2008. Website
Ponzi scheme "is a form of pyramid scheme in which new investors must continually be sucked in at the bottom to support the investors at the top. In this case, new borrowers must continually be sucked in to support the creditors at the top. The Wall Street Ponzi scheme is built on “fractional reserve” lending, which allows banks to create “credit” (or “debt”) with accounting entries. Banks are now allowed to lend from 10 to 30 times their “reserves,” essentially counterfeiting the money they lend. Over 97 percent of the U.S. money supply (M3) has been created by banks in this way.2 The problem is that banks create only the principal and not the interest necessary to pay back their loans, so new borrowers must continually be found to take out new loans just to create enough “money” (or “credit”) to service the old loans composing the money supply. The scramble to find new debtors has now gone on for over 300 years - ever since the founding of the Bank of England in 1694 – until the whole world has become mired in debt to the bankers' private money monopoly. The Ponzi scheme has finally reached its mathematical limits: we are “allborrowed up.”
Rating: In the USA there are seven credit rating institutions. For example, Moody's assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, . Standard & Poor's and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, D. credit rating
Schwartz, Nelson D. And Creswell, Julie, “What Created This Monster?“ New York Times, March 23, 2008. Website
Schwartz, Robert F., “RISK DISTRIBUTION IN THE CAPITAL MARKETS: CREDIT DEFAULT SWAPS, INSURANCE AND A THEORY OF DEMARCATION.“ Fordham Journalof Corporate & Financial Law, 2007. Website
Sharon Bill, “The Federal Reserve - isn’t,“ Between the Cracks, March 31st, 2008. Website
Shedlock, Mish, “ Mishs Togele Bonds – Yet Another High Wire Act,” Global Economic Trend Analysis, June 25, 2007 worst depression
Sub-prime: From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds. These were mortgages issued to home-buyers who bought with no down payment.
Supkis Elaine Meinel, “Bank Rescues Means Exact Replication Of Great Depression,” EZ Reading Money Matters, March 21, 2008. Bank rescue & bad depression
Swaps concept: This is similar to the old fashioned bargaining. Swapping is exchanging one item or commodity for another of equal value.
Sykes Timothy,"Who Is Steve Eisman?" Trade Monster, November 07, 2008. Teather, David,"The woman who built financial 'weapon of mass destruction,'" The Guardian, September 20, 2008. Blythe Masters of JP Morgan maker of CDS
Toxic debt refers to the illiquid mortgage assets that have lost value as the housing correction has proceeded. While the underpinnings for these toxic assets is home mortgages (both sub prime and not), they have been broken down into various instruments which include Mortgage Backed Securities, Collateralized Debt Obligations (CDO's), Equity Tranches, Credit Default Swaps, Structured Investmet Vehicles (SIV's), and who knows what else. These derivatives are less regulated than many investments and their value is much harder to quantify. Toxic debt
_____, “Understanding CDO, CDS and the American's Crash of 2008,” Understanding CDO, CDS
Underwriters for CDO:
____, “UPDATE 3-Financial swaps weaken on credit exposures,” Reuters, March 4, 2008.Website
___ WaMu's credit protection costs fall 19 pct-Markit,” Reuters, Apr 7, 2008 Website
Weissman Robert and Donahue James, “Wall Street’s Best Investment: Ten Deregulatory Steps to Financial Meltdown,” Multinational Monitor, March, 2009.
Their ten steps: [ as in Balber ] The Repeal of Glass-Steagall and the Rise of the Culture of Recklessness
Wikipedia Encyclopedia, “Credit Default Swaps.“ Website
Wikopedia, “Federal Deposit Insurance Corporation.“ Website
Zabel, Richard (2008-09). "Credit Default Swaps: From Protection To Speculation". Robins, Kaplan, Miller & Ciresi L.L.P. Protection to speculation