By Walter Sorochan, Emeritus Professor, San Diego State University
Posted March 18, 2009; Updated December 19, 2014; Disclaimer
Purpose of article: To briefly and simply illustrate the events that lead to the real estate meltdown, Wall Street collapse and global financial depression.
New threat to Global Economy: Greece and PIIGS
How the bankers, lenders, loan companies, insurance companies, wall street and speculators made money at the expense of a naïve public.
By understanding the causes of the many meltdowns, we can 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: A financial instrument Credit Default Swaps [ CDS or SWAPS ], was created by Blythe Masters of JPMorgan 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.
3 Enron 1980s: 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
Step 4 1980 - 2000 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 shenanigans.
Step 5 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) on 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 known 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 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.
Step 7 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
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
Owners who bought homes at beginning of the boom earned an equity as home prices rose.
These owners refinanced their homes & used the extra cash for
home improvements & other purchases. Their loan terms were
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."
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 ]
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 ]
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 explaination
of how CDO work, [ refer to Gagliano
and Hirsch: “ …. CDO is an investment that works kind of like a
champagne bottle." ]
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 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 paids off. Kyle Bass' hedge fund made more than a billion dollars in profit.
Step 15 Banks 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 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:
Example of foreign investor-speculators:
Step 18 The Housing Bubble bursts ... 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.
Non-liquid mortgage assets that have lost value. The Fed thinks that some securities are worth just five cents on the dollar. How big is the problem? In most cases no one knows where these CDS derivative assets are, what kind these are nor how many there are. The federal government was asleep by removing speculation controls and not monitoring CDS. Not being able to identify these toxins is what has disabled us in dealing with this economic mess.
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:
1. Because Washington serves corporate America and no longer the American people. We need to free Washington politicians from drinking from the corporate cup![ e.g. lobbyists as in image on right]. Lobbyists and campaign funds are buying a lot of favoritism and cover-up in Congress and the senate. We need to control lobbying, campaign funding and corporate influence in Washington. For information about campaign contributions from banking, wall street, insurance companies and other sources, refer to following: Fixing US Economy Senator Dodd Fanny Mae & Freddie Barney Frank
2. Toxic debt festers: as long as the financial wound is infected with SWAPS, the toxic debt will continue to fester. We need to clean the germs [ CPO, CDS ] causing the toxins [ unsecured bad paper debt ]; otherwise the infection can cause gangerine . We need to stop the infection [ economic meltdown ] from becoming a gangerine [ economic depression ] and then the patient [ economy ] will heal quickly!
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?
Traditional banking rules enforced by a central government which wishes to avoid massive lending bubbles/panics/depressions, the dreaded BPDs, sets rules for banks. One of the most useful rules is the one that prevents lending/holding ratios from dropping below a sensible limit. Banks have to attract some savings in order to lend. Now, in good times with stability and no bubbles, they are permitted to lend at a 10:1 ratio. Ten dollars can be lent on one dollar of savings. This rationalization of money via lending works in normal times. But when banks or QUASI banks such as investment/finance houses are allowed to do what Bear Stearns just did---lending on a 90-1 dollar ratio, it doesn't take much to trigger a complete collapse in any small downturn.
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 banking system ] Website
Brock James W.. “The real issue behind saving Bear Stearns: size,” The Christian Science Monitor, April 7, 2008. 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
Example: 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
Goodspeed Ingrid, "Overview of the sub-prime market meltdown," Overview of prime-sub meltsown
Hedge funds, wikipedia. Hedge fund info
Sociologist, author, and financial journalist Alfred
W. Jones is credited with the creation of the first hedge fund in
1949. [ Steve Eisen took this instrument to a another level about
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, February 13, 2009. webvideo
Jung, Alexander and Pauly, Christoph, “Iceland's
Credit Crunch Blues,” Business Week, April 11, 2008,
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_08:
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.
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, Katz Alan and David Mildenberg, “Citigroup, Wells Fargo May Loan Less After Downgrades (Update3),“ Bloomberg, April 8, 2008. Website
"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 “all borrowed 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 Journal of 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. For example:
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
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
In structured finance, a tranche (misspelled as traunch or traunche) is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation (see indenture) usually defines the tranches as different "classes" of notes, each identified by letter (e.g. the Class A, Class B, Class C securities). The term "tranche" is used in fields of finance other than structured finance (such as in straight lending, where "multi-tranche loans" are commonplace), but the term's use in structured finance may be singled out as particularly important. Use of "tranche" as a verb is limited almost exclusively to this field. [ Wikipedia] Example: A bank transfers risk in its loan portfolio by entering into a default swap with a "ring-fenced" SPV ("Special Purpose Vehicle"):
Underwriters for CDO:
According to Thomson Financial, the top underwriters before September 2008 were Bear Stearns, Merrill Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank of America Securities. CDOs are more profitable for underwriters than conventional bond underwriting due to the complexity involved. The underwriter is paid a fee when the CDO is issued. The high-risk nature of all asset backed securities caused most of these firms to enter bankruptcy or be bailed out by the taxpayer in 2008 when the risks were properly understood and the value of all tranches collapsed. Underwriters
____, “ 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
Their ten steps: [ as in Balber ] The Repeal of Glass-Steagall and the Rise of the Culture of:
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