“Banking was conceived in iniquity, and born in sin. Bankers own the earth. Take it away from them, but leave them the power to create money, and with the flick of a pen, they will create enough money to buy it back again. Take this great power away from them, and all great fortunes like mine will disappear. And, they ought to disappear, for then this would be a better and happier world to live in. But if you want to continue to be the slaves of the bankers, and pay the cost of your own slavery, then let bankers continue to create money, and control credit.”
– ABRAHAM LINCOLN
In the last decade, we experienced the growth of the greatest number and size of asset bubbles in history made possible by a bubble in instruments that Warren Buffett has labeled “financial weapons of mass destruction.” Now that this mother of all bubbles is breaking, who can afford to pick up the tab? (For definitions, please see the glossary at the end of the article.)
In 1999 Bill Clinton Repealed FDR’d Glass Steagall Act Allowing Off Shore Banks To Indebt The U.S. By Constructing empty ‘derivatives’ for mortgage lending.
It is the stuff of which legends are made. A get-together of finance geniuses in 1994 in Florida from JP Morgan (JPM), all brainstorming on ways to increase the amount of money the bank could loan. How could it find a way to free up more capital to loan and make more in fees?
The answer was simplicity itself. Create an insurance policy in which a third party (investor) would assume the loan risk in exchange for regular premiums from the bank. The bank got what it wanted – remove the loan from its books, freeing up money to make more loans. In return for helping out, the investor got paid for taking the risk in a derivative instrument called a credit default swap. It seemed like a match made in heaven.
“The money powers prey upon the nation in times of peace, and conspire against it in times of adversity. The banking powers are more despotic than a monarchy, more insolent than autocracy, more selfish than bureaucracy. They denounce as public enemies, all who question their methods or throw light upon their crimes.
I have two great enemies, the Southern Army in front of me and the bankers in the rear. Of the two, the one at my rear is my greatest foe. [As a further undesirable consequence of the war…] Corporations have been enthroned, and an era of corruption in high places will follow. The money power of the country will endeavor to prolong its reign by working upon the prejudices of the people until the wealth is aggregated in the hands of a few, and the Republic is destroyed.”
Before long, according to Newsweek, investors were being encouraged to buy into riskier emerging markets in Russia and Latin America insuring debt. In the wake of Enron and WorldCom, it became obvious that there was a need for this type of insurance and the industry was well on its way. By 2000, the CDS market had passed the $100 billion mark and by 2004 it had grown to more than $8 trillion, an 8000% increase. It was just the beginning.
The Perfect Petri Dish
When the Federal Reserve cut interest rates in 2001 and kept cutting them into 2004 in an effort to avert the fallout from the bursting of the internet bubble, it created the perfect environment for a new series of bubbles and real estate was a major beneficiary. Demand for mortgages went through the roof as hordes rushed to buy property.
Banks hobbled by capital reserve restrictions that limited them to $10 in loans for every $1 on deposit needed help in expanding their mortgage businesses and CDSs were the perfect vehicle. Wall Street had come to the aid of Main Street and terms like collateralized debt obligations (CDOs), residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBSs) became new catch phrases in the lexicon of mortgage finance terminology.
Figure 1 – Credit derivative swaps are now the fastest growing segment of the derivatives market. These instruments traded in the billions in 2000. In 2007, credit derivative swaps (CDS) totaled $62.17 trillion up from $34.42 trillion in 2006.
New financial vehicles led to mortgage tranches in which thousand and in some cases millions of individual mortgages were pooled together by banks into CDOs and resold to Wall Street firms. Rating agencies like Standard & Poor’s, Fitches and Moody’s also got into the act to provide financial opinions as to the soundness of these nascent mortgage instruments which were in turn insured by CDSs to offset the risk.
But these instruments were only part of the story. Credit derivatives have been issued for everything from credit card, small business and student loan debt to aircraft loans.
Since it was nearly impossible for the investor to access the creditworthiness of a pool of a million mortgages or loans, Wall Street financial engineers thought it prudent to get a second opinion. Engaging the rating agencies was a brilliant marketing strategy. As it turns out, it was nearly impossible for rating agencies to assess the true risk of these instruments as well but I’m getting ahead of myself.