Once and For All...

by Dr. James Glenn | October 31, 2008
(Let's nail the guilty so we don't have to put up with self serving revisionism.)

"There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved." - Ludwig von Mises

Like most Americans I’ve been watching the dramatic, and often titillating, finger pointing exchanges between Wall Street,Congress, the media, and the candidates with a combination of glee, dismay, disgust, and jaw dropping incredulity. Mostly incredulity, because few of these people, pundits, politicians, or patricians has gotten the story right about our recent financial apocalypse. Let me set the record straight, once and for all.
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The right likes to blame the mess on “Big Government” (surprise), and ‘The Community Reinvestment Act” passed in 1977 which outlawed “redlining” by consumer banks (cherry picking loan customers), and dictated that they must “serve” all of their market when it came to home loans, not just the most lucrative segments. In other words, they had to provide home loans to marginal customers if they could pass the underwriting guidelines. They also heap blame, not entirely meritless, on Fannie Mae, and Freddie Mac, government sponsored entities (GSEs) which were responsible for providing sub prime loans to many of the now bankrupt subprime mortgage market. The critical point missed by these people is that it was investment banks on Wall Street and Wall Street Bankers and a corrupt irresponsible Fed responsible for the meltdown, not consumer banks, sub prime borrowers, or Fannie and Freddie. Limbaugh, Hannity, and their ilk love to demonize the left with sound bites for simpletons, this latest financial debacle being but another perfect example of their taking extremely complex issues like this latest meltdown and its causes, and disgorging simplistic, vacuous, incoherent, and incorrect ruminations to their rabid listeners.

The right has part of this story right however. It was Ronald Reagan’s “big government” of the 80s, which ran up the first trillions in our now 11 trillion dollar debt, which set the ball rolling on our current meltdown. Reagans “deregulation” and “privatization” mantra, aided and abetted by that banking shill, Alan Greenspan, who he appointed as chief fed head, that “deregulated” the S&Ls, which lead to the property bubble of the late 80s, a housing collapse, and the recession of 90-91. This cost the taxpayer approximately 500 billion. Sound familiar? Greenspan just last week, under glaring Congressional testimony, admitted that his long held beliefs regarding deregulation, and banks, and Wall Street being able to “police” themselves, had “proven to be “incorrect.” His “model” of the world was erroneous he says. Thank you Sir Alan for the scintillating confession. A day late and two trillion dollars short. Thus the grubby grasping at “deregulation” by those self serving miscreants in the 80s, as a panacea for everything from the common cold, to world war, set the stage for what was to follow.

On the heels of “deregulation” of the S&Ls came “securitization” in the 90s, which banks and brokerages dreamed up to shift investment risk from themselves to “investors”. Securitization you see allowed banks to “bundle” asset classes for resale. One of the most lucrative of these “asset classes” was mortgages, which could now be taken off the banks balance sheets and sold to investors. This effectively absolved the banks of any responsibility in performing their traditional job, i.e., underwriting good loans by correctly assessing credit risk. Banks balance sheets were freed up, and their reserves replenished so they could “turn” their inventory (mortgages) virtually as fast as they could be written. They no longer kept the mortgage so who cared about credit risk? They just wanted their 1-2% origination fee that came with each loan. Profits soared. Add deregulation, and securitization, to a somnambulant, laizzez faire Fed, the evisceration under Bush of the regulatory and rating agencies, and a rapacious Wall Street, and we had the makings of a tremendously explosive financial meltdown cocktail.

The real coup de gras came in the 90s with the creation of exotic and mostly unregulated financial instruments called “derivatives” which allowed Wall Street to take an asset, like a mortgage, and “leverage” it many, many times over (30-60:1), ostensibly for “risk management” but just as often for pure speculation. Warren Buffet recently called these derivatives “weapons of financial mass destruction” and many, myself included, have been warning about the unregulated, opaque, and greed infested waters in which they trade as a financial disaster waiting to happen for many years.

What cemented our current disaster was the repeal of the Glass-Steagall Act in 1999, passed in 1933 to prevent the cronyism, corruption, and greed of the 20s, brought to you by the same cast of characters as today, from ever happening again. Glass-Sreagall for over 65 years had stood as an effective bulwark against the baser instincts of bankers, brokers, and politicians, essentially preventing banks from buying brokerages, and both of those from buying insurance companies. It strictly forbade co mingling of funds, clients, and personnel between banks, brokerages, and insurance companies because this is what had led to the meltdown in the 20s, and the Great Depression. With the passage of Graham-Leach-Blyly in 1999, the sponsor of whom recently called us all “a nation of whiners”, and said the recession was “imaginary, and all in our heads”, the last remaining semblance of any economic restraint in financial services disappeared with a flourish of the pen. Investment banks could now own consumer banks, insurance companies, mortgage companies, appraisal companies etc. Imagine the possibilities! For cronyism, conflicts of interest, rampant speculation, and unbridled malfeasance! We got it all, not necessarily in that order, and in less than ten years, the same bankers, brokers, and politicians had us dangling from a knife edge, staring into the financial abyss, staring down the barrel of another Great Depression. Amazing isn’t it? How people, and history never change?

Credit default swaps, originating from insurance companies like AIG in the late 90s, and investment banks on Wall Street like Lehman Brothers, were the real icing on the cake however. These instruments were issued to insure against bond defaults. Sounds simple right? Pay us a premium of X, and we’ll insure your bond issue for Y. If the issue went bad, the originators had recourse against AIG to collect on the losses from the issue. These CDSs (Credit Default Swaps) were used extensively at the height of the housing bubble by nervous mortgage originators worried about the solvency of the underlying mortgage pools they were creating (I wonder why), packaging, and reselling to pension funds, insurance companies, bond funds and individual investors worldwide. The collateralized mortgage obligations (CMOs), GNMAs, FNMAs all represented securitized mortgages. Many of these mortgages were of the sub prime variety.

Problem was, the people insuring these mortgage pools were not using realistic pricing models to evaluate the real intrinsic risk in the new asset (mortgage pool). Surprise, surprise. Their models were using totally unrealistic default rates of 3-4% (marked to myth) because it was more profitable (required fewer reserves) when in actuality, nearly anyone with a cerebral cortex knew the default rates on these CDSs would be much, much, higher. More like 25-30%. And of course, it turns out that the rating agencies were in bed with the purveyors of this trash, giving these bonds highly inflated, and undeserved ratings.

When the housing bubble burst and the asset underlying these derivatives and credit default swaps went south, all hell broke loose of course. The inevitable happened as it always does. The leverage of 30-60:1 started working against the hedge funds, brokers, and banks that had been buying these derivatives. Leverage of 60:1 (possible with the eradication of Gas-Steagall and a complicit Fed) against you is not pretty, as we’ve seen in the last 3 months. The value of these instruments plummeted, forcing these players to raise cash. This required selling all other asset classes from gold to stocks, creating a cascade in the financial markets, an “unwinding” of leverage the likes of which no one has ever seen.

Owners of mortgage backed securities, likewise, demanded restitution from those that had “insured” them against default, AIG and Lehman in this example. AIG was on the hook for anywhere from 40-unknown billions due to their massive issuance of CDSs in the last ten years. It had been a massive revenue generator, but was now about to bury the company. In addition, if AIG did not honor its commitments to pay, many of which were to our major creditors, Japan, China, Korea, and the EU, they would not only never lend us another dime, but a “domino effect” could ensue in which AIGs counter parties went belly up, causing their counter parties to go belly up, creating a symbiotic implosion heard around the world. Oh, and by the way, ending capitalism as we know it. Maybe not such a bad thing. So here we were.

Deregulation=S&L debacle (80s) + Securitization (90s)= financial bubbles in bonds/stocks=bust/tech wreck of 2000 = Derivatives + Credit Default Swaps (2000s)= Housing Bubble Extraordinaire= Bust + Depression. Clear? Or, if you prefer:
Deregulation—Securitization—Glas-Steagal Repeal--Derivatives—Credit Default Swaps--Financial Armageddon

This is the daisy chain that leads us to today. This financial “unwinding” as CNBC likes to put it, prompted Paulson, who ran Goldman Sachs for years, and is now head of our Treasury unbelievably, to ironically, run red faced, and panting, to that “Big Government” the right loves to demonize so much for a 750 billion “bailout” just a few short weeks ago. Talk about Socialism! A government owned banking and insurance sector??? Why the rush to pump the taxpayer you rightly ask? Kind of reminiscent of Bushes’ “war resolution” just before midterm elections, or ramming the Patriot Act through Congress, isn’t it?

Paulson has intimate ties to AIG through his days at Goldman, which would also be bailed out by the by, and AIG begged him (or paid him) to get them off the hook. Without a handout, they’d go under and the western world as we know it would cease to exist they pleaded. I’m sure this was the scenario. Their dutiful errand boy then runs to Congress and using extortion and threats (falling financial markets and possible martial law) to force Congress to pony up. A little more sophisticated than a protection racket run by the mob, but not by much. So the thugs get their money, select investment banks (Goldman) and banks (Bank of America and 7 others) get bailouts, while others like Lehman Brothers are allowed to go under. Why Lehman you ask?

Because Lehman was a major competitor to Goldman of course, and this was the perfect opportunity to let them be swallowed up by the cess pit of banking history, and free up more business for Goldman and Morgan, the two go to boys for the Federal Reserve. That is, Morgan and Goldman are the two major purveyors of government bonds, and it is they whom “open market operations” of the Fed are choreographed. Couldn’t have the major purveyors of the bankrupt governments worthless paper going out of business, could we? That wouldn’t instill much “con”fidence in what has come to the biggest con game of all, selling government paper.

So friends, as McCain would say, there you have it. PLEASE get your facts straight before showing off your ignorance. It was unbridled, unregulated, and fraudulent use of derivatives and credit default swaps, by Wall Street, and a corrupt Federal Reserve, which led to this fiasco. Not “big government”, not mortgages made to poor people (they never could have been made if the Fed had been doing its job), not Fannie and Freddie, and certainly not the Community Reinvestment Act. This tripe, drivel and vacuous nonsense peddled by the likes of Hannity would be laughable, if our economy were not at stake. These are the same charlatans calling anyone who disagrees with the bald faced lying, corruption, irresponsibility, and disgraceful and unlawful shenanigans of the last eight years, Marxists and Communists. It would be laughable if it weren’t so tiresome, ugly, and untrue. Some people just have no self respect, or shame, it seems.
Good night friends.