Dirty Laundry

Since the 1600s, there have been five occasions when major worldwide financial crises have occurred, and they all used securitization of credit:

The 1637 Tulip-mania bubble was based on a market in tulip futures, securitized with personal credit notes.

The 1721 South Sea Bubble was securitized by shares of the South Sea company, a company operating in South America.

The 1789-1795 bankruptcy of the French monarchy was securitized by "assignats," bills of credit based on lands confiscated from the clergy.

The Panic of 1857 was securitized by railway shares.

The 1929 Wall Street crash was securitized by stock shares, and by bonds from well over 100 foreign countries. This is described in "The bubble that broke the world."

Today of course we're securitizing credit by turning subprime mortgages and other questionable credit into credit derivatives and CDOs.

We're now overdue for the next generational crash. It could happen tomorrow, next week, next month or next year, but it's coming soon.

Will we see a stagflation, a recession or a depression?

It will be an era of severe depression, worse than the 1930s, with massive unemployment, bankruptcies, homelessness and starvation.

Can something like "circuit breakers" prevent a panic?

"Circuit breakers" are used by the stock markets to try to control a panic. If the market loses, say 15% in one day, then the market closes for a few hours, to let people catch their breath.

Unfortunately, circuit breakers are useless.

A generational crash is an elemental force of nature, like a tsunami.

There will be millions or even tens of millions of Boomers and Gen-Xers in countries around the world, never having seen anything like this before, and not having believed it was even possible, suddenly in a state of total mass panic, trying to sell all at once.

Computer systems will crash or will be clogged for hours, or perhaps even for a day or two. People who had hoped to get out just as the collapse is occurring will be totally screwed, and will lose everything. Brokers and other institutions will go bankrupt. People who went short hoping to make a fortune will find that their brokers' escrow accounts are gone, and they'll be totally screwed, and will lose everything.

Being in the market today, either short or long, is a very high risk proposition.

What's a credit crunch, and what's going on?

The easiest way to understand it is this.. The world's money is disappearing. Everday there's less money in the world than the day before. Since there is less available, it's harder to get money, unless you're willing to pay high interest rates to get it. Hence, there is a "credit crunch."

One result is that banks are hoarding money, and are increasingly reluctant to lend money to one another or to other businesses. This means that even legitimate, credit-worthy individuals and companies are having a hard time getting credit, getting mortgages, or getting loans without having to pay extremely high interest rates.

How could there possibly be less money in the world?

It's not that people are eating dollar bills for lunch.

In fact, paper money is pretty irrelevant these days. Very little money is created by means of printing presses today. Money is created by means of credit. When a central bank (like the Fed or the Bank of England) wants to create more money, it doesn't run the printing presses, but simply lowers the short-term inter-bank lending rate, so that there'll be more credit, hence more money.

Unfortunately, financial institutions found that they can use a technique called "leveraging" to create money from credit, essentially going around the powers of the central bank. They create a new security and tell you that it's worth $10, but they'll let you buy it for $1 and loan you the other $9. So $10 that didn't exist before now does, a magical 'printing press' re-invented.

These securities are called "credit derivatives", and among them are CDSs (credit default swaps) and CDOs (collateralized debt obligations).

The credit bubble has created $750 Trillion in notional value credit derivatives. Are those credit derivatives the same as money? Not exactly. You can't go into the grocery store and pay for your groceries with a credit derivative.

But you CAN use those credit derivatives in your portfolio as collateral for a loan, and then you can use THAT money to buy groceries. So in fact the credit derivatives do create money.

That's what's been happening up until July of this year. But suddenly people are discovering that the security that was supposedly worth $10 is really worth only $5 or $2 or even $1, and sometimes they're totally worthless. So the process of creating money is now going in reverse. Instead of money being created through credit, today money is being destroyed through the unwinding of the credit bubble.

How much money has been destroyed since July?

A huge amount already. Let's start with an example.

Things really started moving in mid-July, when Bear Stearns announced that its hedge funds were practically worthless. That's because the hedge funds were these CDOs that had been magically created, and were supposedly worth several billion dollars. Well, they discovered that nobody wanted to buy them, and if nobody buys them, then they have no market value when they're "marked to market."

Since then a number of financial institutions have "gone to the confessional" explaining they too have lost a great deal of money in write-downs because their portfolios contained worthless CDOs. These are major financial institutions like Citigroup, Merrill Lynch, Morgan Stanley, Goldman Sachs and JPMorgan Chase.

Citibank tried to save itself by means of a fraudulent scheme known as a "Master-Liquidity Enhancement Conduit (M-LEC)." Under the scheme, Citibank and other banks would sell worthless CDOs to each other at inflated prices in order to establish a phony "market price" for the CDOs. Citibank's fraudulent M-LEC idea didn't take off, forcing the bank to take $16.4 Billion in write-offs of worthless CDOs. Citibank might have gone bankrupt except it was saved by an investment by the Abu Dhabi Investment Authority.

These big financial institutions are announcing more every day, and mainstream estimates vary as high as $500 Billion in write-downs.

So now that $500 billion is gone. That's money that existed a few months ago, but no longer exists, and that's how money gets destroyed.

And that's only the large institutions. We've hardly heard from the small institutions, but we're beginning to. State and local governments in Florida and Montana have to freeze their investment pools because the pools were found to have invested in near-worthless CDOs. And that's the tip of the iceberg. There are tens of millions more small and medium-sized institutions around the world that are going to have similar situations, forcing them to write-down these securities.

With $750 Trillion of notional credit derivatives in the world, it would not be surprising if the total write-down amounts to $7.5 Trillion (1%) or even $75 Trillion (10%).

Is that all?

Hardly. Because next you have the De-leveraging problem.

When a bank has $1 Million in assets available, it can loan out 5 or 10 times as much as that, or $5-10 Million. That's leveraging.

But if the $1 Million in assets suddenly disappears, then there's $5-10 Million that it can't loan out any more. That's De-leveraging.

The point of all this is that there's MUCH less money in the world today, and there's less and less everyday.

What do sub-prime mortgages have to do with all this?

For the most part, residential sub-prime mortgages were the original "seeds" for the credit explosion. Banks started requiring less and less from people wanting mortgages, and by the time it was over, anyone could get a mortgage for any amount, with no problems, even if they had no assets, no income, no job, and no hope of even making the mortgage payments.

These mortgage loans, like any other form of credit, created new money. That new money could then be leveraged into credit derivatives that were worth 5-10 times as much as the original mortgage loans. Those credit derivatives could then be leveraged further. This process would continue several times.

However, there were other "seeds" as well. Requirements for credit cards and other forms of credit were also relaxed, so that people could get credit that way as well. Delinquencies have been rising in credit cards, car loans, student loans, even business loans, just as they have in mortgage loans.

Why would banks make loans to people who couldn't pay them back?

Because the banks made money that way, lots of it. The loan officers made commissions from the loans. I'd be happy to lend you $1 Million of someone else's money if I got a $50,000 commission from it, and that's what happened. That's what happened with mortgage loans, with credit card loans, with car loans, with student loans, business loans, and so forth.

And then the financial geniuses got hold of the loan contracts and turned them magically into CDOs with phony notional prices. They sold those, and got even more in hefty commissions from selling them.

So basically along the way, Wall St bankers were loaning out other people's money, and taking fat commissions for themselves.

Isn't that illegal?

You're damn right it's illegal. And I can hardly wait to see some of these financial geniuses get put away.

I've been studying this stuff for awhile now, trying to figure out what's going on.

At first I thought that people were just being naïve or stupid.

But I've since come to the conclusion that the mess that we're in was done on purpose -- by contemptuous and nihilistic Gen-Xers taking advantage of air-head Boomers too dumb to work the numbers on their investment portfolios.

The point is that a lot of people have committed crimes, and they're going to well-deserved jail cells.

What's a "structured investment vehicle" (SIV)?

This is one of the gimmicks that the financial geniuses created. Their objectives were to collect huge commissions for themselves, while defrauding the general public with securities that they knew had to become almost worthless. The SIV is part of that.

When banks issue these CDOs, they aren't issued by the bank itself. Instead, the bank creates a new "virtual" bank called a "structured investment vehicle." All the "financial magic" is done within the SIV, so that if something goes wrong, the original bank had nothing to do with it. That's called "keeping structured securities off-balance sheet" of the original bank, a phrase you see often in the press.

However, the same people are involved in both the original bank and the SIV, and so they still PERSONALLY collect the same huge commissions, often in the millions of dollars.

To understand these, it helps to understand the structure of an SIV -

First an SIV has investors - like hedge funds, or wealthy individuals who invest say $1 Billion in the SIV. Then the SIV issues commercial paper (CP) and medium-term notes (MTN) that pay slightly higher rates than similar duration paper. The typical SIV according to Fitch, uses 14 times leverage, so in our example the SIV would sell CP and MTN for $14 Billion.

Now the SIV invests this $15 Billion ($1 Billion equity and $14 Billion borrowed) in longer term notes. The idea is simple: borrow short, lend long, hedge the interest rate and credit risks - and the profits flow to investors in the SIV.

What happens when the CP comes due and no one wants to buy any more? To cover the CP, the SIV might have to sell the longer term assets at a steep discount, and this would trigger a liquidation of the entire SIV. To prevent this "fire sale", the sponsoring banks stepped up and provided financing to cover the expiring CP.

And just so we know who we're talking about here: When it says "the SIV has investors like hedge funds or wealthy individuals" -- that's a little misleading. Because the investors also include ordinary people's pension funds and so forth. I don't think that the people of Florida would consider themselves "wealthy individuals," now that their investment pool contains SIV funds that must be written down.

The last paragraph above is the reason why banks have been forced to write-down SIV funds: no one wants to buy the commercial paper anymore, once the Bear Stearns hedge funds collapsed in July. And they've been desperately using every trick they could play to keep the fraud going by avoiding the "fire sale" as long as possible.

What part do rating agencies play?

The three ratings agencies -- Standard & Poor's, Moody's Investors Service and Fitch Ratings colluded with the banks to defraud the public, as Bloomberg news accused on June 30.

While the bankers were taking fat commissions for themselves, they were also making fat payments to the ratings agencies to provide AAA ratings on the CDOs in the SIVs. This was an essential part of the scheme.

Take, for example, the Florida investment pool we've been talking about. The people who ran that pool didn't know which securities were good and which were questionable. They just depended on the ratings from the rating agencies. And one of their internal rules is that the pool could invest ONLY in AAA securities.

So if the bank managers pay the ratings agencies to provide AAA ratings on the questionable securities in the SIVs, then Florida and anyone else could invest in them without even asking any questions. The bankers would get their fat commissions, the ratings agencies would get their fat fees, and the investors would be the only ones getting screwed.

And there is NO CHANCE WHATSOEVER that these agencies didn't know what they were doing.

Sure, maybe the first few deals really were OK. But as time went on, and the rules were bent more and more, there could have been NO DOUBT in the minds of these bankers and ratings agencies that they were defrauding the public.

After Bloomberg accused the ratings agencies of fraud on June 30, they knew they had to change. Since then, they've been re-rating many of the SIV securities, sometimes lowering their ratings as many as 10 or 20 levels lower than the original AAA rating. That's what happened to many of the securities that the Florida investment pool had invested in, and that's why they're currently facing a financial crisis.

Hey, who's minding the ship here anyway? Was everyone, all the way to the 'top' cashing in on this fraud?

The answers will come as this credit crunch unwinds, exposing all the dirty laundry on Wall Street, and possibly right up through the political administration in the US itself. Of this, I have no doubts!