Friday, October 31, 2008

The Bigger Picture of the Financial Problems

Afternote: Ok, Lucky Tan feels that the Conspiracy Theory is really unbelievable as Science Fiction. I would say that what is written by the Conspiracy Theorist is really exaggerating but the mechanism that he has mentioned still merit some thought. So beware when you read on the Conspiracy Theory, it should not be taken literally but the purpose here is to understand some of the mechanism that brings this world into this financial crisis.

This issue is linked to the so call Credit Default Swap (or Credit Risk Swap) which both Lehman Brothers Minibonds, DBS High Notes and many other structured credit-linked financial products.

To fully understand the whole issue, we will have to look at how the whole banking and financial system works. Economic times has sketched the structure of sub-prime induced mortgage credit-linked derivative products.

The two articles below, one by Economic Times, the other by a Malaysian Conspiracy Theorist Matthias Chang

Crisis: Don't blame it on subprime loans
30 Oct, 2008, 1345 hrs IST,T T Ram Mohan, ET Bureau

Single page view Text:

There is a pat explanation that’s been put forward to explain the subprime crisis. The US Fed and other central banks flooded the world with liquidity and created an era of low interest rates. Greedy bankers sought to take advantage of low interest rates by selling housing loans to greedy consumers who could not afford these (subprime loans). Once interest rates started rising, defaults on these loans were bound to go up, housing prices fated to fall and institutions exposed to these loans bound to fail.

In other words, an asset bubble, financial inclusion and human greed combined to create the havoc visited on the financial system today. This is only a half-truth at best. You can have a housing bubble, a boom in subprime loans and lots of greed but it does not follow that there should be a financial crisis.

Banks’ losses on subprime loans cannot explain the crisis we have today. The US subprime market is estimated to be $1.3 trillion — or around 10% of all mortgage loans. How much have banks lost on subprime loans? According to the IMF’s Global Financial Stability Report, October 2008 (GFSR), just $50 billion!

It’s true that defaults on subprime loans have a snowballing effect as a fall in housing prices begins to impact on the economy at large. But even if we take this effect into account, the losses are not crippling. Losses on all loans, including commercial real estate, consumer loans, corporate loans, etc, have so far amounted to $425 billion with losses being shared by banks and other financial institutions. This is an order of losses that the financial system can withstand.

However, the financial system has suffered additional losses of $945 billion on investment in securities. Of these, losses on subprime related securities amount to $500 billion. These securities are not entirely subprime-related. Subprime loans are often one underlying component in a package.

It is losses on subprime-related securities that have complicated matters. An important reason why losses on these have been so large is that the accounting treatment of securities is different from that of loans. Traded securities have to be valued at market prices. If market prices fall below the face value of securities, banks must promptly recognise the associated losses. Loans are not required to be ‘marked to market’. Banks make provisions against loans as per regulatory norms.

Financial institutions invested in securities that were highly rated, meaning the risk of default on the underlying loans was believed to be low. When the default rate on subprime loans turned out to be higher than expected, the institutions panicked and wanted to get rid of subprime related securities. In the market, when everybody wants to exit, prices tend to overshoot their correct levels.

The market prices of many securities portfolios today are believed to be lower than warranted by the default rates on the underlying loans. For many illiquid securities, market prices are not available. They have to be valued using methods that tend to understate their values.

The GFSR shows what a world of difference there is between loan exposures and securities exposures. Losses on banks’ housing and real estate loan portfolios amount to only 3.6% of loans outstanding. For the reasons mentioned above, losses on subprime-related securities amount to a staggering 30% of the securities outstanding. Financial institutions are highly leveraged. For an institution that has capital equal to 10% of assets or less, the difference between a 3.4% loss on assets and a 30% loss is the difference between life and death.

So, explosive growth in subprime loans and the collapse of a housing bubble cannot explain the sheer magnitude of the crisis we are facing today. It was the “marketisation” of loans — the conversion of loans into tradeable securities — that created a crisis on such a scale.

True, such “marketisation” facilitated rapid growth in subprime loans. But rapid housing loan growth has happened elsewhere within the banking system without creating a financial crisis. Banking regulation has responded to the challenge through means such as increased risk weights on housing loans and limits on exposures.

When loans were “marketised”, they moved into a netherworld in which regulation was not equal to the task. This is a world that bristles with problems that have been written about so much — incorrect credit ratings, large exposures on the part of highly leveraged institutions dependent on wholesale funding, mark-to-market accounting, etc.

You can have low interest rates, an asset bubble, financial inclusion through subprime housing loans and greedy bankers and consumers. It does not follow that there must be a severe financial crisis. We have one today because traditional loans came to be substituted by financial instruments for which regulation was inadequate.




From Matthias Chang

By Matthias Chang

Let me explain why the situation is so dire and dangerous.

Since Wednesday, when the financial shits hit the ceiling fan, I was hoping that the so-called leading economics and financial commentators and opinion makers would explain the situation to the Malaysian public via the national dailies, the blogs and the TV network. I came across not one article or broadcast that explains the underlying reasons for the inevitable dire consequences.

Sure there were articles on the crisis, but they were merely describing the rescue of the largest insurance company in the USA (A.I.G.) if not the world and the amount involved. No explanation whatsoever, as to why only a few days earlier the Fed and the Treasury allowed the 4th largest bank, Lehman Bros to fold up but rushed in to rescue AIG with an unprecedented US$ 85 billion.

In my various articles published in my website and my final volume of the Future Fast-Forward Trilogy – The Shadow Money-Lenders and the Global Financial Tsunami – I explained in great detail the corruption within the global banking system and how these financial leeches through fraud and political protection created and amassed a global financial fortune in excess of US$500 Trillion. ( A book riddled with racist overtones)

Let me assure you that this is not a typo error. You got it right. It is not billions but a whopping US$500 trillion. I have been advised that as of the Q2 of 2008, the figure may have reached US$565 trillion.

This is a complex subject but I shall endeavour to make it as simple as I can.

Starting Point

The Ponzi Scheme

The crux of the fraudulent Ponzi scheme is the twin pillars of:

1) Fannie Mae & Freddie Mac – the two giant mortgage corporations of USA

2) The Derivative financial tool known as Credit Default Swap (CDS)

Once you have a grasp of these two concepts, you cannot but agree that we are facing total global banking collapse. Why? Because the entire global banking system has been built on these two financial pillars! But the system became irreparable in the last 7 years when CDS became the linchpin in the massive expansion of derivative trading and financial engineering.



The Mechanics

1. Banks became greedy and were unwilling to earn safe and steady profits from mortgages for housing and commercial properties which usually spread over a period of between 5 to 30 years.

2. Banks wanted massive profits in the shortest period of time and the ability to lend massive amounts and not be regulated as to how to do it.

3. The crooks devised a scheme. It was a simple idea.

4. Banks will provide mortgages to all and sundry.

5. I am going to use a simple example and using small numbers to illustrate for ease of calculation. Thus, assuming the Bank gave out US$1 million to finance mortgages, bearing interest at 10%.

6. The bank then sold the mortgages to Fannie Mae and Freddie Mac at a discount. Fannie Mae and Freddie Mac being Government Sponsored Companies (GSCs) are able to get cheap financing to purchase these mortgages as they were assumed to be “guaranteed by the US Government”.

7. Fannie Mae and Freddie Mac then package these mortgages into all sorts of structured financial products and these were sold to investors (private as well governments). Central Banks hold massive amounts of dollar reserves and they need to find a safe haven for them. Hence, and invariably, Central Banks invest their reserves in US Treasuries and financial “mortgage-backed” products issued by Fannie Mae and Freddie Mac as well as other US financial institutions.

8. With the payment of US$ 1 million by Fannie Mae / Freddie Mac, the bank by law, can lend ten times the amount after keeping 10% reserves i.e.US$100,000. Therefore, the bank can lend US$9 million by “creating money out of thin air” i.e. by crediting the borrowers in their loan accounts in amount of the loans extended. These US$9 million loans secured by mortgages are then sold to Fannie Mae / Freddie Mac again.

The cycle keeps repeating and the banks keep creating more and more loans.

It was so easy that the banks decided to create dubious loans called “Liars Loans” whereby the borrower need not state the actual income and or ability to repay.

9. As more and more of these loans were created, investors (government and private) demanded assurances that these loans were good for investments. The rating agencies (e.g. Moodys, Standard & Poor and Fitch etc.) who in collusion with banks, gave AAA ratings to what were essentially junks. This fraud led investors to believe that these financial products were good investments.

10. The rating agencies were only too aware that this scheme needed something more concrete to prolong the fraud and induce the investors to part with their monies.

11. The insurance companies like A.I.G. came into the picture. They were seduced by the idea that if they can insure against risks of accidents, storms etc., they could also insure risks against default by the mortgage holders. Thus was born the financial innovation – Credit Default Swap (CDS). Any financial product with a sound CDS would be rated AAA. It was as good as being guaranteed by Uncle Sam. *******s the world over, especially central banks, fell for it – hook, line and sinker. Bank Negara was no exception.

12. The scheme works out like this – AIG sells protection – i.e. in the event there is a default, AIG will pay out to the buyer who buys the protection (the CDS) in exchange for the payment of premiums covering the period of protection not unlike your usual insurance policy. It was easy money for everyone.

The banks get to sell their loans and have the liquidity to create more loans.

Fannie Mae / Freddie Mac and other financial institutions get the opportunity to repackage these loans / mortgages and sells them to investors with a tidy profit.

The investors are happy with their so-called guaranteed returns. The insurance companies, investment banks and other players get their premium income for selling protection. It was old fashion mafia loan sharking and protection business dressed up in modern financial jargon and everyone was too arrogant and greedy to see through the fraud.

13. When loans default and continue to be delinquent, the law (depending on each country) provides that if the loan is in default for 90 days or more, it should be declared a Non-Performing Loan (NPL) and banks must provide reserve to cover the loss.

14. What happened was banks were covering the defaults and kept them on the books for two years or more in the hope that no one would be wiser and interest income from new loans would cover the defaulted old loans – the classic ponzi modus operandi.

15. When the two years default reached critical proportions starting with the sub-prime loans, the fraud began to unravel. Investors began demanding their protection money for the losses arising from these defaults. It has been estimated that the market value of the CDS was in excess of US$60 trillion but the capital of the insurance companies like AIG are only in the billions. It is therefore a physical impossibility to make good the demand for payment for the defaults.

16. If AIG the No. 1 insurer in US and the world is in default, it means the rest are in deep shits. You can take it as a given that no one and no one has good coverage and protection anymore.

17. When there is no coverage and protection, how can there be AAA ratings for new issues of such financial products? Fannie Mae/Freddie Mac etc. cannot package these products for sale to investors and if they cannot sell, they will have no funds to buy more dubious mortgages from corrupt and fraudulent Wall Street banks. With no additional funds, these crooks in JP Morgan Chase, Goldman Sachs, Citigroup, Lehman Bros., Morgan Stanley, Merrill Lynch, Bank of America, UBS, Barclays, HSBC, Deutsche Bank, Credit Suisse, etc. will have difficulty extending new loans.

The “Musical Money Chair” will have to come to a complete halt. The entire system gets into a gridlock.

Given the above explanation, can the US government and the Fed continue to bail out banks and other financial institutions? When US is in deficit in both the budget and current accounts, where else can they get the extra monies except by creating out of thin air (virtually by keying digits into computers) or print more dollars.

If you are a sovereign lender or a private hedge fund, knowing the situation, would you lend more monies to the US Treasury knowing that each dollar issued (whether digitally or in printed notes) are not worth the value stated therein.

These dollars ARE NO BETTER THAN TOILET PAPER.

The bulk of our reserves are in US dollars. Our trade – petroleum products, palm oil and other exports are mainly traded in dollars. When the dollar dives into the cesspool of waste, what then?

This is the impending mess that Malaysia will be facing as early as end of 2008.

Have you heard anyone other than this writer talking about it?

3 comments:

LuckySingaporean said...

Ooi, GMS that conspiracy theory is worse than science fiction. At least fiction has to be written in a believable manner.

If $500 trillion is amassed, oil will be $10000 per barrel. These crooks can own every country every thing and dilute the rest of us to nothingness.

I really think Matthias' theory belongs to the dustbin. At the very edge of believability is this series of video which is quite popular:

http://www.youtube.com/watch?v=cy-fD78zyvI

I say this can be hardly believed.

Goh Meng Seng said...

Dear Lucky Tan,

LOL! ;) Yes, that conspiracy theory is a bit off and exaggerating but I think it actually has some points on how this subprime-credit linked derivatives blown out of proportion in this current financial crisis.

That is why I put the Economic Times article first and this little conspiracy theory latter.

Goh Meng Seng

LuckySingaporean said...

GMS,

Well the conspiracy mixes some truth and fiction. The fictional part is the author makes it seem the banks keep manufacturing debt at a rapid rate to grow this thing into $500T. You can't do that because at the other end there is a borrower who is a homebuyer who is borrowing for a home.ie. the borrowing can take place at a limited rate. There is only $15T in mortgages in USA. Most of these are actually "above water" and have +ve equity. The problem is if 10-20% are bad the problem is $3T of bad debts. Nowhere near $500T.

The CDS is the other problem. It was unregulated an grew to $55T. This is a big headache. The Fed now has the breakdown of this number and they know the impact if a certain company goes down. That is why GM is likely to get a bailout. It makes sense to give GM $10B and rescue it to prevent losses of, say, $100B linked to CDS. The other solution is by now famous Nouriel Roubini to stimulate the economy and keep the recession shallow until most of these CDS expire. I believe they will do this almost immediately after the US presidential elections.

We have seen the effects of a company collapsing - Lehman. Lehman resulted in about $200B of losses. I have explained in my blog how these losses possibly caused "black holes" that resulted in a heavy rapid selloff of stocks and commodities in the world. Late last week putting together some info. from Jim Jubak, I predicted that the stock markets would put in a bottom by about Friday. Now we see the rebound because the selloffs due to Lehman would abate.

There are some important and interesting links of this crisis to the income gap. The only time the global income gap was as high was in 1929. I have a few articles in my blog to explain how the gap possibly led to a huge imbalance the end result of which is this crisis.

This crisis will throw up many theories and conspiracies. It will be many years before everything is fully understood. In the meantime govts and central banks will have to move forward with whatever limited knowledge and understanding of what is going on.

As bloggers we have to be careful with wild theories. People are already very scared, lets not spook them unnecessarily with bad information.