Friday, November 16, 2007
A Financial System under Siege
"If
these items [promised
benefits in Social Security, Medicare, Veterans Administration and other
entitlement programs] are factored in, the total [debt] burden in
present value dollars is estimated to be about $53 trillion. Stated
differently, the estimated current total burden for every American is nearly
$175,000; and every day that burden becomes larger."
"The economic forces driving the
global saving-investment balance have been unfolding over the course of the
past decade, so the steepness of the recent decline in long-term dollar yields
and the associated distant forward rates suggests that something more may have
been at work."
Alan
Greenspan, former Fed Chairman, July 20, 2005
“The subprime black hole is appearing deeper, darker and
scarier than they [the banks] thought. They’ve worked through ... about
40 percent of the backlog of the leveraged loan side, and there’s
definitely some signs of thaw there.”
Tony
James, president and CEO of Blackstone Group LP
The global dollar-based financial system
is in crisis and is threatening the prosperity and stability of many economies.
Financial excesses of all kinds have undermined its legitimacy and its
efficiency. The U.S. dollar is losing its preeminence as the main international
reserve currency while many banks are caught in the turmoil of the subprime credit crisis.
The overall background is the
unprecedented real estate bubble that took place worldwide, from 1995 to 2005.
In the United States, for example, owner-occupied home prices increased
annually by an average of about 9 percent. The market value of the stock of
owner-occupied homes in the U.S. rose from slightly less than $8 trillion
in 1995 to slightly more than $18 trillion in 2005. It has been
contracting ever since, confirming the working of the 18-year
Kuznets realestate cycle, which has gone from the top of 1987 to the
2005 top.
What
makes this period especially dangerous is the fact that the average 54-year
long inflation-disinflation-deflation Kondratieff cycle
is also at play, having begun in 1949 after prices were unfrozen. World
inflation then rose for twenty years, until 1980, which was followed by a
period of disinflation under the Volcker Fed. The entry of China into
the World Trade Organization (WTO) on December 11,
2001, with its abundant labor and low wages, unleashed strong
deflationary forces worldwide. This in turn led to lower inflation expectations
paving the way for the Greenspan Fed to keep interest
rates abnormally low.
Persistent
low interest rates and low inflation expectations led to a binge in borrowing
and to a vast increase in market valuation, not only in real estate but also in
stocks and bonds. Banks and other mortgage lending institutions took advantage
of the opportunity to introduce some financial innovations in order to finance
the exploding mortgage market. These innovations resulted in the severing of
the traditional direct link between borrower and lender and the reduction in
the lending risk normally associated with mortgage loans.
Thus, with the connivance of the rating
agencies and of the Federal Reserve System, large banks invented new financial
products under various names such as "Collateralized Bond
Obligations" (CBOs), "Collateralized Debt Obligations" (CDOs),
also called "Structured Investment
Vehicles" (SIVs), which
had the characteristics of unfunded short term commercial paper. In the
residential mortgage market, for example, mortgage brokers and retail lenders
would sell their mortgage loans to banks, which in turn would package them
together and slice them into different classes of mortgage-backed
securities (RMBS), carrying different levels of risk and return,
before selling them to investors.
Indeed, these new financial instruments
were the end result of a process of "asset
securitization" and were slices of bundles of loans, not only of
mortgage loans but also of credit cards debts, car loans, student loans and other receivables. Each
slice carried a different risk load and a different yield. With the blessing of
rating agencies, banks went even one step further, and they began pooling the
more risky financial slices into more risky bundles and divided them again to
be sold to investors in search of high yields.
By selling these new debt
instruments to investors in search of high yields and higher yields, including
hedged funds and pension funds, banks were doubly rewarded. First, they
collected handsome managing fees for their efforts. But second, and more
importantly, they unloaded the risk of lending to the unsuspected buyer of such
securities, because in case of default on the original loans, the banks would
be scot-free. They had already been paid and had been released from the risk of
default and foreclosure on the original loans.
The
banks' residual role was to collect and distribute interest, as long as
borrowers made their interest payments. But if payments stopped, the capital
losses incurred because of the decline in the value of unperforming loans would
instead be carried by the investors in CBOs and CDOs. The banks themselves
would suffer no losses and would be free to use their capital bases to engage
in additional profitable lending. In fact, the end of the line investors became
the real mortgage lenders (without reaping all the rewards of such risky loans)
and the banks could reuse their capital to pyramid upward their loan
operations. These were the best of times for banks and they gorged themselves
without restraint. Some of them paid their employees tens of billions of
dollars in year-end bonuses.
Indeed, and it is here that the Fed and other
regulatory agencies failed, first line mortgage lenders became more and more
aggressive in their lending, with the full knowledge that they could profitably
unload the risk downstream. This explains the expansion of the
"subprime" mortgage market where borrowing was done with no down
payment, no interest payments for a while and no questions asked as to the
income and creditworthiness of the borrower. These were not normal lending
practices. Such Ponzi schemes could not
last forever. And when housing prices started to decline, foreclosures also
increased, thus shaking the new financial house of cards to its foundations.
Banks became the reluctant owners of some of the foreclosed properties at very
discounted values.
Why then are so many banks in financial
difficulties, if the lending risk was transferred to unsuspecting investors?
Essentially, because when the housing boom burst, the banks' inventory of
unsold "asset-backed securities" was unusually
high. When the piper stopped playing and investors stopped buying the newly
created risky investments, their value plummeted overnight and banks were left
with huge losses still not fully reflected in their financial balance sheets.
Indeed, banks that did not unload their stocks of packaged mortgages
were forced to accept ownership of foreclose properties at very discounted
values. With little or no collateral behind the loans, bad-debt losses became
unavoidable.
Since noboby
knows for sure the value of something which is not traded, it will take months
before banks come to terms with the total losses they have suffered in their
stocks of unsold pre-packaged "asset-based securities". It is more
than a normal "liquidity crisis" or "credit crunch" (which results
when banks borrow
short term and invest in illiquid long term assets);
it is more like a "solvency crisis" if the banks' capital base is overtaken by the disclosure
of huge financial losses incurred when the banks are forced to sell
mortgaged assets in a depressed real estate market.
This
is this financial and banking mess which is unfolding under our very eyes and
which is threatening the American and international financial system. There are
four classes of losers. First, the homebuyers who bought properties at inflated
prices with little or no down payment and who now face foreclosure. Second, the
investors who bought illiquid mortgage-backed commercial paper and who stand to
lose part or all of their investments. Third, the holders of bank stocks who
profited when the system worked smoothly but who now face declining stock
values. And, finally, anybody who stands to fall victim, directly or
indirectly, to the coming economic slowdown.
________________________________________
Rodrigue Tremblay is a Canadian economist who lives in Montreal; he can
be reached at rodrigue.tremblay@yahoo.com
Visit his blog site at: www.thenewamericanempire.com/blog.
Author's Website: www.thenewamericanempire.com/
Check
Dr. Tremblay's coming book "The Code for Global Ethics"
at: www.TheCodeForGlobalEthics.com/
Posted,
Friday, November 16, 2007, at 5:30 am
Email to a friend:
http://www.TheNewAmericanEmpire.com/tremblay=1077
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