Ali’s blog

Mostly quant stuff with occasional digressions

F. William Engdahl on subprime

Posted by alifinmath on February 24, 2008

Engdahl is another favorite writer of mine (albeit he doesn’t write much — I only have his “A Century of War). Here he explains the gory details of subprime, which were entertainingly touched upon by Michael Perelman. An excerpt from Engdahl:

 It required a Congress and Executive branch that would repeatedly reject rational appeals to regulate over-the-counter financial derivatives, bank-owned or financed hedge funds or any of the myriad steps to remove supervision, control, transparency that had been painstakingly built up over the previous century or more. It required that the major government-certified rating agencies give their credit AAA imprimatur to a tiny handful of poorly regulated insurance companies called Monolines, all based in New York. The monolines were another essential part of the New Finance.

 In 1995, well into the Clinton-Rubin era, Alan Greenspan’s former bank, J.P. Morgan, introduced an innovation that was to revolutionize banking over the next decade. Blythe Masters, a 34-year old Cambridge University graduate hired by the bank, developed the first Credit Default Swaps, a financial derivative instrument that ostensibly let a bank insure against loan default; and Collateralized Debt Obligations, bonds issued against a mixed pool of assets, a kind of credit derivative giving exposure to a large number of companies in a single instrument.

 Their attraction was that it was all off the bank’s own books, hence away from the Basle Accord’s 8% capital rules. The goal was to increase bank returns while eliminating the risk, a kind of “having your cake and eating it too,” something which in the real world can only be very messy.

 J.P.Morgan thereby paved the way to transform US banking away from traditional commercial lenders to traders of credit, in effect, into securitizers. The new idea was to enable the banks to shift risks off their balance sheets by pooling their loans and remarketing them as securities, while buying default insurance, Credit Default Swaps, after syndicating the loans for their clients. It was to prove a staggering development, soon to hit volumes measured in the trillions for the banks. By the end of 2007 there were an estimated $45,000 billion worth of Credit Default Swap contracts out there, giving bondholders the illusion of security. That illusion, however, was built on bank risk models of default assumptions which are not public and, if like other such risk models, were wildly optimistic. Yet the mere existence of the illusion was sufficient to lead the major banks of the world, lemming-like, into buying mortgage bonds collateralized or backed by streams of mortgage payments from unknown credit quality, and to accept at face value a Moody’s or Standard & Poors AAA rating.

Monoline insurance became a very essential element in the fraud-ridden Wall Street scam known as securitization. By paying a certain fee, a specialized (hence the term monoline) insurance company would insure or guarantee a pool of sub-prime mortgages in event of an economic downturn or recession in which the poor sub-prime homeowner could not service his monthly mortgage payments.

A cautious reader might ask the question, “Who insures these eleven monoline insurers who have guaranteed billions indeed trillions in payment flows over the past five or so years of the ABS financial revolution?”

 No one, yet, was the short answer.

 For the monolines,  guaranteeing such bonds seemed risk -free, with average default rates running at a fraction of 1 per cent in 2003-2006. As a result, monolines leveraged their assets to build their books, and it was not being uncommon for a monoline to have insured risks 100 to 150 times the size of its capital base. Until recently, Ambac had capital of $5.7 billion against guarantees of $550 billion.

The entire securitization revolution allowed banks to move assets off their books into unregulated opaque vehicles. They sold the mortgages at a discount to underwriters such as Merrill Lynch, Bear Stearns, Citigroup, and similar financial securitizers. They then in turn sold the mortgage collateral to their own separate Special Investment Vehicle or SIV as they were known. The attraction of a stand-alone SIV was that they and their potential losses were theoretically at least, isolated from the main underwriting bank. Should things ever, God forbid, run amok with the various Asset Backed Securities held by the SIV, only the SIV would suffer, not Citigroup or Merrill Lynch.

 The dubious revenue streams from sub-prime mortgages and similar low quality loans, once bundled into the new Collateralized Mortgage Obligations or similar securities, then often got an injection of Monoline insurance, a kind of financial Viagra for junk quality mortgages such as the NINA (No Income, No Assets) or “Liars’ Loans,” or so-called stated-income loans, that were commonplace during the colossal Greenspan Real Estate economy up until July 2007.

 According to the Mortgage Brokers’ Association for Responsible Lending, a consumer protection group, by 2006 Liars’ Loans were a staggering 62% of all USA mortgage originations. In one independent sampling audit of stated-income mortgage loans in Virginia in 2006, the auditors found, based on IRS records that almost 60% of the stated-income loans were exaggerated by more than 50%.  Those stated-income chickens are now coming home to roost or far worse. The default rates on those Liars’ Loans, which is now sweeping across the entire US real estate market, makes the waste problems of Tyson Foods factory chicken farms look like a wonderland. [14]

 None of that would have been possible without securitization, without the full backing of the Greenspan Fed, without the repeal of Glass-Steagall, without monoline insurance, without the collusion of the major rating agencies, and the selling on of that risk by the mortgage-originating banks to underwriters who bundled them, rated and insured them as all AAA.

 In fact the Greenspan New Finance revolution literally opened the floodgates to fraud on every level from home mortgage brokers to lending agencies to Wall Street and London securitization banks to the credit rating agencies. Leaving oversight of the new securitized assets, hundreds of billions of dollars worth of them, to private “self-regulation” between issuing banks like Bear Stearns, Merrill Lynch or Citigroup and their rating agencies, was tantamount to pouring water on a drowning man. In Part V we discuss the consequences of the grand design in New Finance.

This is all great fun to read and fleshes out the hilarious cartoon account to be found in Michael Perelman’s PowerPoint presentation. It also lends credibility to my contention that all modern finance is a criminal racket and dressing up some of it in the language of, say, stochastic calculus and default probabilities, doesn’t change anything. Financial “engineering” is complete baloney and whenever one hears the expression one should ask oneself, “Exactly who is getting fleeced this time?” 


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