Yes...but!

October 13 2008

Home > Columns >Yes...But! Year 8-49

Even though the cause of the 1929 crash is still shrouded in a cloud of mystery, and still fathers many opinions, there are some very pointed indications what caused the End the Great Boom of the first decade in the year 2000. In all deep slumps – those in 1929 and subsequent ones – human foolishness, bordering on downright dishonesty is close to the real reason. This one is no exception. After all the love of money is the root of many evils.

It is beyond argument that our society generated the largest leveraged asset and credit bubble in the history of humanity. Bubbles abounded: there were a housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, and hedge funds bubbles. Now they all are exploding like a cluster time-bomb in every corner of the globe, each bomb setting off an avalanche, every one growing in size as it thunders downhill: falling real estate values causing greater unemployment, resulting in fewer sales, feeding more lay-offs, multiplying store closures, throwing more people out of work, which …..

In the USA there are 17 square feet of retail space for each person there. In Canada we have a mere 10 square feet per capita. The USA depends for 70 percent on people buying stuff. Europe and Canada has a 55 percent ratio there. In this new economy a major adjustment in the US will take place with plummeting property values, vacant malls and empty office towers, thanks to bank mergers. GM and Chrysler combine for only one reason: eliminate jobs and use less factory space.

So who is to blame for this obese bloated-ness? AIG, the American International Group, is one culprit.

Here’s how it played out. Banks must have reserves for the loans they make: the riskier the loans the more capital they must keep in reserve. Normally risky liars’ loans – no down payment, no job or income verification – would never have been approved. However the smart people at AIG invented a way to get around the rules, via unregulated insurance contracts, known as credit default swaps or CDSs.
It became as simple as a call to your friendly AIG broker, who used incredibly sophisticated computer models to sell the sub-prime securities as Triple AAA investments, with five year terms at a premium of 2% of face value. Thus on a $100,000 loan, a bank would create a profitable mortgage out of thin air, earning it 6 percent or a minimum of $ $30,000 less $2,000 to AIG = $28,000 in pure profit.
Although AIG's credit default swaps were really insurance contracts,
AIG didn't put up any capital as collateral on its swaps, so there was no real capital cost to selling these: it simply was a license to print money. AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate, which was supposed to be zero percent.
The broker who sold the swap was paid a bonus at the end of the first year - long before the actual profit on the contract was made.
With this false facade in place, all banks were able to assure its
regulators it was holding fully insured, triple-A credits, and so the bank could lend to the full extent allowable, while the broker could book hundreds of millions in "profit", without having to pony up billions in collateral.
It was pure fraud. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. Now these mortgages are worth less than $0.15 on the dollar.
The result was that enormous amounts of capital were created out of thin air and tossed into global real estate markets, on which the Wall Street people collected million dollar commissions. Paulson in Washington – himself a Wall Street veteran - bailed his buddies out with trillions of dollars of tax payers’ money.

While the rich benefit, the poor middle class pays the bill, which, I think, will result in a revolt of the small guy, because there is a tremendous amount of anger out there, fed by John McCain and his Palin woman.

I would not be surprised if there be violent clashes, even before the next US election, when the full extent of these manipulations became plain to all and the market melt-down sinks in.

We live in different times. The adjustment from the old to the new always creates friction. Let’s hope that the transition is gradual and not abrupt.