Brown Web of Debt The Shocking Truth about our Money System (3rd ed)

Chapter 31 - The Perfect Financial Storm

in the real estate market for its private owners. Contrary to popular belief, Fannie Mae is not actually a government agency. It began that way under Roosevelt’s New Deal, but it was later transformed into a totally private corporation. It issued stock that was bought by private investors, and eventually it was listed on the stock exchange. Like the Federal Reserve, it is now “federal” only in name.

Before the late 1970s, there were two principal forms of mortgage lending. The lender could issue a mortgage loan and keep it; or the lender could sell the loan to Fannie Mae and use the cash to make a second loan, which could also be sold to Fannie Mae, allowing the bank to make a third loan, and so on. Freeman gives the example of a mortgage-lending financial institution that makes five successive loans in this way for $150,000 each, all from an initial investment of $150,000. It sells the first four loans to Fannie Mae, which buys them with money made from the issuance of its own bonds. The lender keeps the fifth loan. At the end of the process, the mortgage-lending institution still has only one loan for $150,000 on its books, and Fannie Mae has loans totaling $600,000 on its books.

In 1979-81, however, policy changes were made that would flood the housing market with even more new money. Fannie Mae gathered its purchased mortgages from different mortgage-lending institutions and pooled them together, producing a type of lending vehicle called a Mortgage-Backed Security (MBS). Fannie might, for example, bundle one thousand 30-year fixed-interest mortgages, each worth roughly $100,000, and pool them into a $100 million MBS. It would put a loan guarantee on the MBS, for which it would earn a fee, guaranteeing that in the event of default it would pay the interest and principal due on the loans “fully and in a timely fashion.” The MBS would then be sold as securities in denominations of $1,000 or more to outside investors, including mutual funds, pension funds, and insurance companies. The investors would become the owners of the MBS and would have a claim on the underlying principal and interest stream of the mortgage; but if anything went wrong, Fannie Mae was still responsible. The MBS succeeded in extending the sources of funds that could be tapped into for mortgage lending far into U.S. and international financial markets. It also substantially increased Fannie Mae’s risk.

Then Fannie devised a fourth way of extracting money from the markets. It took the securities and pooled them again, this time into an instrument called a Real Estate Mortgage Investment Conduit or

296

Web of Debt

REMIC (also known as a “restructured MBS” or collateralized mortgage obligation). REMICs are very complex derivatives. Freeman wrote, “They are pure bets, sold to institutional investors, and individuals, to draw money into the housing bubble.” Roughly half of Fannie Mae’s Mortgage Backed Securities have been transformed into these highly speculative REMIC derivative instruments. “Thus,” said Freeman, “what started out as a simple home mortgage has been transmogrified into something one would expect to find at a Las Vegas gambling casino. Yet the housing bubble now depends on precisely these instruments as sources of funds.”

Only the first of these devices is an “asset,” something on which Fannie Mae can collect a steady stream of principal and interest. The others represent very risky obligations. These investment vehicles have fed the housing bubble and have fed off it, but at some point, said Freeman, a wave of mortgage defaults is inevitable; and when that happens, the riskier mortgage-related obligations will amplify the crisis. They are particularly risky because they involve leveraging (making multiple investments with borrowed money). That means that when the bet goes wrong, many losses have to be paid instead of one.

In 2002, Fannie Mae’s bonds made up over $700 billion of its outstanding debt total of $764 billion. Only one source of income was available to pay the interest and principal on these bonds, the money Fannie collected on the mortgages it owned. If a substantial number of mortgages were to go into default, Fannie would not have the cash to pay its bondholders. Freeman observed that no company in America has ever defaulted on as much as $50 billion in bonds, and Fannie Mae has over $700 billion – at least ten times more than any other corporation in America. A default on a bonded debt of that size, he said, could end the U.S. financial system virtually overnight.

Like those banking institutions considered “too big to fail,” Fannie Mae has tentacles reaching into so much of the financial system that if it goes, it could take the economy down with it. A wave of home mortgage defaults would not alone have been enough to bring down the whole housing market, said Freeman; but adding the possibility of default on Fannie’s riskier obligations, totaling over $2 trillion in 2002, the chance of a system-wide default has been raised to “radioactive” levels. If a crisis in the housing mortgage market were to produce a wave of loan defaults, Fannie would not be able to meet the terms of the guarantees it put on $859 billion in Mortgage-Backed Securities, and the pension funds and other investors buying the MBS would

297

Chapter 31 - The Perfect Financial Storm

suffer tens of billions of dollars in losses. Fannie’s derivative obligations, which totaled $533 billion in 2002, could also go into default. These hedges are supposed to protect investors from risks, but the hedges themselves are very risky ventures. Fannie Mae has taken extraordinary measures to roll over shaky mortgages in order to obscure the level of default currently threatening the system; but as households with declining real standards of living are increasingly unable to pay rising home prices and the demands of ever larger mortgages and higher interest payments, mortgage defaults will rise. The leverage that has been built into the housing market could then unwind like a rubber band, rapidly de-leveraging the entire market.5

In 2003, Freddie Mac was embroiled in a $5 billion accounting scandal, in which it was caught “cooking” the books to make things look rosier than they were. In 2004, Fannie Mae was caught in a similar scandal. In 2006, Fannie agreed to pay $400 million for its misbehavior ($50 million to the U.S. government and $350 million to defrauded shareholders), and to try to straighten out its books. But investigators said the accounting could be beyond repair, since some $16 billion had simply disappeared from the books.

Meanwhile, after blowing the housing bubble to perilous heights with a 1 percent prime rate, the Fed proceeded to let the air back out with a succession of interest rate hikes. By 2006, the housing boom was losing steam. Nervous investors wondered who would be shouldering the risk when the mortgages bundled into MBS slid into default. As one colorful blogger put it:

So let me get this straight . . . . Is the following scenario below actually playing out?

For starters ma n’ pa computer programmer buy a 500K house in Ballard using a neg-am/i-o [negative amortization interest-only mortgage] sold to them by a dodgy local fly-by night lender. That lender immediately sells it off to some middle-man for a period of time. The middlemen take their cut and then sell that loan upstream to Fannie Mae/Freddie Mac before it becomes totally toxic and reaches critical mass. At which point FM/FM bundle that loan into a mortgage backed security and sell it to pension funds, foreign banks, etc. etc.

What happens when those loans go into their inevitable default? Who owns the property at that point and is left holding the bag?6

298

Web of Debt

Nobody on the blog seemed to know; but according to Freeman, Fannie Mae will be holding the bag, since it guaranteed payment of interest and principal in the event of default. When Fannie Mae can’t pay, the pension funds and other institutions investing in its MBS will be left holding the bag; and it is these pension funds that manage the investments on which the retirements of American workers depend. When that happens, comfortable retirements could indeed be things of the past.

What Happens When No One Has Standing to Foreclose?

In October 2007, a U.S. District Court judge in Ohio threw another wrench in the works, when he held that Deutsche Bank did not have standing to foreclose on 14 mortgage loans it held in trust for a pool of MBS holders. Judge Christopher Boyko said that a security backed by a mortgage is not the same thing as a mortgage. Securitized mortgage debt has become so complex that it’s nearly impossible to know who owns the underlying properties in a typical mortgage pool; and without a legal owner, there is no one to foreclose and therefore no actual “security.”7 That could be good news for distressed borrowers but a major blow to MBS holders. Outstanding securitized mortgage debt now comes to $6.5 trillion -- or it did before its value was put in doubt. What these securities would fetch on the market today is hard to say. If large numbers of defaulting homeowners were to contest their foreclosures on the ground that the plaintiffs lacked standing to sue, $6.5 trillion in MBS could be in jeopardy. The MBS holders, in turn, might have a very large class action against the banks that designed these misbranded investment vehicles.8

The discovery that securities rated “triple-A” may be infected with toxic subprime debt has made investors leery of investing and lenders leery of lending, and that includes the money market funds relied on by banks to balance their books from day to day. The entire credit market is at risk of seizing up.

It is at risk of seizing up for another, more perilous reason . . . .

299

Web of Debt

Chapter 32

IN THE EYE OF THE CYCLONE: HOW THE DERIVATIVES CRISIS HAS GRIDLOCKED THE BANKING SYSTEM

In the middle of a cyclone the air is generally still, but the great pressure of the wind on every side of the house raised it up higher and higher, until it was at the very top of the cyclone; and there it remained and was carried miles and miles away.

– The Wonderful Wizard of Oz,

“The Cyclone”

The looming derivatives crisis is another phenomenon often described with weather imagery. “The grey clouds are getting darker,” wrote financial consultant Colt Bagley in 2004; “the winds only need to kick up and we’ll have one heck of a financial cyclone in the making.”1 A decade earlier, Christopher White told

Congress:

Taken as a whole, the financial derivatives market, orchestrated by financiers, operates with the vortical properties of a powerful hurricane. It is so huge and packs such a large momentum, that it sucks up the overwhelming majority of the capital and cash that enters or already exists in the economy. It makes a mockery of the idea that a nation exercises sovereign control over its credit policy.2

Martin Weiss, writing in a November 2006 investment newsletter, called the derivatives crisis “a global Vesuvius that could erupt at almost any time, instantly throwing the world’s financial markets into turmoil . . . bankrupting major banks . . . sinking big-name insurance companies . . . scrambling the investments of hedge funds . . .

overturning the portfolios of millions of average investors.”3

301

Chapter 32 - In the Eye of the Cyclone

John Hoefle’s arresting image was of fleas on a dog. “The fleas have killed the dog,” he said, “and thus they have killed themselves.”4 Colt Bagley also sees in the derivatives crisis the seeds of the banks’ own destruction. He wrote in 2004:

Once upon a time, the American banking system extended loans to productive agriculture and industry. Now, it is a vast betting machine, gaming on market distortions of interest rates, stocks, currencies, etc. . . . JP Morgan Chase Bank (JPMC) dominates the U.S. derivatives market . . . JPMC Bank alone has derivatives approaching four times the U.S. Gross Domestic Product of $11.5 trillion. Next come Bank of America and Citibank, with $14.9 trillion and $14.4 trillion in derivatives, respectively. The OCC [Office of the Comptroller of the Currency] reports that the top seven American derivatives banks hold 96% of the U.S. banking system’s notional derivatives holding. If these banks suffer serious impairment of their derivatives holdings, kiss the banking system goodbye.

Martin Weiss envisions how this collapse might occur:

Portfolio managers at a major hedge fund bet too much on declining interest rates and they lose. They don’t have enough capital to pay up on the bet, and the counterparties in the transaction – the winners of the bet – can’t collect. Result: Many of these winners, also low on capital, can’t pay up on their own bets and debts in a series of other derivatives transactions. Suddenly, in a chain reaction that no government or exchange authority can halt, dozens of major transactions slip into default, each setting off dozens of additional defaults.

Major U.S. banks you’ve trusted with your hard-earned savings lose billions. Their shares plunge. Their uninsured CDs are jeopardized.

Mortgage lenders dramatically tighten their lending standards. Mortgage money virtually disappears. The U.S. housing market, already sinking, busts wide open.5

Derivatives 101

Gary Novak, whose website simplifying complex issues was quoted earlier, explains that the banking system has become gridlocked because its pretended “derivative” assets are fake; and the fake assets have swallowed up the real assets. It all began with deregulation in

302

Web of Debt

the 1980s, when government regulation was considered an irrational scheme from which business had to be freed. But regulations are criminal codes, and eliminating them meant turning business over to thieves. The Enron and Worldcom defendants were able to argue in court that their procedures were legal, because the laws making them illegal had been wiped off the books. Government regulation prevented the creation of “funny money” without real value. When the regulations were eliminated, funny money became the order of the day. It manifested in a variety of very complex vehicles lumped together under the label of derivatives, which were often made intentionally obscure and confusing.

“Physicists were hired to write equations for derivatives which business administrators could not understand,” Novak says. Derivatives are just bets, but they have been sold as if they were something of value, until the sales have reached astronomical sums that are far beyond anything of real value in existence. Pension funds and trust funds have bought into the Ponzi scheme, only to see their money disappear down the derivatives hole. Universities have been forced to charge huge tuitions although they are financed with huge trust funds, because their money has been tied up in investments that are basically worthless. But the administrators are holding onto their bets, which are “given a pretended value, because heads roll when the truth comes to light.” Nobody dares to sell and nobody can collect. The result is a shortage of available funds in global financial institutions. The very thing derivatives were designed to create – market liquidity – has been frozen to immobility in a gridlocked game.6

The author of a blog called “World Vision Portal” simplifies the derivatives problem in another way. He writes:

Anyone who has been to Las Vegas or at the casino on a cruise ship can understand it perfectly. A bank gambles and bets on certain pre-determined odds, like playing the casino dealer in a game of poker (banks call this “hedging their risks with derivative contracts”). When they have to show their cards at the end of the play, they either win or lose their bet; either the bank wins or the house wins (this is the end of the derivative contract term).

For us small-time players, we might lose $10 or $20, but the big-time banks are betting hundreds of millions on each card hand. The worst part is that they have a gambling addiction and can’t stop betting money that isn’t theirs to bet with. . . .

303

Chapter 32 - In the Eye of the Cyclone

Winners always leave the gambling table with a big smile and you can see the chips in their hand to know they won more than they had bet. But losers always walk away quietly and don’t talk about how much they lost. If a bank makes a good profit (won their bet), they would be telling everyone that their derivative contracts have paid off and they’re sitting pretty. In reality, the big-time gambling banks are not talking and won’t tell anyone how much they gambled or how much they lost.

We’ve been hoodwinked and the game is pretty much over.7

The irony is that derivative bets are sold as a form of insurance against something catastrophic going wrong. But if something catastrophic does go wrong, the counterparties (the parties on the other side of the bet, typically hedge funds) are liable to fold their cards and drop out of the game. The “insured” are left with losses both from the disaster itself and from the loss of the premium paid for the bet. To avoid that result, the Federal Reserve, along with other central banks, a fraternity of big private banks, and the U.S. Treasury itself, have gotten into the habit of covertly bailing out losing counterparties. This was done when the giant hedge fund Long Term Capital Management went bankrupt in 1998. It was also evidently done in 2005, but very quietly . . . .

A Derivatives Crisis Orders of Magnitude

Beyond LTCM?

Rumors of a derivatives crisis dwarfing even the LTCM debacle surfaced in May 2005, following the downgrading of the debts of General Motors and Ford Motor Corporation to “junk” (bonds having a credit rating below investment grade). Severe problems had apparently occurred at several large hedge funds directly linked to these downgradings. In an article in Executive Intelligence Review in May 2005, Lothar Komp wrote:

The stocks of the same large banks that participated in the 1998 LTCM bailout, and which are known for their giant derivatives portfolios – including Citigroup, JP Morgan Chase, Goldman Sachs, and Deutsche Bank – were hit by panic selling on May 10. Behind this panic was the knowledge that not only have these banks engaged in dangerous derivatives speculation on their own accounts, but, ever desperate for cash to cover their

304

Web of Debt

own deteriorating positions, they also turned to the even more speculative hedge funds, placing money with existing funds, or even setting up their own, to engage in activities they didn’t care to put on their own books. The combination of financial desperation, the Fed’s liquidity binge, and the usury-limiting effects of low interest rates, triggered an explosion in the number of hedge funds in recent years, as everyone chased higher, and riskier, returns. There can be no doubt that some of these banks, not only their hedge fund offspring, are in trouble right now.8

Dire warnings ensued of a derivatives crisis “orders of magnitude beyond LTCM.” But reports of a major derivative blow-out were being publicly denied, says Komp, since any bank or hedge fund that admitted such losses without first working a bail-out scheme would instantly collapse. An insider in the international banking community said that “there is no doubt that the Fed and other central banks are pouring liquidity into the system, covertly. This would not become public until early April [2006], at which point the Fed and other central banks will have to report on the money supply.”9

We’ve seen that when the Fed “pours liquidity into the system,” it does it by “open market operations” that create money with accounting entries and lend this money into the money supply, “monetizing” government debt. If it became widely known that the Fed were printing dollars wholesale, however, alarm bells would sound. Investors would rush to cash in their dollar holdings, crashing the dollar and the stock market, following the familiar pattern seen in Third World countries.10 What to do? The Fed apparently chose to muffle the alarm bells. It announced that in March 2006, it would no longer be reporting M3. M3 has been the main staple of money supply measurement and transparent disclosure for the last half-century, the figure on which the world has relied in determining the soundness of the dollar. In a December 2005 article called “The Grand Illusion,” financial analyst Rob Kirby wrote:

On March 23, 2006, the Board of Governors of the Federal Reserve System will cease publication of the M3 monetary aggregate. The Board will also cease publishing the following components: large-denomination time deposits, repurchase agreements (RPs), and Eurodollars. . . . [These securities] are exactly where one would expect to find the “capture” of any large scale monetization effort that the Fed would embark upon – should the need occur.

305