Deconstructing the Financial Meltdown

Deconstructing the Financial Meltdown: Wall Street’s unraveling
By Monica Perez Nevarez
October 10, 2008

The history of the financial markets is one of continuous booms and busts, and some experts categorize the current situation as but one more “correction” in a long line of recurring cycles. Unfortunately, this one is amplified by underreported hyper-inflation, fever-pitch greed happening within a globalized economy, inextricably linked financial markets, and a viral malaise stemming from the convoluted alchemy of derivatives trading.

History Repeats
Eighty years ago, when the pace of life was considerably slower, the Florida real estate crash of 1927 was an important factor in triggering the Stock Market crash of 1929, a harbinger of the Great Depression. After the crash, a public outcry for stiffer regulation in order to prevent future crashes ensued. In 1933, Congress passed the Glass-Steagall Act, which established the Federal Deposit Insurance Corporation (FDIC) and included banking reforms to control speculation.

Under this law, banks, brokerages and insurance companies were barred from entering each others' industries, and investment banking and commercial banking were separated.

Five decades later the banking industry began to successfully lobby the government to roll back what they considered to be a legislative straightjacket and an outmoded residue of Franklin Roosevelt’s New Deal. The Depository Institutions Deregulation and Monetary Control Act of 1980 and the Gramm-Leach-Bliley Act of 1999 repealed the precautionary provisions contained within Glass-Steagall and opened the floodgates of financial cross-pollination and mergers. Bank Holding Companies could now own a portfolio of financial businesses under one roof which included commercial banking, insurance, mortgage houses and investment banks. Along with modernizing the banking laws, the Gramm-Leach-Bliley also stipulated oversight from Congress, which was subsequently ignored.

Without the constraints of the Glass Steagall Act, and little or no actual oversight, the deregulated banking industry bloomed and the economy grew. The demise of Barings Bank, founded in 1762 and the oldest merchant bank in London until its collapse in 1995, should have been a wake-up call extolling the downside of derivative trading, but was seen as a mere cautionary tale in the larger euphoria of an expanding economy.

In the broader world, the new millennium saw globalization interconnect the economies of all nations; telecommunications brought the farthest reaches of the planet into the office or living room instantly; and a slew of nascent tech companies salivated over their Initial Public Offerings (IPO’s). Unseen, there was one more element in the mix.

According to Robert Prechter, President of Elliott Wave International (www.elliottwave.com), the first decade also saw the rise of a silent predator: inflation. In a recent video (seen here http://www.youtube.com/watch?v=SjS60TaD_J8 ), he explains that if stocks today were priced in real money, that is to say, in gold, we would have seen a substantial decline in stock values in the last ten years. “It’s been a silent crash because of the increase in the amount of credit and the drop in the value of dollar. The same thing happens with oil; its price in dollars has gone up, but priced in gold, it’s priced about where it was seven years ago, so it reflects the amount of inflation we have been enduring in the last decade which we did not see.” These forces, along with an insatiable and seemingly unstoppable financial sector, became the foundation of the Tech Bubble of the early 2000’s.

Greed, inflation and the fear of being left behind in the biggest boom in recent history infected other sectors of the economy. Beginning in 2001, the implosions of Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom, attest to that fact. The Sarbanes-Oxley Act of 2002, also known as the Public Company Accounting Reform and Investor Protection Act, regulated publicly traded corporate accounting practices, but did little to derail the banking juggernaut, which quickly began to look for other places to invest in.

Connecting the Financial Dots
Before the globalization era, problems in the economy caused problems in the financial markets when economically strapped consumers and businesses had trouble repaying their loans, but the consequences were usually limited to a specific segment of the banking industry. This time, the viral malaise in the mortgage sector infected the stock market, the loans sector, hedge funds and investment houses, heralding a domino effect throughout the American economy, and therefore, the world economy, that according to Henry Paulson, Secretary of the US Treasury, threatens to collapse the entire system.

Ironically, Paulson, Ben Bernanke of the Federal Reserve and President Bush had been publicly touting a ‘strong’ economy for over a year before the dominoes started to topple, hoping that their words alone would bolster enough consumer confidence to steady the financial ship, in response to a small cadre of analysts and experts that were predicting a looming crash in the financial markets during that time.

To make matters worse, the financial downturn had the makings of a political and national security issue, as China and other foreign investors hold most of the US government’s outstanding debt, which has also spiraled out of control.

On September 30, 2008, the total U.S. federal debt passed the $10 trillion mark, or $32,895 per U.S. resident. Adding unfunded Medicaid, Medicare, Social Security, and similar obligations, the debt rises to a total of $59 trillion, or $196,348 per household. And of course, there’s the almost one trillion dollars being spent on the wars in the Middle East, which put further pressure on the system.

Current GDP (a measure of national income) is $13 trillion dollars, and the CIA ranks the US debt load as a percentage of GDP in 26th place when comparing it to other national debt ratios. To put these numbers in perspective, it’s like a man with a thirteen thousand dollar yearly salary assuming debts of almost sixty thousand dollars: depending on interest rates and inflation, the payments could eat up more than half of his monthly income, leaving scant resources to pay the regular bills that due to inflation have increased substantially.

After the dot.com bust, there were millions of dollars looking for investment and nowhere to place them except real estate. Add a dash of governmental incentive in the form of a Presidential and Congressional housing initiative, and what had started as a conservative strategy to get more people into homes snowballed into the irrational exuberance equivalent of “day trading” in real estate.

Coincidentally, a large percentage of Baby Boomers found themselves nearing retirement age with fewer savings than what they expected to be able to live on. They saw the opportunity to invest in real estate as a safe and quick way to bolster their retirement portfolios, a way much "safer" than investing in the relatively complicated stock market. The combination of low interest rates, no-money-down mortgages and ever-increasing home prices fueled a bubble the likes of which, in absolute numbers, had never been seen before. At its height, annual home appreciation rates of 25% to 30% in hot markets were common.

[graph here]Robert Shiller’s plot of U.S. home prices, population, building costs, and bond yields, from his book Irrational Exhuberance.

To paraphrase a recent article in Time magazine, in the fall of 2006, real estate was booming and the world was awash in cheap money after three years of unprecedented growth. There was no fear of buying a house with nothing down, because housing prices were only going up. And there was no fear of making half-baked mortgage loans, because "house-price appreciation" would increase the value of the collateral if borrowers couldn't pay. The idea that there could be depreciation was never considered. For businesses, there was money available to buy other corporations, but since manufacturing jobs were migrating to Asia in droves, real estate was an attractive option for many that had lost jobs or lived with reduced salaries.

Then Wall Street expanded on a novel idea that had cropped up in the nineties: "securitize" the mortgage loans. The thinking was that everything was safe, because by chopping up the mortgages into small pieces, they were spreading the risk around the globe. Little did they know that precisely because they were spreading the risk, they were also spreading the subprime virus that is now consuming the world markets (subprime is a banking term for junk mortgages that do not conform to traditional due diligence parameters).

Enter the Dragon
During the first half of this decade, financial companies had noticed that growth in world wealth had stabilized, but profits from derivatives trading had skyrocketed since 2003 (see graph below). Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or hedge against it. Their value depends on the value of other underlying financial instruments, as opposed to a tangible product or service. The main types of derivatives are futures, forwards, options and swaps. For quick profit junkies, these are the drug of choice.


[graph here]Total world derivatives from 1998-2007 compared to total world wealth in the year 2000, http://en.wikipedia.org/wiki/Derivative_(finance)

There is a wide range of derivatives contracts available to be traded in the market, based on different types of assets such as commodities, equities, stocks, residential mortgages, commercial real estate loans, credit, bonds, interest rates, exchange rates or indexes. There are even derivatives contracts on an index of weather conditions. These are far removed from the original purpose of derivatives, and much more convoluted.

“Derivatives are weapons of financial mass destruction”
Warren Buffett, 2003

Initially, derivatives were used as a tool to transfer risk by taking the opposite position in the underlying asset. For example, a corn farmer and a tortilla producer could enter into a futures contract to exchange cash for corn in the future. Both parties reduced a future risk by buying derivatives in case their original deal fell through: for the farmer, the uncertainty of the future price was mitigated by buying forwards, and for the tortilla maker, the availability of corn was assured by buying a swap that would pay out in the event of non-fulfillment of the contract.

But once financiers realized that almost anything can be securitized (made into a tradable commodity), derivatives became a whole new avenue in which to make money. BIG money.

The Opening Salvos
Here is how leverage works: when things go well, an investor is immensely profitable; if the markets go against you, things can go down the tubes in a hurry. This is where the greed comes in. Since you can invest in derivatives with only a small percentage of the value down, if you choose right, the upside is huge. For example, if you borrow 35 times your capital and those investments rise only 1%, you've made 35% on your money (after paying back the borrowed sum). If, however, the market moves against you — as they did with Lehman Brothers during the summer — a 1% or 2% drop in the value of your assets puts the entire company’s future in doubt.

When there was a slight downturn in the economy, Lehman began to rely on investments in derivatives to produce profits, increasing its exposure while trying to overcome its losses, very much the same way as Nick Leeson did by speculating on futures contracts for Barings Bank a decade before. Lehman ultimately could not overcome its losses, so it went bankrupt. And that is what can happen to countless other financial institutions that are still equally over-leveraged in derivatives across the entire global economy.

Even though loan officers on the ground knew that deregulated mortgages were an obvious risk since 2005 when the market began to heat up, the enormity of the consequences would not be apparent to the general public until companies began asking the government for bailouts, after it was clear that many of those loans would not be paid.

Falling Dominoes
In the nine months beginning on June 2007, Bear Stearns rescued one of its struggling subprime-linked hedge funds for $3.2 billion; Goldman Sachs was bailed out for $3 billion; an $80 billion structured-investment vehicle (SIV) fund for short-term debt was created; Citigroup Inc. had its $58 billion SIV bailout; the Federal Reserve created the $20 billion Term Auction Facility; President Bush signed a $100 billion “Economic Stimulus” bill; and JP Morgan bought Bear Stearns for $29 billion.

If all these well-funded multinational corporations were susceptible, what could be expected to happen to all the smaller players in the financial markets?

Then in one extraordinary week late last September, the Federal Government bailed out Fannie Mae and Freddie Mac, the two largest mortgage companies in the US, and dumped more than $5 trillion dollars of the firms' debt onto taxpayers, nearly doubling the federal debt. Lehman Brothers declared bankruptcy, and Merrill Lynch wooed white knight Bank of America in order to avoid a similar fate. Then, the US Treasury and the Federal Reserve rescued American International Group (AIG), a $1 trillion insurance company, to the tune of $85 billion for 80% equity, citing that “the firm was too large to let fail, and that it was an exceptionally good deal to make”. Within two weeks, the government had funneled $35 billion more dollars for a total of $120 billion into AIG, after new valuations on their assets were performed.

To the US Treasury, which has a list of over 90 banks holding worthless mortgages or mortgage securities that are potential future bankruptcies, the sound of falling dominoes brought home the realization that the entire financial system could fall apart, and an immediate infusion of cash into the system was the only way to stop the hemorrhage.

Paulson and Bernanke pushed hard for a Congressional bailout package of $700 billion, which was rejected on its first pass through Capitol Hill, but was signed into law after an additional $140 billion of pork was added to it. This measure is seen by all as the first in a series of measures that will be needed to stem the economic meltdown in the next twelve to eighteen months. See it in its entirety here: http://senateconservatives.files.wordpress.com/2008/10/bailouttext.pdf

The Root of the Problems
The downside of financial internationalization is that many of the mortgages and mortgage securities owned or guaranteed by Fannie Mae and Freddie Mac were bought by foreign central banks. The Federal Reserve and US Treasury felt compelled to bail out Fannie and Freddie because if they didn't, foreigners wouldn't continue funding US trade and federal-budget deficits. So what had begun as a financial problem was becoming a political and national security problem that had to be dealt with. Meanwhile, Paulson and Bernanke kept saying that a $13 trillion U.S. economy and a $54 trillion world economy would survive a “correction” of a couple of trillion dollars.

The government felt it was imperative to save AIG because as the largest insurer in the world it had sold credit-default swaps (CDS’s, or securities that insure against a company defaulting on its obligations) to thousands of other companies. For example, if ABC Inc. bought $10 million in XYZ Company bonds, for instance, they would also hedge their bet by buying a $10 million CDS from AIG where AIG agreed to pay $10 million if XYZ defaulted on its obligations.

These transactions need collateral, and that collateral has to be paid up front. Unfortunately for AIG, the amount of collateral depends on a company’s credit rating. So if a company’s credit is downgraded, say, after rating agencies revalued the subprime mortgages and mortgage securities they hold — as happened with AIG— they have to post more collateral immediately. When Standard & Poor and Moody’s downgraded AIG’s credit rating, they had to post $14 billion overnight, which it did not have. And if it did not post it immediately, the next week AIG would have had to come up with $250 billion. And that is the downside of derivative trading: the numbers are huge both coming up and going down.

What scared the government was not the loss of one of the biggest companies in the world; it was what that loss would mean to all the companies it had insured. AIG has $1 trillion in assets, more than 70 million customers and many of the world’s biggest and most important financial firms as clients. If AIG went bankrupt, all its customers who thought they had hedged their bets would suddenly have "unbalanced books", which could lead to their own potential demise, which could lead to still more companies failing, and eventually to what economists call "systemic failure." In other words, a financial meltdown.

The derivatives markets dwarf the stock market in size. The Financial Times has published estimates that the size of the derivatives markets is currently estimated to be $450 trillion dollars US and the notional value of credit default swaps is $62 trillion US. These staggering sums do not include government and corporate bond markets or the commercial paper markets, which are also huge.

The ratio between global GDP and global debt is reaching a point where it is becoming harder to afford the payments; the instability of the market and the desperate bets on derivatives make the situation even more precarious. These numbers also point to the fact that more and more of the world’s wealth is created from speculation, and not from producing tangible goods. It stands to reason that at some point limits must be set on speculation, but free market forces were aligned against regulation, and when a tipping point was passed, the dominoes simply started to fall.

Black September
There is another downside to globalization in the financial markets: interconnectedness. By the time the opening bell rang in the New York Stock Exchange Monday Sept. 29, $1.2 trillion had already vanished from the US stock market, and all of it had happened elsewhere. Here is a brief timeline.

Shortly before 6 p.m. New York time on Sunday, Sept. 28, Belgium, the Netherlands and Luxembourg agreed to rescue the failing Fortis Bank for $16 billion. A few hours later, the German government pledged $43 billion to save Hypo Real Estate, a commercial property lender. Both rescue packages were refused and the government had to go back to the drawing table to settle the deals.

At 2:50 am, news came that the British Treasury had seized lender Bradford & Bingley and quickly sold the bulk of it to Banco Santander of Spain. The German DAX was off 256 points, or 4.2 percent, and stocks had tumbled throughout Europe.

In Tokyo, where stocks had opened higher in early trading on Monday, traders faced reports suggesting the financial crisis was taking a toll on the global economy and began to sell off. Markets across Asia followed suit. The Nikkei 225 sank 1.5 percent. In India, stocks fell nearly 4 percent. In Hong Kong, HSBC bank raised key lending rates because of the credit market turmoil, so the Hang Seng tumbled nearly 4.3 percent. As one market fed off the information of another market, all tended downwards, pushing the system further into negative territory.

As investors in New York were waking up, the credit markets were flashing red as banks reported higher borrowing costs. Investors continued to seek safety in Treasuries. The yield on one-year Treasury bills, for instance, fell to almost zero, meaning investors were willing to accept no return on their money just for the assurance that they would get their money back.

What had started 24 hours earlier, with a modest sell-off in stock markets in Asia, had turned into Wall Street’s blackest day since the 1987 crash. The broad market, as measured by the Standard & Poor’s 500-stock index, plunged almost 9 percent, its third-biggest decline since World War II. The Dow Jones industrial average (DJIA) fell nearly 778 points, or 6.98 percent, to 10,365; a week later it had fallen to 8,144.

While the European financial markets have different regulations than the US, they do not have one ‘supranational’ organization that can monitor and control the markets like the US Treasury and the Federal Reserve. Each nation has to fight this meltdown independently. But in an unprecedented move on October 8, the European central banks joined the US, Canada, Australia, China, Switzerland and various other countries’ central banks in unilaterally cutting their lending rates to 1.5%, in the hopes that this would calm the markets. Unfortunately, the stock market responded by continuing to go down, showing the government that easier credit was not what they were looking for.

Are we Facing a Depression?

Suze Orman recently stated on CNN’s Anderson Cooper 360 show that the economy is like a patient that is in intensive care, and will likely stay in intensive care for another year or year and a half. Then the patient will need to be in the hospital for another similar length of time, after which the patient will need outpatient therapy for another year or two. So while she did not think this was going to turn into a Depression, she did think that the situation was a delicate one that would last five to six years. Her prediction for the stock market bottom was a prescient 8,200, explaining that we still have some ground to lose before we can recover. The market hit bottom at 8,144 two days later.

Fareed Zakaria of CNN’s Global Public Square Oct 5 show put the possibility of a Depression into perspective: “In 1929 the stock market saw a 40% loss of value with the DJIA dropping from 381 to 229, ending in 198 at the end of the month, and $30 billion lost in one week. In 1987 the stock market lost 22% of its value, or $500 billion dollars, when the DJIA dropped 508 points from 2247 to 1739 in one day. Last week we saw the DJIA lose 7%, or more than $1 trillion dollars in one day. In terms of percentage it’s not as large as the 1929 crash, but it is a very large, very worrisome situation that will have serious repercussions for a long time to come. But it is not as bad as the crash of ’29.”

Unfortunately, a week later the market was 47% off of last year’s high (in the 14,000’s). Notwithstanding, Lou Dobbs was even more forceful: “We are not going to be in a depression!” he said emphatically on his Oct. 8 show. Let’s hope the pundits are right, and all we get is a deep recession.

Robert J. Samuelson summed the comparison up in his Oct. 5 Washington Post column, http://www.washingtonpost.com/wp-dyn/content/article/2008/10/05/AR2008100501251.html thusly:
“There have been 10 previous postwar bear markets, defined as declines of at least 20 percent in the Standard & Poor's 500-stock index. The average decline was 31.5 percent; those of 1973-74 and 2000-02 were nearly 50 percent. By contrast, the S&P's low point so far [Friday Oct.3] was 30 percent below the peak reached in October 2007.”

“The Great Depression that followed the stock market's collapse in October 1929 was a different beast. By the low point in July 1932, stocks had dropped almost 90 percent from their peak. The accompanying devastation -- bankruptcies, foreclosures, bread lines -- lasted a decade. Even in 1940, unemployment was almost 15 percent. Unlike postwar recessions, the Depression submitted neither to self-correcting market mechanisms nor government policies. Why?”

“Capitalism's inherent instabilities were blamed -- fairly, up to a point. Over-borrowing, over-investment and speculation chronically govern business cycles. But the real culprit in causing the Depression's depth and duration was the Federal Reserve. It unwittingly transformed an ordinary, if harsh, recession into a calamity by permitting a banking collapse and a disastrous drop in the money supply.”

“From 1929 to 1933, two-fifths of the nation's banks failed; depositor runs were endemic; the money supply (basically, cash plus bank deposits) declined by more than a third. People lost bank accounts; credit for companies and consumers shriveled. Economic retrenchment fed on itself and overwhelmed the normal mechanisms of recovery. These channels included: surplus inventories being sold, so companies could reorder; strong firms expanding as weak competitors disappeared; high debts being repaid so borrowers could resume normal spending.”

“What's occurring now is a frantic effort to prevent a modern financial disintegration that deepens the economic downturn. It's said that the $700 billion bailout will rescue banks and other financial institutions by having the Treasury buy their suspect mortgage-backed securities. In reality, the Treasury is also bailing out the Fed, which has already -- through various actions -- lent financial institutions roughly $1 trillion against myriad securities. The increase in federal deposit insurance from $100,000 to $250,000 aims to discourage panicky bank withdrawals. In Europe, governments have taken similar steps; Ireland and Germany have guaranteed their banks' deposits. Fed Chairman Ben Bernanke, a scholar of the Depression, understands the error [of acting timidly]. The Fed's lending and the bailout aim to avoid a ruinous credit contraction.”

“The economy will get worse. The housing glut endures. Cautious consumers have curbed spending. Banks and other financial institutions will suffer more losses. But these are all normal symptoms of recession. Our real vulnerability is a highly complex and global financial system that might resist rescue and revival. The Great Depression resulted from the mix of a weak economy and perverse government policies. If we can avoid a comparable blunder, the great drama of these recent weeks may prove blessedly misleading.”

Some contrarians have been calling the Bailout a thinly veiled attempt to save wealthy political contributors, or at the very least, the same organizations that created the crisis in the first place. Many advocate direct support of homeowners, or direct support of smaller, local banks nationwide instead of saving only the biggest players. But as Samuelson points up above, the government is not trying to save the largest institutions; it is trying to save the entire system, and the only way to do that is by saving the biggest players. So while it may seem justified to save the small homeowners and investors who depended on the government and the big financial companies for their homes or retirement plans, bailing them out will not save the system, and without the system, everybody would suffer.

Does the system need overhauling, and more intelligent regulation and oversight created? Absolutely. The best way to do that, using Ms. Orman’s analogy, is reviving the moribund patient, and then putting him on a strict health regimen.