As stated in a previous article in this series, my intention is not only to describe the crisis of '08, but to prove that the collapse was no accident but a carefully calculated act of class war against working people. The unprecedented shift of wealth from the working class to the super affluent was not the unintended result of bad policy, incompetence, regulatory indifference, or the excessive greed of rogue elements on Wall Street, although each of these were essential parts, it was rather the criminal act of those on the very top of the economic pyramid. I believe that a familiarity with the circumstances can lead only to that conclusion. The "financial weapons of mass destruction"[1] which decimated our economy were brilliantly configured to maximize effect, and targeted precisely those institutions where that effect could not go unremedied without dire, systemic consequences, both political and economic.
The sub-prime mortgage bond was the Wall Street construct whose detonation brought the economy down like wounded game. These securities were of a type which made them attractive to pension funds and mutual funds. Often workers who participate in 401Ks will invest money in stock funds until they near retirement and then switch to the usually safer bond funds. The elimination of retirement savings caused by the implosion made it politically impossible for government to let investors suffer their losses as the political party making such a decision would become quite unpopular with voters. It is hard to conceive of a better way to sabotage an economy and compel government thereafter to respond in your favor.
As we saw in the last article, the mortgage bond became quite popular with long-term investors like retirement funds because of their perceived safety. Prime loans were backed by Fannie Mae and other GSE who were in turn backed by the government of the United States. They were as close to a certainty as is possible. However sub-prime loans were not backed by the government, and were anything but a sure thing.
The sub-prime mortgage bond mimicked its prime antecedent in that it was tranched, and that it too adopted the pay-as-you-go method of redemption. Now the danger wasn't that the underlying mortgages would be paid off too soon, but that they wouldn't be paid at all. So the first tranches, like their prime counterparts, would pay a better rate of interest, but contained the riskiest mortgages in the bond.
Despite these new bonds having a reduced credit rating, they sold well, with most non-professional buyers not realizing that a sea change in the quality of the underlying loans had occurred. Alan Greenspan and the Fed had green-lighted these new securities, so they must be okay, or so the argument went.
Given that the ever-dependable Fed chief was keeping interest rates at all time lows,[2] and that big investment banks were buying these sub-prime mortgages as fast as they were written, the market took off. There was no risk to the lender so long as they could pass these mortgages along to Wall Street. Predictably, they adopted an originate-and-sell policy. As they did, their criteria for assessing risk weakened in proportion to Wall Street's demand for product for their MBS business. With the dot.com bubble having not long before burst, Wall street needed new and, putatively at least, less risky investments, MBS, with their reputation for reliability, was just what the banks needed. Soon the sub-prime mortgage bond became a large part of Wall Street's business. Eventually, MBS would constitute ninety percent of the financial industry's bond revenue. In fact, the day came when the housing industry could not keep up with the finance industry's demand for mortgages, and new and even more esoteric MBS were fashioned by Wall Street to offset the decline. Thus was the CDO born.[3]
The housing market went into overdrive. With Wall Street egging them on, mortgage originators found new ways to make loans. The one incentive which mattered most but was insufficiently understood by sub-prime borrowers, was the variable-rate mortgage. This meant that the rate of interest one had to pay on a mortgage was pegged to the prime lending rate. The borrowers debt would increase when rates rose, and decrease as rates declined. This feature was particularly attractive in the low-rate environment created by the Fed. As an added inducement, most sub-prime loans offered a low "teaser" rate for the first three years or so. It was a great deal: You didn't need any money down; you got a really low starter rate; and it appeared that the Fed wasn't going to raise rates any time soon, if ever. It must have seemed too good to be true.
In the 1980s, the big investment banks came up with a new option for bond issuers called the interest rate swap ( never reduced to abbreviation as those letters were already in use, and would not have been helpful for their sales staff ). This enabled bond issuers to exchange a fixed rate for a variable one. The investment banks are making a bet that they will benefit from future rates being favorable to them. If so, the swap will be profitable. If the market turns against them, they can take a loss.
The interest rate swap turns the bank from broker to interested party in the transaction, and thus exposes it to risk. Unfortunately for the banks, government regulation required that they keep sufficient assets in reserve against the possibility of losses. They had an option: They could take out a CDS ( credit default swap, essentially an insurance policy against investment losses ) in which case the insurer would then be obligated to maintain the required reserves. They found an insurance company willing to write such policies in AIG ( American Insurance Group ). The significance role that this company with deep links to the intelligence services would play in the crash will be discussed in later articles in this series.
There were those who recognized that the new sub-prime mortgages, and the bonds upon which they were based, would not be viable in the long term, and resolved to bet against them. The problem was that, unlike stocks, these bonds were impossible to short. One could buy a credit default swap against them but one needed to own the underlying bond in order to do so. One's potential gains from the insurance company's pay-off were offset by the need to buy the bond ( or tranches thereof ). As if by the intervention of Providence, the introduction of the "naked" credit default swap occurred thanks to the good offices of our friends over at J P Morgan Chase, a bank owned in part by the Rothschild banking dynasty, who would be the chief beneficiary of the stock market crash and subsequent bailout.
Naked, at least in the investment sense, means that one didn't own the bond or other financial instrument one was insuring. It's simply a wager one makes with an insurance company. If the bonds tank, you get paid, even though you don't own them. Like any insurance policy, you had to pay the premiums. So the question one had to answer is when you thought the housing market would disintegrate. Since the teaser rates for the variable-rate mortgages lasted three years, the likelihood of default was negligible until then. Thereafter, it depended upon the Fed and what it would do with the prime lending rate. As it happened, a coincidence I'm sure, Fed chief Alan Greenspan began raising rates just about three years after the sub-prime mortgage bonds hit the market.
These naked credit default swaps were approved by Greenspan, although now he expresses regret. Our government doesn't share the former Fed chief's remorse though, the Senate voted against a ban on these Las Vegas style wagers which were the "toxic assets" that brought the global economy to a lurching halt and drove tens of millions into unemployment and despair.[4]
The stage was now set. The Fed allowed these derivatives to enter the market and did nothing to regulate their exchange. Predictably, new mortgage lenders sprang up like weeds--Aames, Loomis, Greentree, The Money Store--and went public just as fast. Wall Street cashed in by buying these mortgages and selling them as bonds to their clients. When the housing market couldn't originate fast enough to slake Wall Street's inextinguishable thirst for loans for its new best-selling product, they replaced these first-generation sub-prime mortgage bonds with new MBS of ever-increasing complexity and vulnerability. The market kept turning because the major players were not exposed to risk. The lenders sold to Wall Street. Wall Street sold to the public or insurers. The people at risk were the mortgage borrowers, bond buyers, and the end-of-the-line insurers who were buying based on the evaluations of ratings agencies which were now owned, thanks to deregulation, by the banks who were making money hand-over-fist from selling these bonds.
Expecting, as Alan Greenspan now claims he did, that the market would police itself by refusing to deal in dubious investments, was expecting Wall Street to put ethics ahead of profit. Nobody is that stupid, not even Greenspan. These bonds were ticking, and thousands involved in their creation and distribution heard them tick. Nobody, or very few at least, were willing to call attention to the turd in the punchbowl when everybody was having such a good time at the party.
[1] Warren Buffet
[2] The subprime rate is linked to the prime lending rate, traditionally it's three points higher.
[3] collateralized debt obligation. This will be discussed in detail in an upcoming article.
[4] http://www.marketwatch.com/story/senate-rejects-ban-of-naked-credit-default-swaps-2010-05-18-211800
