Everybody is looking for a scapegoat. They can't choose the "bankers" because that is too close to the truth... so they must blame the relatively independent "mortgage brokers" for the financial fiasco.
What happened?
Simply put, the financial engineers in Wall Street firms packaged both mortgage and corporate debt into separate pools, added a hedging strategy which was supposed to mitigate any undue risk, submitted the derivatives package to the ratings agencies who rated the entire package as being "investment grade," which in turn allowed the Wall Street boys and girls to sell their packages to investors such as hedge funds, pension funds, mutual funds and other financial institutions and allowing them to pocket their multi-million bonuses in real dollars. Not promised dollars based on the performance of their products, but real commission dollars based on what others paid for these toxic packages.
The poison was widely spread...
Thus permeating the poison throughout the entire national and international financial community. And they did this over-and-over and over again until there was no going back -- and no accounting for what they had done.
The collapse...
The shell game collapsed when the ratings agencies no longer had confidence in the warranties and representations of those who packaged various debt instruments for sale and could not directly verify the underlying assets for themselves. The ratings agencies finally came to their senses and realized that their are two scenarios which defy risk hedging: one is if the underlying debt is based on fraud and is relatively worthless and the other is if no counterparty can be found to purchase the other side of the hedge. The ratings agencies began to issue downgrades of these financially-engineered products.
Whoops, we are screwed!
Leaving financial firms and their customers with billions of dollars of downgraded "investment grade" derivatives which not only were illiquid, but required the use of sophisticated mathematical pricing models for pricing. Assuming, of course, a willing buyer could be found.
Greed amplifies the situation...
Those who were purchasing these "investment grade" derivatives were already planning to "leverage" their investment by using borrowed funds to make their purchases. With little or no capital of their own at risk, toxic investments were purchased with OPM (Other People's Money) thus compounding the positive yield and insuring that any negative return would grow to avalanche proportions.
A closer look at Citi...
According to an article in the venerable Wall Street Journal...
"Citigroup's subprime exposure -- and source of its problems -- is found in two big buckets that together total $55 billion in its securities and banking unit, the bank said. The first bucket totals $11.7 billion, including securities tied to subprime loans that were being held, or warehoused, until they could be added to debt pools for investors. The second, totaling $43 billion, covers so-called super-senior securities.
These highly rated super-senior securities are portions of collateralized debt obligations, or CDOs. CDOs are repackaged pools of lower-rated securities backed by subprime loans into pieces with different levels of risk and return. Analysts estimate that $60 billion in such super-senior tranches are sitting on the books of banks, insurers and investment funds."
While some of Citi's problems can be linked to non-performing or fraudulent subprime mortgages, it is estimated that much of their losses were actually caused by highly-leveraged CDOs (Collateralized Debt Obligations) in which they allegedly took mortgage and corporate debt, layered them by risk and then formed them into synthetic securities to be sold at high margins. Citi, as well as many other firms, often kept the worst performing of the underlying security batches as very few buyers could be found for these high-risk/small yield tranches.
Mark-to-market...
Enter pesky regulations. Certain government accounting regulations demand you "mark-to-market," that is figure out what your portfolio is worth as if it were a liquid investment that could be sold today. No waiting for the loans to mature or any defaults to subside. The value right now. If these regulations had not been in place, the entire situation may have resolved itself instead of fomenting a major financial crisis. Yes, there would have been significant losses, but they probably wouldn't have been magnified by the financial panic that drove prices ever downward.
I want my money (or at least some of it) back now...
So when investors in the hedge funds or mutual funds or other investment pools saw a large loss developing, they demanded their money back. In essence a type of "bank run" where the financial institution is forced to liquidate what securities can be sold, borrow additional funds or go bankrupt.
Back to the Fed...
Which leaves us with the machinations of the Fed and the Treasury department trying to stave off a financial catastrophe that could potentially result in the demise of many name-brand firms.
For those who think there is a simple solution, that is to revalue the underlying assets of a derivative, the problem or unwinding these various derivative products may be next to impossible.
Unfortunately, this cannot be done because a single mortgage loan or a single commercial loan may have had their yields sliced and diced into various risk categories and the underlying transaction cannot be easily re-assembled to assess its value. An example: a mortgage loan yielding 6 percent may have been divided into a guaranteed 4 per cent yield and a the remainder turned into floating yield that depended on some price index. Each portion being sold in a different securities package that may have, yet again, been packed into an even larger investment package. All to be purchased by some schmuck who relied on the ratings agency and used borrowed funds to leverage up their profits.
So where are we now?
Everybody in the financial and political community and some large investors are demanding we save the "iconic" institutions who have perpetrated this debacle. We are at "crisis" time which demands a bailout lest those who are financially and politically connected suffer any personal consequences for their actions. This will probably be another case of corporate entities paying a fine without admitting guilt.
Where is the money that is required to solve this mess coming from?
Of course, it is you and I, the American taxpayer. And to a very, very, very small extent, those executives who made tens of millions of dollars in personal compensation. Which, knowing what they had produced, promptly placed their funds in hard assets, in real estate and tax-free municipal funds, to avoid increasing the impact of the meltdown on their "personal" fortunes. Even the heads of the big institutions that have resigned or who have been fired are walking away with fifty to one hundred million dollar or more parachutes.
So what are the government regulators going to do about this.
Instead of the "transparency" that they highly tout, they plan to obscure the "grand scheme" in an even more audacious maneuver. The are going to bundle the crap into a single package and sell it again to investors.
What? Yes, that's right -- they are going to wrap the whole stinking package in a bright new shiny wrapping and try to sell it all over again.
The government steps in...
It seem that Fed Chairman Bernanke and Treasury Secretary Paulson now had the same goals: to stabilize the United States financial markets and to bailout those who erred without too much disclosure to the average American taxpayer who will ultimately pay the price.
The Citibank Gambit?
The first response of the Fed was to solve the liquidity crisis. With nobody wanting to purchase toxic packages and the major financial firms unwilling to lend money to other firms and financial institutions, there were simply no funds to purchase new business -- no matter how good the borrower's credit. The economy was moving toward a standstill... unforgivable and damaging in the context of an upcoming election cycle.
While everybody in the media was concentrating on the cut in the Federal Funds target rate, almost nobody except the financial boys also noticed that the Fed also reduced the interest rate for borrowing at the "overnight window." Overnight was stretched into thirty-days or longer. And the Fed would accept mortgage loans as collateral for these overnight loans. Plus the rules on lending the money to subsidiaries was somewhat relaxed.
A perception problem...
Traditionally, those that borrowed at the "discount window" were impaired firms who could not meet their federally-mandated redemption liquidity ratio. Thus the whole financial world knew of their troubles. Followed by the exit of the large "brokered" from other institutions; deposits in excess of FDIC-insured limits... further compounding their liquidity problem into a downward spiral leading to merger or dissolution.
The Fed Gambit: How to overcome the perception of being a needy bank...
Even though the nation's four largest banks (Citigroup Inc., Bank of America Corp., JPMorgan Chase & Co. and Wachovia Corp.) claimed that they had access to money at cheaper rates, they also explained that the President of the New York Branch of the Federal Reserve had personally requested that the banks take a leadership role and use the Discount Window. So they borrowed $500 million each to ostensibly demonstrate that there is "no stigma" attached to borrowing such funds.
The "spin" apparently continued...
In published reports from Bloomberg and others...
"'These banks are all taking extraordinary and economically disadvantageous actions in order to help the Fed,'' said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. LLC in New York. 'The banks are also acting in their self interest by hoping their actions will contribute to stability in the financial system.'''
"Citibank, based in New York, said in a statement that it borrowed $500 million on behalf of unnamed clients even though it 'has substantial liquidity and widespread borrowing capacity.'''
The action of borrowing unneeded funds at higher rates, in and of itself, would be an indication of malfeasance as the stockholders were disadvantaged by management's actions.
But, was this song-and-dance a charade to channel money to the bank that needed it the most?
In retrospect, it now appears that one bank, Citibank, may have really needed the funds to maintain their liquidity and the other three banks, although hurting, weren't as desperate for cash.
While plans were being laid for a $100 BILLION bailout...
As reported in the Wall Street Journal...
"In a far-reaching response to the global credit crisis, Citigroup Inc. and other big banks are discussing a plan to pool together and financially back as much as $100 billion in shaky mortgage securities and other investments."
"The banks met three weeks ago in Washington at the Treasury Department, which convened the talks and is playing a central advisory role, people familiar with the situation said. The meeting was hosted by Treasury's undersecretary for domestic finance, Robert Steel, a former Goldman Sachs Group Inc. official and the top domestic finance adviser to Treasury Secretary Henry Paulson. The Federal Reserve has been kept informed but has left the active role to the Treasury."
Enter the "off balance sheet" structured vehicles...
While the Securities and Exchange Commission decried the lack of "transparency" in financial transactions, it quickly approved new rules (FAS Rule 140) allowing covered SPEs (Special Purpose Entities) to exist independent of the parent's balance sheet provided certain conditions were met. This dull, dry rule thus kept the bulk of the special purpose entities designed to deal with the deteriorating "structured investment vehicles" away from the prying eyes of the public and investors who may not have been sophisticated enough to realize that the risk assumed by the parent organization was ginormous compared to the parent's asset base.
Again, reported by the Wall Street Journal...
"Citigroup has nearly $100 billion in seven affiliated structured investment vehicles, or SIVs. Globally, SIVs had $400 billion in assets as of Aug. 28, according to Moody's."
"Such vehicles are formally independent of the banks that create them. They issue their own short-term debt, usually at relatively low interest rates reflecting their high credit rating. The vehicles use the money to buy higher-yielding longer-term assets such as securities tied to mortgages or receivables from midsize businesses seeking to raise cash."
Had the structured investment vehicles been displayed on the bank's balance sheet, the exposure would have been limited by the reactions of depositors, investors and the regulators. And now we find that the regulators are once again favoring obscurity over transparency.
Does this mean that the $100 BILLION fund is a Citi bailout?
Nobody really knows because details of the actual working of the alleged fund is a closely held secret between the officials at the Treasury Department and the participant banks themselves. What we do know is that the transparency which would allow investors to accurately assess a financial institution's underlying risk are now more murky than ever.
Are they approaching insolvency?
Again, nobody really knows. But the London Telegraph is reporting a curious story...
"The analyst who triggered the departure of Citigroup chairman and chief executive Charles "Chuck" Prince has called on his successors to break up the banking conglomerate."
"Ms Whitney's comments last week on the state of Citi's balance sheet sparked a $369bn (£177bn) fall in world markets and helped trigger an emergency meeting of the bank's board at the weekend at which Mr Prince tendered his resignation."
"Citi is the largest victim to date of the global credit crisis, announcing further write-downs of up to $11bn on top of $5.9bn revealed in the third quarter."
"Asked about the possibility of a Citi break-up, Ms Whitney, who received death threats following her comments last week, said: 'That's really the only thing they can do. They don't have the capital to manage it as an ongoing entity.'"
And why don't they fire the perpetrators instead of rewarding them with obscene compensation packages and even more obscene "exit" packages.
According to the New York Times...
"According to The New York Times, the soon-to-be former chairman and chief executive could leave with a minimum of $147.1 million for his four-year tenure. The wild card beyond any severance pay is his set of stock options — which currently have no market value, thanks to Citi’s low stock price."
"One development to watch out for is whether Mr. Prince’s departure is labeled a retirement, as was the exit of E. Stanley O’Neal from Merrill Lynch. Through that label, Mr. O’Neal was allowed to keep $161.5 million, or all of the pension and retirement benefits he had accrued during his 22-year career at Merrill, as well as some of his salary from this year. That is on top of the roughly $70 million he earned over the past five years."
Is it really "that bad?"
The good news is that there are still a substantial amount of real estate and corporate assets underlying the basic derivative products. Even foreclosed properties can be sold for lesser amounts to new buyers who are seeking a pricing opportunity. The actual loss is limited to the funds advanced (loan) minus the amount paid for the property and the costs of processing the foreclosure. A negative number in most instances, but mostly significant in large aggregated pools. According to the ratings agencies, the default ratios are not as staggering as the media would have you believe. The majority of the loss that will be incurred by the financial institutions and others who hold these derivatives in their portfolio can be attributed to their "leveraging" activities which will magnify an acceptable loss into a horrific loss because of the cost of the funds used to leverage the package.
But time is required for the workout. Had Orange County held its derivative investments instead of immediately declaring bankruptcy, they would have incurred a minor and acceptable loss.
The bottom fishers appear...
The game is by no means over. Purchasers with good funds will be treated to some spectacular profits as they buy asset pools at a substantial discount. These are the "operators" who always seem to make a profit on the back of other people's problems.
How is it going to end?
I honestly don't know and am not sufficiently connected to even project what the answer might be. This is one case where you need to rely on the regulators to do the right thing at the right time. The matter has grown beyond the ability and comprehension of most financial analysts to accurately assess the situation. We will have to wait and see.
But I do know one thing: it will be the American taxpayer who will, once again, be screwed by the politically-connected financial institutions.
What can YOU do?
Reconsider all of your investments using no-risk treasury bonds as your guideline. For those wanting some upside risk mitigated, use TIPS (Treasury Inflation Protected Securities) as your baseline. Ask yourself, whether or not each new investment's profit potential warrants the risk premium over a no-risk investment.
Plan a diversified portfolio so you are not extremely vulnerable to a downturn in the economy or when a number of investment sectors tank.
Engage a professional advisor who does not earn money from companies whose products they tout. Forget the fancy titles of "Account Executive," "Investment Specialist," etc. -- if they are paid a commission based on your purchases, they are sales people who more often than not, have their own best interests at heart. Never accept legal, accounting or other advice from someone who is not an experienced, licensed practitioner who must has a fiduciary responsibility to provide the best advice for your current and future situation.
Should someone flatter you as a "sophisticated investor," run, do not walk, away as fast as you can. It is the mark of a salesman offering a dubious investment.
Should someone of repute tout an investment, consider it carefully. A high-standing in the community or superb reputation is no guarantee that they have checked out the investment thoroughly and are not being conned themselves. They may have been given promotional stock or received preferential payments that are unavailable to later investors. The number of "name" businessmen and celebrities who have been conned is legion.
Consider switching out of mutual funds into ETFs (Exchange Traded Funds which can be found for almost all asset classes that can make-up a fairly sophisticated and diversified portfolio.
Do not patronize the large banks. Consider instead your local community bank or credit union.
Always structure your investments to stay under the government insurance guarantees (FDIC, NCUA) limits. These are federal funds backed by the full faith and credit of the United States government. Do not rely on any firm's supplemental insurance as they too can easily go out of business leaving you with nothing. Remember there is no federal guarantee for securities fraud. It is important to understand that SIPC is not the securities world equivalent of FDIC–the Federal Deposit Insurance Corporation.
Believe in the BBB (Better Business Bureau) slogan: "Investigate Before You Invest."
And most importantly, elect honest forthright public officials who will appoint diligent, knowledgeable and honest people to supervise the government institutions which protect your hard-earned money.
-- steve
A reminder from OneCitizenSpeaking.com: a large improvement can result from a small change…
The object in life is not to be on the side of the majority, but to escape finding oneself in the ranks of the insane. -- Marcus Aurelius
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the problem is some lazy bastards who dont want to work for a living have a printing press .which their croneys in the goverment who they bought off allow them to use .we work hard for years paying their interest to them in turn they milk us like fucking cows .why is interest always paid first on a home loan ?those bastard should be hung! bring back the greenback!!!
Posted by: banjojambo | April 07, 2008 at 04:41 PM
Finally someone who pins the tail on the real arse. Food here for days and days of dialogue and rumination.
The one characteristic that seems common from the bottom guy in St. Louis with with a subprime ARM to the top guy on Wall Street is greed. Everyone wanted more than they had and they wanted it immediately!
But you're right: investors and the entire investment sector are far more responsible both for the real estate run-up and for foreclosures than is commonly discussed in the media.
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Thank you for taking the time to read my blog and comment. You are correct in noting that almost everybody was part of a "cycle of greed" which produced a confluence of unintended and toxic effects. Along with big executive bonuses for those who everybody assumed were "in the know" and watching the shop. Again, thanks for your comment.
-- steve
Posted by: Amazonian | November 14, 2007 at 03:26 PM