http://intellectual-detox.com/2008/09/27/10-best-articles-about-the-financial-crisis/

http://www.aim.org/guest-column/the-cause-of-the-2008-financial-crisis/

The Cause of the 2008 Financial Crisis

BY JAMES F. DAVIS | OCTOBER 14, 2008

The facts are that approximately 6% of all mortgage loans in United States are in default.  Historically, defaults were less than one-third of that, i.e., from 0.25% to 2%.

A huge portion of the increased mortgage loan defaults are what are referred to as ‘sub-prime’ loans.  Most of the sub-prime loans have been made to borrowers with

poor credit ratings, no down payment on the home financed, and/or no verification of income or assets (Alt-A’s). close to 25% of sub-prime

and Alt-A’s loans are in default.

Why would banks make such risky loans?

The answer is that the Clinton administration pressured the banks to help poor people become homeowners, a noble liberal idea.  Also the Clinton Justice Department threatened banks with lawsuits and fines ($10,000 per application) for redlining (discrimination) if they did not make these loans. Also ACORN (Obama’s community service organization) was instrumental in providing borrowers and pressuring the banks to make these loans.

To allow Fannie Mae to make more loans, President Clinton also reduced Fannie Mae’s reserve requirement to 2.5%. That means it could purchase and/or guarantee $97.50 in mortgages for every $2.50 it had in equity to cover possible bad debts. If more than 2.5% of the loans go bad, the taxpayers (us) have to pay for them. That is what this bailout is all about. It is not the government paying the banks for the bad loans, it is us!!

Principally Senate Democrats demanded that Fannie Mae & Freddie Mac (FM&FM) buy more of these risky loans to help the poor.  Since the mortgages purchased and guaranteed by FM&FM are backed by the U.S. government, the loans were re-sold primarily to investment banks which in turn bundled most of them, taking a hefty fee, and sold the mortgages to investors all over the world as virtually risk free.

As long as the Federal Reserve (another government created agency) kept interest rates artificially low, monthly mortgage payments were low and housing prices went up. Many home owners got home equity loans to pay their first mortgages and credit card debt.

Unfortunately home prices peaked in the winter of 2005-06 and the house of cards started to crumble. People could no longer increase their mortgage debt to pay previous debts. Now, we taxpayers are being told we have to bail out the banks and everyone in the world who bought these highly risky loans. The politicians in Congress (mostly Democrats) do not want you to know they caused the mess.

During the past eight years, the Bush administration made 17 attempts to reform FM&FM, having been made aware by whistleblowers that the books had been cooked by Clinton appointees, James Johnson and Franklin Raines (most recently Barack Obama financial advisors) who gave large bonuses to themselves and other Clinton appointees by falsely showing huge profits.

Not surprisingly, virtually all the investment banks that are in trouble and being bailed out are run by financial supporters of Obama and other Democrats. Secretary of the Treasury Paulsen was head of Goldman Sachs. The new head of the $700 million bailout is also from Goldman Sachs. This is like letting the fox be in charge of hen house security.

Result

Taxpayer financed bailout should be reversed immediately as it will only encourage more irresponsible fraudulent behavior.

The Fed pumped money into the US economy and slashed its main interest rate - the Federal Funds rate - from 3.5% in August 2001 to a mere 1% by mid-2003. The Fed held this rate too low for too long.

Monetary expansion generally makes it easier to borrow, and lowers the costs of doing so, throughout the economy. It also tends to weaken the currency and increase inflation. All of this began to happen in the US.

The Fed's easy money policy is now stoking US inflation rather than a recovery. ... Yet the Fed, in its desperation to avoid a US recession, keeps pouring more money into the system, intensifying the inflationary pressures.

Having stoked a boom, now the Fed can't prevent at least a short-term decline in the US economy, and maybe worse. If it pushes too hard on continued monetary expansion, it won't prevent a bust but instead could create stagflation... The Fed should take care to prevent any breakdown of liquidity while keeping inflation under control and avoiding an unjustified taxpayer-financed bailout of risky bank loans. ...

Recent data make inflation less of a worry, though not completely absent, and I am not as sure as Sachs is that the Fed's unconventional policies steps, e.g. adjusting balance sheets, expanding lending facilities, etc., have not had any effect. We can't know for sure without rerunning the last several months absent the policy steps that have been taken to see how things would have been different, something we'd need a time machine to do, but I think it's safe to say that the Fed's actions have helped some financial firms avoid experiencing more severe problems, and the psychological effect - the perception that the Fed stands ready take action - is also important but hard to measure.

Going back to the question of who caused the crisis, Greenspan says, as usual, get off of it - it wasn't my, or the Fed's, fault:

Greenspan Stands His Ground, by Steven Mufson, Washington Post: ...The record of long-time Federal Reserve chairman Alan Greenspan -- worshipped by business leaders and dubbed "Maestro" in a 2000 biography by The Post's Bob Woodward -- is getting a critical look as his successor Ben S. Bernanke wrestles with problems that began on the Maestro's watch.

Many economists blame Greenspan for lax bank supervision and for keeping interest rates too low, too long from mid-2003 to mid-2004. ...

In an interview yesterday, Greenspan said the Fed wasn't to blame. He said that global forces beyond the control of the Federal Reserve had kept long-term interest rates low, fueling the housing bubble earlier this decade. "Those who argue that you can incrementally increase interest rates to defuse bubbles ought to try it some time," he said. "I don't know of a single example of when interest rate policy has been successful in suppressing gains in asset prices."

Regarding the current turmoil, Greenspan said that a market crisis was inevitable. "If it weren't the subprime crisis it would have been something else," he said. That is because an era was ending that had seen "disinflationary forces" from developing countries such as China and a "protracted period" in which there was an "underpricing of risk."

Not all economists are ready to let the former Fed chairman off so easily.

Lee Hoskins, former president of the Cleveland Fed and Fed chairman from 1987 to 1991, says that to find "partial causes" of the credit turmoil, "you have to go back to the Fed's decision to push the federal funds rate down to 1 percent and leave it there for over a year." ...

Greenspan says that the Fed was worried about "corrosive deflation" at the time and that he saw that as a greater threat to the U.S. economy than a housing bubble. "There was a real serious concern about deflation," he said yesterday. "If you look at the notes of the Open Market Committee, the pressures were to go lower than 1 percent. There were no dissents." Bernanke, a member of the Fed board at the time, was also concerned about deflation.

Greenspan also argues that while the Fed has a lot of power over short-term rates, it has less influence over long-term rates, which he asserted were more important to housing prices. ... He said that at the time "it became apparent that we lost control" of long-term interest rates "as did the Bank of England and all the central banks. As a consequence, we had very little ability to put a brake on the rise in home prices." ...

Others reviewing the Greenspan era at the Fed say there is a difference between the way Greenspan reacted during sharp sell-offs of stocks and the way he reacted to the technology and housing bubbles.

Kenneth Rogoff, a Harvard economics professor and former chief economist at the International Monetary Fund, says that "the important point . . . is the philosophy of monetary policy that says 'you don't pay attention to asset prices when they are rising, only when they are falling.' " In reality, Rogoff adds, "if you cut interest rates when asset prices are in free fall, then when asset prices are rising while indebtedness is rising all over country, you need to raise rates. He actively chose not to do that."

Other economists fault Greenspan for his failure to closely regulate big banks. Alan Blinder ... says that the delay in raising rates in 2003-04 was a "minor blemish" on Greenspan's "stellar" record managing monetary policy. But Blinder says that he would give the former chairman "poor marks" for bank supervision, another key role of the Fed. ...

"Lending standards were being horribly relaxed, and the Fed should have done something about that, not to mention about deceptive and in some cases fraudulent practices," Blinder said. ...

Examination of bank lending

Greenspan said that most of the subprime mortgages were originated by firms regulated by other agencies, but he adds, "In retrospect it was clearly a mistake" not to examine bank lending more closely. ...http://www.smartmoney.com/investing/stocks/good-as-gold-18980/

Good as Gold

"...In the absence of the gold standard, there is no way to protect savings from confiscation through inflation."

Twenty years later, Greenspan took control of the world's largest manufacturer of paper money — the Fed. The irony couldn't be more complete: There is no institution in the world more completely divorced from the gold standard. And by that point, the profession of economics had completely dismissed gold as an archaic artifact of a quaint bygone era, calling it (in Keynes's term) a "barbaric relic," and consigning it to the scrap heap of economic history.

But that didn't stop Greenspan. He didn't literally revive the gold standard. But he talked frequently about gold and other commodities as sensitive indicators of inflation risk. When the gold price rose,

Greenspan argued that the market was forecasting inflation — which is the decline in the value of the dollar vs. hard assets.

This view had two other friends on the Fed when Greenspan arrived in 1987. Fed Governors Manuel Johnson and Wayne Angell were both avid followers of gold and other commodity prices as inflation indicators.

Take a look at the chart below, covering the entire period of Greenspan's tenure as Fed chairman. The light blue line is the fed-funds rate, the key overnight interbank interest rate determined by Fed policy. The gold line is, of course, gold — the two-year moving average price.

Note that for the first half of Greenspan's tenure, the fed-funds rate closely tracked the moving average gold price. This means, simply, that whenever gold was in an intermediate-term rising trend, Greenspan was raising interest rates to head off the inflation that the gold price was warning about. When gold was in a falling trend, Greenspan lowered interest rates because gold was now warning of deflation.

This "virtual gold standard" helped Greenspan make some great decisions — which all the recent stories about his career have been at an utter loss to explain. For example, from late 1989 to early 1991, inflation was on the rise, with the consumer price index moving from 4% to 5.5%. But Greenspan was cutting interest rates during those years — because the two-year moving average price of gold was falling. And what do you know? Inflation ended up turning around and heading lower.

Greenspan abandoned his golden formula in early 1996, shortly after he gave his famous "irrational exuberance" speech and started worrying about the "wealth effect" created by elevated stock prices. The gold price started to fall in early 1997, and Greenspan responded by raising interest rates, in direct contradiction to his formula.

The result was an era of unprecedented turbulence in financial markets, starting with the Asian debt crisis, and then rolling into the Russian debt crisis, the collapse of Long Term Capital Management, the Nasdaq bubble-and-bust, and finally the monetary deflation that prompted Ben Bernanke in 2002 — when he was a Fed Governor — to talk about dropping money out of helicopters, if necessary, to right the economy.

In his last two years in office, Greenspan made the opposite mistake. With gold screaming higher, the Fed has kept interest rates too low for too long. I guarantee you that the result over the next several years will be a great deal more inflation than anyone expects now — and a lot more market turbulence.

I have no idea what prompted Greenspan to abandon his "virtual gold standard" when it had been such a winning formula for so many years. If Bernanke is reading these words, I invite him to consider this explanation of the Greenspan era at the Fed, and to put Greenspan's formula into service once again.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com.

Read more: Good as Gold - Investing - Stocks - SmartMoney.com http://www.smartmoney.com/investing/stocks/good-as-gold-18980/#ixzz1JtMIj1nS

Triple-A FailureBy ROGER LOWENSTEINThe Ratings GameIn 1996, Thomas Friedman, the New York Times columnist, remarked on “The NewsHour With Jim Lehrer” that there were two superpowers in the world — the United States andMoody’s bond-rating service — and it was sometimes unclear which was more powerful. Moody’s was then a private company that rated corporate bonds, but it was, already, spreading its wings into the exotic business of rating securities backed by pools of residential mortgages.Obscure and dry-seeming as it was, this business offered a certain magic. The magic consisted of turning risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans. To get why this is impressive, you have to think about all that determines whether a mortgage is safe. Who owns the property? What is his or her income? Bundle hundreds of mortgages into a single security and the questions multiply; no investor could begin to answer them. But suppose the security had a rating. If it were rated triple-A by a firm like Moody’s, then the investor could forget about the underlying mortgages. He wouldn’t need to know what properties were in the pool, only that the pool was triple-A — it was just as safe, in theory, as other triple-A securities.Over the last decade, Moody’s and its two principal competitors,

Standard & Poor’s and Fitch, played this game to perfection —

putting what amounted to gold seals on mortgage securities that investors swept up with increasing élan. For the rating agencies, this business was extremely lucrative. Their profits surged, Moody’s in particular: it went public, saw its stock increase sixfold and its earnings grow by 900 percent.By providing the mortgage industry with an entree to Wall Street, the agencies also transformed what had been among the sleepiest corners of finance. No longer did mortgage banks have to wait 10 or 20 or 30 years to get their money back from homeowners. Now they sold their loans into securitized pools and — their capital thus replenished — wrote new loans at a much quicker pace.Mortgage volume surged; in 2006, it topped $2.5 trillion. Also, many more mortgages were issued to risky subprime borrowers. Almost all of those subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street.

But who was evaluating these securities? Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating.Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody’s and Standard & Poor’s that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.In the wake of the housing collapse, Congress is exploring why the industry failed and whether it should be revamped (hearings in the Senate Banking Committee were expected to begin April 22). Two key questions are whether the credit agencies — which benefit from a unique series of government charters — enjoy too much official protection and whether their judgment was tainted. Presumably to forestall criticism and possible legislation, Moody’s and S.&P. have announced reforms. But they reject the notion that they should have been more vigilant. Instead, they lay the blame on the mortgage holders who turned out to be deadbeats, many of whom lied to obtain their loans.Arthur Levitt, the former chairman of the Securities and Exchange Commission, charges that “the credit-rating agencies suffer from a conflict of interest — perceived and apparent — that may have distorted their judgment, especially when it came to complex structured financial products.” Frank Partnoy, a professor at the University of San Diego School of Law who has written extensively about the credit-rating industry, says that the conflict is a serious problem. Thanks to the industry’s close relationship with the banks whose securities it rates, Partnoy says, the agencies have behaved less like gatekeepers than gate openers. Last year, Moody’s had to downgrade more than 5,000 mortgage securities — a tacit acknowledgment that the mortgage bubble was abetted by its overly generous ratings. Mortgage securities rated by Standard & Poor’s and Fitch have suffered a similar wave of downgrades.Presto! How 2,393 Subprime Loans Become a High-Grade InvestmentThe business of assigning a rating to a mortgage security is a complicated affair, and Moody’s recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper. Moody’s was fair-minded in choosing an example; the case they showed me, which they masked with the name “Subprime XYZ,” was a pool of 2,393 mortgages with a total face value of $430 million.Subprime XYZ typified the exuberance of the age. All the mortgages in the pool were subprime — that is, they had been extended to borrowers with checkered credit histories. In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.Moody’s did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications. “We aren’t loan officers,” Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody’s, told me. “Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?”The loans in Subprime XYZ were issued in early spring 2006 — what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody’s identified as a “nonbank lender.” Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody’s.Moody’s assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers’ credit histories and much else that might, at very least, have given Moody’s pause. Three-quarters of the

borrowers had adjustable-rate mortgages, or ARMs — “teaser” loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble — lending on the belief, or the hope, that new money will bail out the old.Moody’s learned that almost half of these borrowers — 43 percent — did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.On the plus side, Moody’s noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. “That was a comfort feeling,” Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, “You’ll give up your ski chalet first.”Another factor giving Moody’s comfort was that all of the ARM loans in the pool were first mortgages (as distinct from, say, home-equity loans). Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property’s presumed resale value, which meant the borrowers had not a cent of equity.In the frenetic, deal-happy climate of 2006, the Moody’s analyst had only a single day to process the credit data from the bank. The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle — a ghost corporation with no people or furniture and no assets either until the deal was struck — would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody’s was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank’s point of view, the key to the deal was obtaining a triple-A rating — without which the deal wouldn’t be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. “People say, ‘How can you create triple-A out of B-rated paper?’ ” notes Arturo Cifuentes, a former Moody’s credit analyst who now designs credit instruments. It may seem like a scam, but it’s not.The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses.It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody’s to classify them as triple-A. Imagine a seaside condo beset by flooding: just as the penthouse will not get wet until the lower floors are thoroughly soaked, so the triple-A bonds would not lose a dime unless the lower credits were wiped out.Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. “Everyone assumed the credit agencies knew what they were doing,” says Joseph Mason, a credit expert at Drexel University. “A structural engineer can predict what load a steel support will bear; in financial engineering we can’t predict as well.”Mortgage-backed securities like those in Subprime XYZ were not the terminus of the great mortgage machine. They were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.’s. C.D.O.’s were financed with similar ladders of bonds, from triple-A on down, and the credit-rating agencies’ role was just as central. The difference is that XYZ was a first-order derivative — its assets included real mortgages owned by actual homeowners. C.D.O.’s were a step removed — instead of buying mortgages, they bought bonds that were backed by mortgages, like the bonds issued by Subprime XYZ. (It is painful to consider, but there were also third-order instruments, known as C.D.O.’s squared, which bought bonds issued by other C.D.O.’s.)

Miscalculations that were damaging at the level of Subprime XYZ were devastating at the C.D.O. level. Just as bad weather will cause more serious delays to travelers with multiple flights, so, if the underlying mortgage bonds were misrated, the trouble was compounded in the case of the C.D.O.’s that purchased them.Moody’s used statistical models to assess C.D.O.’s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.’s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, “There was a large failure of common sense” by rating agencies and also by banks like his. “Very complex securities shouldn’t have been rated as if they were easy-to-value bonds.”

The Accidental Watchdog

John Moody, a Wall Street analyst and former errand runner, hit on the idea of synthesizing all kinds of credit information into a single rating in 1909, when he published the manual “Moody’s Analyses of Railroad Investments.” The idea caught on with investors, who subscribed to his service, and by the mid-’20s, Moody’s faced three competitors: Standard Statistics and Poor’s Publishing (which later merged) and Fitch.

Then as now, Moody’s graded bonds on a scale with 21 steps, from Aaa to C. (There are small differences in the agencies’ nomenclatures, just as a grande latte at Starbucks becomes a “medium” at Peet’s. At Moody’s, ratings that start with the letter “A” carry minimal to low credit risk; those starting with “B” carry moderate to high risk; and “C” ratings denote bonds in poor standing or actual default.) The ratings are meant to be an estimate of probabilities, not a buy or sell recommendation. For instance, Ba bonds default far more often than triple-As. But Moody’s, as it is wont to remind people, is not in the business of advising investors whether to buy Ba’s; it merely publishes a rating.

Until the 1970s, its business grew slowly. But several trends coalesced to speed it up. The first was the collapse of Penn Central in 1970 — a shattering event that the credit agencies failed to foresee. It so unnerved investors that they began to pay more attention to credit risk.

Government responded. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody’s 10 top grades). This prompted a question: investment

grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three — S.&P., Moody’s and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies.

Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed. Over the ’80s and ’90s, a latticework of such rules redefined credit markets. Many classes of investors were now forbidden to buy noninvestment-grade bonds at all.

Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies — realizing they had a hot product and, what’s more, a captive market — started charging the very organizations whose bonds they were rating. This was an efficient way to do business, but it put the agencies in a conflicted position. As Partnoy says, rather than selling opinions to investors, the rating agencies were now selling “licenses” to borrowers. Indeed, whether their opinions were accurate no longer mattered so much. Just as a police officer stopping a motorist will want to see his license but not inquire how well he did on his road test, it was the rating — not its accuracy — that mattered to Wall Street.

The case of Enron is illustrative. Throughout the summer and fall of 2001, even though its credit was rapidly deteriorating, the rating agencies kept it at investment grade. This was not unusual; the agencies typically lag behind the news. On Nov. 28, 2001, S.&P. finally dropped Enron’s bonds to subinvestment grade. Although its action merely validated the market consensus, it caused the stock to collapse. To investors, S.&P.’s action was a signal that Enron was locked out of credit markets; it had lost its “license” to borrow. Four days later it filed for bankruptcy.

Another trend that spurred the agencies’ growth was that more companies began borrowing in bond markets instead of from banks. According to Chris Mahoney, a just-retired Moody’s veteran of 22 years, “The agencies went from being obscure and unimportant players to central ones.”

A Conflict of Interest?

Nothing sent the agencies into high gear as much as the development of structured finance. As Wall Street bankers designed ever more securitized products — using mortgages, credit-card debt, car loans, corporate debt, every type of paper imaginable — the agencies became truly powerful.

In structured-credit vehicles like Subprime XYZ, the agencies played a much more pivotal role than they had with (conventional) bonds. According to Lewis Ranieri, the Salomon Brothers banker who was a pioneer in mortgage bonds, “The whole creation of mortgage securities was involved with a rating.”

What the bankers in these deals are really doing is buying a bunch of I.O.U.’s and repackaging them in a different form. Something has to make the package worth — or seem to be worth — more that the sum of its parts, otherwise there would be no point in packaging such securities, nor would there be any profits from which to pay the bankers’ fees.

That something is the rating. Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails. As with a would-be immigrant traveling from Mexico, there is a huge incentive to get over the line.

The challenge to investment banks is to design securities that just meet the rating agencies’ tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money comes into the pool and is available for paying bond interest. But if the mortgages are too risky, Moody’s will object. Banks are adroit at working the system, and pools like Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over the border. “Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,” a former Moody’s expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, “Gaming is the whole thing.”

When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an “enhancement.” The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank’s profits). It’s

up to the agency to make sure that the cushion is big enough to safeguard the bonds. The process involves extended consultations between the agency and its client. In short, obtaining a rating is a collaborative process.

The evidence on whether rating agencies bend to the bankers’ will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them. For instance, they do not reward analysts on the basis of whether they approve deals. No smoking gun, no conspiratorial e-mail message, has surfaced to suggest that they are lying. But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody’s has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody’s $200,000 and more for complicated deals. And the banks pay only if Moody’s delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody’s through the mid-’90s, says this arrangement is unhealthy. If Moody’s and a client bank don’t see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as “ratings shopping.”

And it seems to have helped the banks get better ratings. Mason, of Drexel University, compared default rates for corporate bonds rated Baa with those of similarly rated collateralized debt obligations until 2005 (before the bubble burst). Mason found that the C.D.O.’s defaulted eight times as often. One interpretation of the data is that Moody’s was far less discerning when the client was a Wall Street securitizer.

After Enron blew up, Congress ordered the S.E.C. to look at the rating industry and possibly reform it. The S.E.C. ducked. Congress looked again in 2006 and enacted a law making it easier for competing agencies to gain official recognition, but didn’t change the industry’s business model. By then, the mortgage boom was in high gear. From 2002 to 2006, Moody’s profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance. In 2006, Moody’s reported net income of $750 million. Raymond W. McDaniel Jr., its chief executive, gloated in the annual report for that year, “I firmly believe that Moody’s business stands on the ‘right side of

history’ in terms of the alignment of our role and function with advancements in global capital markets.”

Using Weather in Antarctica To Forecast Conditions in Hawaii

Even as McDaniel was crowing, it was clear in some corners of Wall Street that the mortgage market was headed for trouble. The housing industry was cooling off fast. James Kragenbring, a money manager with Advantus Capital Management, complained to the agencies as early as 2005 that their ratings were too generous. A report from the hedge fund of John Paulsonproclaimed astonishment at “the mispricing of these securities.” He started betting that mortgage debt would crash.

Even Mark Zandi, the very visible economist at Moody’s forecasting division (which is separate from the ratings side), was worried about the chilling crosswinds blowing in credit markets. In a report published in May 2006, he noted that consumer borrowing had soared, household debt was at a record and a fifth of such debt was classified as subprime. At the same time, loan officers were loosening underwriting standards and easing rates to offer still more loans. Zandi fretted about the “razor-thin” level of homeowners’ equity, the avalanche of teaser mortgages and the $750 billion of mortgages he judged to be at risk. Zandi concluded, “The environment feels increasingly ripe for some type of financial event.”

A month after Zandi’s report, Moody’s rated Subprime XYZ. The analyst on the deal also had concerns. Moody’s was aware that mortgage standards had been deteriorating, and it had been demanding more of a cushion in such pools. Nonetheless, its credit-rating model continued to envision rising home values. Largely for that reason, the analyst forecast losses for XYZ at only 4.9 percent of the underlying mortgage pool. Since even the lowest-rated bonds in XYZ would be covered up to a loss level of 7.25 percent, the bonds seemed safe.

XYZ now became the responsibility of a Moody’s team that monitors securities and changes the ratings if need be (the analyst moved on to rate a new deal). Almost immediately, the team noticed a problem. Usually, people who finance a home stay current on their payments for at least a while. But a sliver of folks in XYZ fell behind within 90 days of signing their papers.

After six months, an alarming 6 percent of the mortgages were seriously delinquent. (Historically, it is rare for more than 1 percent of mortgages at that stage to be delinquent.)

Moody’s monitors began to make inquiries with the lender and were shocked by what they heard. Some properties lacked sod or landscaping, and keys remained in the mailbox; the buyers had never moved in. The implication was that people had bought homes on spec: as the housing market turned, the buyers walked.

By the spring of 2007, 13 percent of Subprime XYZ was delinquent — and it was worsening by the month. XYZ was hardly atypical; the entire class of 2006 was performing terribly. (The class of 2007 would turn out to be even worse.)

In April 2007, Moody’s announced it was revising the model it used to evaluate subprime mortgages. It noted that the model “was first introduced in 2002. Since then, the mortgage market has evolved considerably.” This was a rather stunning admission; its model had been based on a world that no longer existed.

Poring over the data, Moody’s discovered that the size of people’s first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans — that is, their total debt — combined. This was rather intuitive; Moody’s simply hadn’t reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a “strong predictor” of defaults this time. Translation: even people with good credit scores were defaulting. Amy Tobey, leader of the team that monitored XYZ, told me, “It seems there was a shift in mentality; people are treating homes as investment assets.” Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them. Homeowners’ equity had never been as high as believed because appraisals had been inflated.

Over the summer and fall of 2007, Moody’s and the other agencies repeatedly tightened their methodology for rating mortgage securities, but it was too late. They had to downgrade tens of billions of dollars of securities. By early this year, when I met with Moody’s, an astonishing 27 percent of the mortgage holders in Subprime XYZ were delinquent. Losses on the pool

were now estimated at 14 percent to 16 percent — three times the original estimate. Seemingly high-quality bonds rated A3 by Moody’s had been downgraded five notches to Ba2, as had the other bonds in the pool aside from its triple-A’s.

The pain didn’t stop there. Many of the lower-rated bonds issued by XYZ, and by mortgage pools like it, were purchased by C.D.O.’s, the second-order mortgage vehicles, which were eager to buy lower-rated mortgage paper because it paid a higher yield. As the agencies endowed C.D.O. securities with triple-A ratings, demand for them was red hot. Much of it was from global investors who knew nothing about the U.S. mortgage market. In 2006 and 2007, the banks created more than $200 billion of C.D.O.’s backed by lower-rated mortgage paper. Moody’s assigned a different team to rate C.D.O.’s. This team knew far less about the underlying mortgages than did the committee that evaluated Subprime XYZ. In fact, Moody’s rated C.D.O.’s without knowing which bonds the pool would buy.

A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does so. Thus, the agencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the C.D.O. manager’s discretion.

Late in 2006, Moody’s rated a C.D.O. with $750 million worth of securities. The covenants, which act as a template, restricted the C.D.O. to, at most, an 80 percent exposure to subprime assets, and many other such conditions. “We’re structure experts,” Yuri Yoshizawa, the head of Moody’s’ derivative group, explained. “We’re not underlying-asset experts.” They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral.

Moody’s rated three-quarters of this C.D.O.’s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation — as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren’t like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody’s structured-finance division, remarks, it was “like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.” And second, the

bonds weren’t random. Moody’s had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.

Moody’s estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent. The bonds it rated have been decimated, their market value having plunged by half or more. A triple-A layer of bonds has been downgraded 16 notches, all the way to B. Hundreds of C.D.O.’s have suffered similar fates (most of Wall Street’s losses have been on C.D.O.’s). For Moody’s and the other rating agencies, it has been an extraordinary rout.

Whom Can We Rely On?

The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody’s, S.&P. and Fitch say that they are tightening procedures — they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model. Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.

Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves — not farm the job out to Moody’s. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody’s itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not “rely” on ratings for buy-and-sell decisions.

This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess

vehicles in the future. Vickie Tillman, the executive vice president of S.&P., told Congress last fall that in addition to the housing slump, “ahistorical behavorial modes” by homeowners were to blame for the wave of downgrades. She cited S.&P.’s data going back to the 1970s, as if consumers were at fault for not living up to the past. The real problem is that the agencies’ mathematical formulas look backward while life is lived forward. That is unlikely to change.

Roger Lowenstein, a contributing writer, last wrote for the magazine about the Federal Reserve chief, Ben Bernanke. His new book, “WhileAmerica Aged,” will be published next month.

http://www.signallake.com/innovation/FedReserve1995.pdf

The banking system in the US is a fractional reserve central banking system. One canread about this in more detail at the link supplied but the gist is that banks are required tokeep a fraction of their assets on hand, deposited safely at the Fed, to act as a "cashcushion'' at times when depositors demand their money from the bank as cash. This cashreserve is in proportion to the amount of depositors' money that is loaned out. Theproportion of this cash reserve to the total amount loaned out is intended to provide justenough of a buffer to keep the bank solvent and keep things running smoothly in theevent a lot of depositors make demands for cash at once, such as during a run on thebank. This fraction, called the reserve fraction (or ratio), is typically from 5% to 20% ofthe amount of money the bank has loaned out. This may seem low, but holding any morecash in reserve than is needed except for outlier cases is considered an uneconomical useof capital by a bank. The cash in reserve is not making money for either the bank or itsdepositors as loans, so from a day-to-day operations persective, the less reserves thebetter. From a longer term risk management perspective, the more the better. Statistically,5% to 20% reserves is the "right" amount, except in those outlier cases where these levelsare either too high because reserves at those levels are at some times constraining theeconomy's access to credit or, conversely, too low at other times because too manydepositors are making a rush to liquidity and demanding their cash.

The reserve fraction, considered as a number that is mutable as a matter of policy, is also one of the most powerful tools a central bank can use to adjust the amount of money available to the economy. It is easy to see why: a reserve requirement of 10% means that banks can lend out ten times the actual money on deposit with the fed. Even a seemingly small change from, say, 2% to 8% means that 12.5 times the money on deposit can be lent out. For example, $10bln initially on deposit with a 10%, reserve requirement results

in approximately $100bln of money available as loans. If the reserve fraction is reduced from 10% to 8%, the for the same $10bln cash on deposit there can be approximately $125bln of money available as loans in the economy. This is an incre

The key event that happened around 1995 is that the fractional reserve ratio was not only lowered, it was effectively eliminated entirely. You read that right. The net result of changes during that period is that banks are not required to back assets which largely correspond to M3 or "broad money'' with cash reserves. As a consequence, banks can effectively create money without limitation. I know that sounds hard to believe, but let's look at the factPredictably, when these changes were made, total cash reserves in the banking system

dropped sharply. The economy liquefied nicely, and we came out of the recession relatively quickly, just not fast enough to save Bush Senior's hide.

Securitization of Mortgages 

.         Securitization reduces the risk of the underlying assets. Consider a random selection of mortgages.  Firms in the mortgage business know from experience that a certain percentage of mortgages will experience payment difficulties such as late payments or even defaults.  The problem is that firms can't identify in advance exactly which mortgages will become problematic.   Thus, the riskiness of a given mortgage is difficult to ascertain. 

.          Securitization eliminates that uncertainty and allows the risk to be priced through higher interest rates. 

.         Pooling together a random selection of mortgages, firms can reduce the overall risk they face since the risk of the pool will approximate the average payment difficulties known from experience.  By charging a higher interest rate, securities issuers can be compensated for the expected losses. 

.         This is how Fannie Mae and Freddy Mac expand the depth and breadth of mortgage markets, increasing the likelihood that low income and underserved customers would obtain credit by expanding competition and volume in mortgage markets.  Both entities buy individual mortgages from mortgage lenders, then securitize them for sale in the secondary mortgage market.  This activity brings in funding from investors - both US and foreign - who wouldn't buy individual mortgages, but will buy mortgage-backed securities.  This is especially the case when the securities are issued by government-sponsored enterprises like Fannie Mae and Freddie Mac with their implicit government guarantees.  The net result is more funding for mortgages across the board. 

.         By the end of 2008,the US mortgage market had $14.6 trillion outstandin of which $7.6 trillion was mortgage-backed securities, including $5 trillion held or guaranteed by Fannie May and Freddie Mac, and $2.6 trillion in held by private entities.  An additional $5 trillion was held as individual mortgages by commercial banks, thrifts and life insurance companies. 

Regards, 

Umair Asif 

Credit default swaps are financial instruments that serve to protect against a default by a particular bond or security. They were invented by Wall Street in the late 1990s as a form of insurance. Between 2000 and 2008, the market for such swaps ballooned from $900 billion to more than $30 trillion. In sharp contrast to traditional insurance, swaps are totally unregulated. They played a pivotal role in the global financial meltdown in late 2008. More recently, swaps have emerged as one of the most powerful and mysterious forces in the crisis shaking Greece and other members of the euro zone.

In May 2010,the German financial regulator, BaFin, enacted a ban on so-called "naked short selling" of credit-default swaps on euro zone government bonds, meaning investors would not be allowed to bet against the government being able to repay its debt unless they actually owned the underlying bonds.

The financial regulatory reform bill passed by the Senate in May includes a provision that would force some of the biggest banks to spin off their trading in swaps, the most lucrative part of the derivatives business, into separate subsidiaries, or be denied access to the Fed's emergency lending window. The measure is bitterly opposed by the banks and is not supported by the Obama administration; the House version contains no such provision.

The original purpose of swaps was to make it easier for banks to issue complex debt securities by reducing the risk to purchasers. It is similiar to the way the insurance a movie producer takes out on a wayward star makes it easier to raise money for the star's next picture. Here is a more detailed but still simplified explanation of how they work, given by Michael Lewitt, a Florida money manager, in a New York Times Op-Ed piece on Sept. 16, 2008:

"Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss. The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small. As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized."

Swaps proved to be very profitable — in the short term. Banks and other companies that issued them earned fees for insuring events they thought would never happen, like the bottom falling out of the market for mortgage-backed securities. As a result, the losses produced by the end of the housing bubble were multiplied manyfold, as the issuers of swaps found themselves faced with huge liabilities they had not prepared for. It was this cycle that brought down the American International Group, the insurance giant, which eventually needed $180 billion in taxpayer support.

Swaps also became something traded in and of themselves, as a form of speculation. That kind of trading also landed investment banks in multiple and seemingly conflicted roles, as when Goldman Sachs helped sell bundles of mortgage-backed securities and then used swaps to bet that they would go belly up.

The role of banks like Goldman also became the focus of criticism as Greece, Spain and other southern European countries found themselves facing a debt crisis. Over the last decade, Goldman and others helped the Greek government legally mask its debts so the nation appeared to comply with budget rules governing its membership in the euro, Europe's common currency. In that role, Goldman advised Greece and, in return, collected hundreds of millions of dollars in fees from Athens.

But, just as the true extent of Greece debts began to worry investors, Goldman put on another hat. Last July, it sent clients a 48-page primer on credit-default swaps entitled "C.D.S. 101." The report said that credit-default swaps enabled investors "to short credit easily" — that is, to bet against certain borrowers. The report made no mention of Greece. But its disclosure in March 2010 fueled the suspicions of European officials who have called for investigations into the role swaps have played in the current crisis.

.......................................................................................................................................

2008 Financial Crisis

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Contents

1 Companies Involved

o 1.1 US Investment Banks

o 1.2 US Retail Banks

o 1.3 European Banks

o 1.4 Mortgage Lenders

2 Precursors to the Credit Crisis

o 2.1 The Rise and Fall of the Housing

Market and its Impact on the U.S.

Financial System

o 2.2 Subprime Lending

o 2.3 Deregulation in the banking

industry

o 2.4 Credit Ratings Agencies mis-rate

mortgage securities

o 2.5 Structured Products Spread

Subprime Debt Throughout the

Financial System

3 Federal Government Bailout

o 3.1 The Bailout Bill

4 International Involvement

o 4.1 Europe

4.1.1 Government Intervention

in European Markets

4.1.2 UK Leads Government

Effort to Purchase Bank Stocks

4.1.3 European Central Bank

o 4.2 Russia

o 4.3 Asia

o 4.4 Middle East

o 4.5 Pakistan

5 Implications of the Crisis

RELATED WIKI ARTICLES

Investment Banks

Credit Crunch (definition)

2007 Credit Crunch

Troubled Assets Relief Program (TARP)

Oil

more ▼

WIKI ANALYSISThis article describes a concept which could impact a variety of companies, countries or industries. To see what companies and articles reference this concept page, click here.

 

TOP CONTRIBUTORS

Vernon Beckford

Jack Houlgate

Patrick Cushing

This article details the fallout within the Financial industry in 2008. For a definition of the term "credit crunch," see  Credit Crunch

(definition). For information on the 2007 Credit Crunch, see 2007 Credit Crunch

In 2008, a series of bank and insurance company failures triggered a financial crisis that effectively halted global credit markets

and required unprecedented government intervention. Fannie Mae (FNM) and Freddie Mac (FRE) were both taken over by the

government. Lehman Brothers declared bankruptcy on September 14th after failing to find a buyer. Bank of America agreed to

purchase Merrill Lynch (MER), and American International Group (AIG) was saved by an $85 billion capital injection by

the federal government.[1] Shortly after, on September 25th, J P Morgan Chase (JPM) agreed to purchase the assets

of Washington Mutual (WM) in what was the biggest bank failure in history.[2] In fact, by September 17, 2008, more public

corporations had filed for bankruptcy in the U.S. than in all of 2007. [3] These failures caused a crisis of confidence that made

banks reluctant to lend money amongst themselves, or for that matter, to anyone.

The crisis has its roots in real estate and the subprime lending crisis. Commercial and residential properties saw their values

increase precipitously in a real estate boom that began in the 1990s and increased uninterrupted for nearly a decade.

Increases in housing prices coincided with the investment and banking industry lowering lending standards to market

mortgages to unqualified buyers allowing them to take out mortgages while at the same time government deregulation blended

the lines between traditional investment banks and mortgage lenders. Real estate loans were spread throughout the financial

system in the form of CDOs and other complex derivatives in order to disperse risk; however, when home values failed to rise

and home owners failed to keep up with their payments, banks were forced to acknowledge huge  write downs and write offs on

these products. These write downs found several institutions at the brink of insolvency with many being forced to raise capital

or go bankrupt.

Companies Involved

US Investment Banks

Goldman Sachs

Morgan Stanley

Merrill Lynch

Lehman Brothers

Bear Stearns

US Retail Banks

Citigroup

Wachovia Bank

Washington Mutual

Bank of America

Wells Fargo

European Banks

UBS

Credit Suisse

Deutsche Bank

Royal Bank of Scotland

HBOS

ING

Fortis (FORB-BT)

Northern Rock

Mortgage Lenders

Fannie Mae

Freddie Mac

Precursors to the Credit Crisis

The Rise and Fall of the Housing Market and its Impact on the U.S. Financial System 

For 50 years after WWII, the U.S. housing market grew steadily with just a few set backs as prices increased. The government

policies during this era had their roots in the agencies and government entities created in reaction to the massive mortgage

foreclosures that occurred during the great depression. During 1930's Great Depression the US had experienced a greater

mortgage crisis than the one we are experiencing now. In 1933, about half of mortgage debt was in default, the unemployment

rate had reached about 25 percent. Thousands of banks and savings and loans had failed. The amount of annual mortgage

lending had dropped about 80 percent, as had private residential construction. States were enacting moratoriums on

foreclosures. In response to this, the Home Owners Lending Corporation (HOLC) was created in 1933. The average borrower

that the HOLC eventually refinanced was two years' delinquent on the original mortgage and about three years behind on

property taxes. The HOLC was a created to handle the immediate problem of mortgage foreclosures. Congress created the

Federal Housing Administration (FHA) in 1933 as a long term solution for stabilizing and managing the housing market and it

chartered Fannie Mae in 1938 to facilitate the home mortgage lending market. In the post WWII era government policies

continued to encourage homeownership. Primary among these policies to facilitate home lending was establishment of two

Government Sponsored Enterprises (GSEs). The U.S. Federal Government chartered two leading mortgage

institutions crisis, Fannie Mae (created as a government agency in 1938) which was charted as a private corporation in 1968

and Freddie Mac 1970.[4] [[1]]

Fannie Mae operates in the U.S. secondary mortgage market. Rather than making home loans directly with consumers, Fannie

works with mortgage bankers, brokers, and other primary mortgage market partners to help ensure they have funds to lend to

home buyers at affordable rates. Fannie funds its mortgage investments primarily by issuing debt securities in the domestic and

international capital markets. Freddie Mac was charted by Congress in 1970 by the “Federal Home Loan Mortgage Corporation

Act.” Freddie Mac's purpose is: (1) to provide stability in the secondary market for residential mortgages; (2) to respond

appropriately to the private capital market; (3) to provide ongoing assistance to the secondary market for residential mortgages

(including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic

return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and

improving the distribution of investment capital available for residential mortgage financing; and (4) to promote access to

mortgage credit throughout the Nation (including central cities, rural areas, and underserved areas) by increasing the liquidity of

mortgage investments and improving the distribution of investment capital available for residential mortgage financing. [[2]]

In the 1990s Congress urged the GSEs, particularly Fannie and Freddie, to acquire loans made to borrowers that were

considered a bit more risky. By doing this it was hoped than an additional 3% of borrowers could qualify for a Fannie and

Freddie loan. The objective was to take home ownership in the US from 66% of the populace to 70%. [5] Originally backed by

the Democrats and the Clinton Administration this goal was further embraced by the Bush Administration which continually

emphasized that we were now an "Ownership Society". The Fed (under Alan Greenspan) abetted the availability of cheap

money in the 2003-2006 time-frame by keeping the Fed Funds rate relatively low. As this environment developed, it should be

noted that the foreclosure rate on a conforming Fannie and Freddie insured loan barely increased. Fannie and Freddie’s impact

on the financial market was significant. As they acquired more and more mortgages, they increased the securitization of the

mortgages into AAA rated mortgage backed securities (MBS). The cash received from this securitization was used to support

the purchase of even more mortgages, and more MBS. By the end of 2008 Fannie and Freddie held or guaranteed 5 trillion or

about half the US mortgage market.

The market for debt securitization was massive and the investment banking community (Goldman Sachs, Bear Stearns,

Lehmann Brothers, Citicorp, Merrill Lynch) was competing hard with the GSE’s. The investment bankers believed that

securitization reflects innovation in the financial markets at its best. Pooling assets and using the cash flows to back securities

allows originators to unlock the value of illiquid assets and provide consumers lower borrowing costs at the same time. MBS

and ABS securities offer investors with an array of high quality fixed-income products with attractive yields. The popularity of

this market among issuers and investors has grown dramatically since its inception 30 years ago to $6.6 trillion in outstanding

MBS/ABS in 2003. By 2008 it was at 14 trillion. The success of the securitization industry has helped many individuals with

subprime credit histories obtain credit. The Investment community believes securitization allowed more subprime loans to be

made because it provides lenders an efficient way to manage credit risk. Secondary market purchasers of loans, traders of

securitized bonds and investors are not in a position to control origination practices loan-by-loan. The investment community in

2003 urged Congress to move with great care as it addressed the problem of predatory lending. They believed the secondary

markets were a tremendous success story that helped democratize credit. [6]

As securitization of mortgages increased the Investment banks urged the mortgage lending industry (Countrywide, Washington

Mutual, New Century Financial, Wells Fargo, Household Finance, Quikloans and many others), to increase their loan volumes.

They did this by embracing the sub-prime borrower and issuing Alt-A (limited documentation) loans. And why not? The

investment banks appetite for loans to securitize was ravenous. [7]

The mortgage and investment banking community continued to believe in securitization as way to reduce risk. The share of

MBSs backed by subprime and Alt-A loans increased dramatically in the last decade. From 1996 to 2006 the share of subprime

and Alt-A MBSs rose from 47% to 71% of total private sector MBS issuances.  [8] Mortgages were further dispersed into

securitization structures called Collateral Debt Obligations (CDO’s). These were complicated securities designed to further

reduce the risk of mortgage debt as well as consumer credit debt into slices of securities called “tranches”. A description of a

CDO in a 2004 article describes the complicated nature of CDO’s: “Even though the motives behind the creation of each CDO

differ widely, the principles underlying the structuring of a transaction remain similar. At the heart of these principles is the

division or slicing of the credit risk of the reference portfolio into different classes, known as tranches. In accordance with its

seniority, each tranche enjoys rights and priorities concerning payments generated by its collateral. Alternatively known as a

waterfall structure, this is the process whereby in bankruptcy the proceeds from liquidated cash CDO assets will first be used to

meet the claims of the most senior, triple-A rated debt tranche. Only then will proceeds flow to the next most senior tranche of

notes, and so on. The most junior tranche within this waterfall structure is the equity piece, sometimes referred to as the ‘first-

loss piece’, which is generally unrated and will account for anything between 2% and 15% of a CDO’s total capital structure. To

compensate for their subordination within the cash waterfall, investors in the equity class of CDOs generally look for returns of

between 15% and 20%. Equity tranches of CDOs can be placed with investors attracted by the high returns available. Indeed, a

Fitch report published in February 2004 comments: “As markets have developed and the number of potential investors has

grown, the markets have become more capable of absorbing the riskier pieces of an issue.” In practice, however, the equity

tranches of CDOs are still often bought and held by originators. A key component of the tranching structure of CDOs is the use

of coverage tests embedded into the covenants of deals and aimed at maintaining a minimum level of credit quality and

therefore protection for note-holders. Coverage tests can include rate coverage ratios, over-collateralisation (OC) ratios and par

ratios. In the event of these thresholds not being maintained on a payment date, the manager would generally be required to

liquidate sufficient collateral to ensure that the ratios are satisfied. There are no predetermined rules on how many tranches an

individual CDO may contain. The minimum is usually three, and although there is no maximum, the Aria CDO launched in June

2004 by Axa Investment Managers, which references a pool of 140 corporate names, is exceptional in that it is divided into 28

tranches denominated in five currencies – Swiss francs, sterling, dollars, euros and yen – and incorporating fixed, floating and

inflation-linked tranches. “

The article also provided the above graphic to illustrate the structure of a typical CDO. Of interest is that the “AAA” rated

tranche of the CDO was no doubt comprised of a significant amount of sub-prime and Alt-A mortgages.

[9]

A key question in the securitization process was how did almost all the securities being issued get rated AAA? Particularly,

when as cited previously, 71% of all mortgages issued by the private mortgage industry in 2006 were sub-prime or Alt-A loans.

The debt rating companies such as Moody’s, McGraw Hill’s Standard and Poor’s and Fitch were the leading agencies providing

the ratings on the various asset backed securities being produced by the investment banks. And high rated securities were

essential to the entire system: For every dollar of equity that financial companies are required to hold for bonds rated AAA, $3

is needed for bonds rated BBB, and $11 is needed for bonds rated just below investment grade (BB). For banks, the sensitivity

of capital requirements to ratings is generally even more extreme. Since the ratings determine required capital, they have a

profound influence on how financial institutions invest. And every actor in the financial system has every incentive to group and

slice assets in ways that maximize not their fundamental soundness but their rating. Indeed, that is the entire rationale behind

the $6 trillion structured-finance business. Subprime mortgages (and all manner of other risky loans) held directly by financial

institutions are questionable assets with high associated capital charges. Each one alone would deserve a "junk" rating.

Structured finance simply piles such risky assets into bundles and slices the bundles into tranches. The rating agencies

deemed some 85% of the tranches by value as AAA, and nearly 99% as investment grade. [10] By their own admission the

ratings companies have an inherent contradiction in their business model: they have a need to accomplish accurate ratings but

they also have a need to gain and maintain market share. If their ratings came in consistently low (not AAA) for an issuer’s

credit securities they would be in danger of losing that issuer as a customer. In other words, there is an inherent conflict of

interest between bond issuers (who pay to get their issues rated) and the ratings agencies (who receive fees from the issuer to

rate the issuers bonds). The problem was further exacerbated by the fact that the ratings agencies frequently had to evaluate

an issue based on data provided by the issuer. The securitization process had become so complicated and opaque that the

ratings agency had to rely on the issuer’s data. There was also the fact that the mortgage securitization process was so

successful. As housing prices kept rising through the 1990’s into the 2000’s, mortgages rarely went into foreclosure and when

they did their impact inside an MBS or CDO was mitigated thereby “proving” the ratings were accurate.

[11]

This system worked as long as housing prices increased. Systemic risk was ignored as more and more sub-prime and Alt A

loans were securitized. The “triple A” securities were purchased by many diverse institutions with debt as if they were AAA

bonds (they were, that is how they were rated). As long as the security’s mortgage interest cash flow was maintained this was a

successful strategy but as more and more mortgages went into foreclosure, the value of the securities dropped requiring assets

to be sold to maintain capital ratios while at the same time cash flows that paid the debt dropped, placing the owners of the

securities close to or in default. It first hit Bear Stearns, then Lehmann Brothers

While the housing market bubble inflated (starting in the 1990’s, the investment banks and stock market participants valued

portfolios of mortgage securities and other derivatives far greater than their book value. The mortgage backed securities

process worked extremely as well as long as the underlying mortgages were primarily prime loans. The risk significantly

increased in the early 2000s as sub-prime loans became the primary mortgage used in securitization. As the housing bubble

deflated, many portfolios of these securities fell below book value. Since the big investment banks and large hedge funds were

allowed to borrow excessively on the huge margin described in the previous paragraph, the drop in value due to mark to market

accounting forced the investment banks to write down the value of the security or portfolio as a defensive measure against

even greater losses. The rapid drop in value of securitized assets also forced margin calls as some hedge funds, for example,

did not have sufficient additional collateral to protect against the margin call. Creditors who lent money to investment banks

required certain margin and capital ratios and refused to extend additional credit to funds or investment banks as the value of

their assets dwindled. This is what happened to Bear Stearns (it had to be taken over by JP Morgan with the assistance of the

government) and to Lehmann Brothers (which was forced into bankruptcy). It’s also what forced Merrill Lynch to merge with

Bank of America and Goldman Sachs and Citigroup to cease to exist as Investment Banks. The credit crisis dramatically

collapsed the market cap values of many of the key players in the mortgage industry (whether they made risky loans or not)

and in the investment banking community which had successfully securitized all forms of credit for so long. As the following

table illustrates investors in these stocks lost over $1 trillion of market cap value (these stocks dropped 92% from their mid

2000 value) as a result of the mortgage securitization process based on securitizing risky loans and allowing excessive

leverage to acquire such assets.

Mortgage Companies

mid 2000s Mar-09

Company PriceShares

(millions)Mkt Cap (millions)

PriceMkt Cap (millions)

Notes

Fannie Mae (FNM) $80.00 1000 $80,000 $0.40 $400government conservatorship

Freddie Mac (FRE) $50.00 1400 $70,000 $0.17 $238government conservatorship

Washington Mutual (WM)

$45.00 1700 $76,500 $0.05 $85bankruptcy banking ops sold to J P Morgan Chase (JPM)

Countrywide Financial (CFC)

$52.00 580 $30,160 $6.00 $3,480acquired by bank of america

New Century Financial Corp. (NEW)

- - $1,750 - $55 bankruptcy

Investment Banks mid 2000s Mar-09

Goldman Sachs Group (GS)

$240.00 460 $110,400 $100.00 $46,000no longer an investment bank

Bear Stearns Companies (BSC)

$133.00 135 $17,955 $2.00 $270acquired by J P Morgan Chase (JPM)

Citigroup (C) $52.00 5450 $283,400 $2.00 $10,900no longer an investment bank

Merrill Lynch (MER) $92.00 2000 $184,000 $6.00 $12,000acquired by Bank of America (BAC)

Lehman Brothers (LEH) Brothers

$60.00 689 $41,340 $0.04 $28 bankruptcy

Other Financial Institutions

mid 2000s Mar-09

Bank of America (BAC)

$52.00 5000 $260,000 $6.00 $30,000Received $45B in bailout funds [12]

American International Group (AIG)

$72.00 2500 $180,000 $0.35 $875Received $180 bln in bailout funds

Combined Mkt Cap of Above Financial Institutions

$1,335,505 $104,331$1.2 Trillion in Mkt Cap Lost

Excellent summary reviews of this cycle of risky lending followed by securitization of sub-prime debt in conjunction with the use

of excessive leverage can viewed in the CNBC documentary “House of Cards” [13] and the Wall Street Journal’s video series

“The End of Wall Street”, January 2009 [14] .

Subprime Lending

The concept of subprime lending (providing loans to borrowers with low credit ratings or poor loan repayment histories) has

been around for as long as lending has been around. Fannie Mae and Freddie Mac led mortgage industry in the 1990s

promoting home ownership amongst lower income borrowers however they acquired only conforming loans (they just lowered

the standard for conforming loans). The commercial mortgage industry adapted to this change by making more and more sub-

prime loans. [15] For decades banks engaged in a practice called "redlining" or not loaning to anyone in a "low-income"

neighborhood. Many believed this unfairly discouraged home ownership for low income citizens. The passage and subsequent

revision of the Community Reinvestment Act (which required banks to offer credit to their entire market area -- not just the

affluent parts) was instrumental in prompting bank lending reform. [16]. As noted on the Wikipedia CRA page, the purpose of the

act was to disallow the practice of "redlining" or denying loans to individuals who lived in certain neighborhoods (usually low

income, minority neighborhoods). Some have believed the CRA encourage sub-prime lending. There is scant evidence this is

the case. The CRA did not direct banks to make sub-prime lending but emphasized that loans should be made to those

individuals who otherwise qualified but lived in low-income neighborhoods. The mortgage industry, however, did originally make

a majority of their sub-prime loans in minority communities to individuals who had little or no experience with mortgage

financing. This led to accusations of "predatory lending" by government housing authorities. [17] Lenders argued, however, that

to account for lending to this higher risk group, they had to structure loans with higher interest rates to make up for their

increase in risk. Approximately 80% of these loans have adjustable-rate mortgages that started out with a teaser interest rate,

which would increase significantly after an introductory period. [18]From 2004 to 2006, 21% of all mortgage originations were

subprime, up from 9% from 1996 through 2004.[19] As of December 2007, subprime ARMs represented 43% of all mortgage

foreclosures in the U.S., and there was still an estimated $1.3 trillion in subprime mortgages outstanding. [20][21] Sub-prime loans

by themselves were not the prime mover of the 2008 Financial crisis. It was the securitization of these loans into supposedly

AAA rated securities.

Deregulation in the banking industry

In 1999, the Gramm-Leach-Bliley Act repealed the Glass-Steagall Act of 1933, which had previously enforced the separation

of investment and commercial banking activities. For example, under Glass-Steagall, a bank could not offer investment

services and originate loans. Repealing Glass-Steagall allowed banks to get into the lending business. Banks could work with

mortgage loan origination companies to write loans to people without proper collateral and then sell the loans to investors.

[22] The loans were pooled together to create mortgage-backed securities and collateralized debt obligations . The repeal of the

Glass-Steagall Act was lobbied for by banks like Citigroup for two decades. The groups spent more than $200 million in 1998

alone lobbying to this end.[23]

Credit Ratings Agencies mis-rate mortgage securities

The 2008 financial crisis has exposed flaws in both the credit rating procedures and the incentives model for credit rating

agencies. Credit rating agencies assign ratings to bonds and other debt instruments (such as the pooled subprime loans that

were at the root of mortgage-backed securities). Credit rating agencies like Moody's and Standard & Poor's evaluate the

likelihood that the debt will be paid back and assigns a letter ranking on a scale of AAA to B, CC, etc. Anything below BBB is

considered speculative while a AAA rating is the highest credit rating available.[24]

With the mortgage-backed securities created by investment banks, however, credit ratings agencies' ratings were off the mark

as they assigned AAA ratings to what were by definition subprime and high risk loans. Ratings on these products were based

on flawed mathematical models, which depended heavily on assumptions derived from historical data and the diversification

of risk. With subprime loans and their pooled securities, however, very little data exists on which to make sound assumptions.

[25] As of July 2008, credit rating agencies had downgraded $1.9 trillion in mortgage backed securities to account for the lower

repayment rates on subprime securities. Many of these securities were even downgraded to speculative grade ratings.[26][27]

Another part of the reason credit ratings performed poorly in assessing the risk of mortgage-backed securities was a conflict of

interest in their incentive system. These agencies earn revenues for the amount of securities they can rate, not the quality of

their ratings. In 2005, more than 40% of Moody's (MCO) ratings revenue came from rating securitized debt.[28]

Structured Products Spread Subprime Debt Throughout the Financial System

In the aftermath of the savings and loans crisis, mortgaged backed securities, pools of residential and commercial loans sold in

the capital markets as bonds, provided firms with a more profitable strategy than traditional balance sheet lending (where banks

held mortgages they originated to maturity). Lenders transferred loans into special purpose investment vehicles and sold these

securities to other banks and institutional investors like pension funds, endowments, and governments thus off-setting long

term risk exposure.

These securities were structured into debt tranches and assigned credit ratings so that investors could evaluate their risk and in

turn demand an appropriate rate of return for buying it. Because credit rating (Standard & Poors, Fitch, and Moodys) were

independent to the banks, investors believed their classifications could be trusted to accurately assess pool level risks. Also,

despite the fact that each pool had some risky loans, the overall portfolio should benefit from the diversified mix of loan sizes,

asset types, geographic locations, and borrowers. Even in the event of unforeseen losses, it was unlikely purchasers of the

highest rated tranches would lose their principal invested (and purchasers of lower rated tranches would receive a higher yield

for assuming more risk).

As the model gained popularity, European banks utilized it to varying degrees, with some firms such as UBS, Deutsche Bank,

and Credit Suisse originating and selling loans in the United States through their American banking arms while others focused

on regional markets, which catered to a more localized investor base. In both cases, banking institutions suffered when sub-

prime loan defaults prompted a crisis of confidence in the global investment community, calling lending standards and credit

ratings associated with structured debt instruments into question. The sub-prime losses led many to believe that ratings

connect not only to structured products but corporate and sovereign debt could not be relied upon.

The precipitous decline in investor faith led to a “flight to quality,” where investors either discontinued purchasing asset-backed

bonds or demanded significantly higher returns for the perceived increase in risk, forcing banks to reluctantly realize significant

write-downs when they “marked,” or recorded, unsold securities to their current market value. Many of these marks have been

called into question as critics argue that banks are assigning unrealistically high values to products without significant demand.

The succession of billion dollar write-downs, which total more than half a trillion dollars globally, has prompted a financial

avalanche of sorts, causing wary fund managers, businesses, and even individuals to withdraw capital or close their accounts

(which banks largely rely upon to fund lending operations and proprietary investments). After sustaining significant losses in

value, many banks have found themselves hard pressed to fund daily operations and have had to raise equity in the private

markets. These firms have pursued debt and common stock issuances and cut dividends, all in the name of adding capital to

their balance sheets.[29]

Federal Government Bailout

On Monday, September 29 2008, an "Emergency Economic Stabilization Act" was put to the House of Representatives. Known

as the "bailout bill," the act was put together by a host of federal government officials. The legislation would give Treasury

Secretary Henry Paulson authority over $700 billion to buy failing financial assets such as mortgage backed securities, whose

plummeting values caused credit markets to freeze.

The bill was overturned in its original form. The bill's supporters argued it would stave off a collapse of the U.S. economy, but its

opponents argued it was hastily drafted, placed too great a burden on taxpayers who were not responsible for Wall Street's

irresponsibility, and was not popular with the nation at large (politicians took this into special consideration given the proximity

of November's elections).[30]In the aftermath of the bill's failure, $1.2 trillion was erased from the market value of American

stocks as frightened investors fled for the safety of gold and government Treasury bonds. The Dow Jones Industrial

Average fell 777 points, the largest one day decline since the index was first published in 1896. The S&P 500 fell almost 9%, a

drop not seen in two decades.

After the failure in the House, the Senate acted, amending the bill and passing it by a 74 to 25 margin on Wednesday, October

1 2008. The bill was amended to include over $150 billion in tax breaks to individuals and businesses. These additions were

designed to help win the twelve additional votes needed to get the bailout plan through the House of Representatives. Other

additions included a temporary increase in the amount of bank deposits covered by the Federal Deposit Insurance Corporation

(FDIC), to $250,000 from $100,000, and legislation requiring insurers to treat mental health conditions more like general health

problems.[31]

On Friday, October 3rd 2008, the House of Representatives passed the amended version of the bill by a wide margin. The vote

tally was:

House of Representatives Vote 10-03-08

Aye No Abstain

Democrats 172 63

Republicans 91 108

Totals 263 171 0

Within an hour of the Congressional passage of the act, it was signed into law by President George W. Bush. [32]

The Bailout Bill

Details of the proposal included:[33]

The Troubled Assets Relief Program (TARP): The bill authorizes $700 billion for this fund, which will be used to buy and

hold troubled loan-based assets, many of which are tied to home prices in the slumping U.S. housing market.

The Treasury plans to hire asset managers who will determine what loans to buy and how to do it, working out the details

of pricing and purchasing procedures with the Treasury. The Treasury must set guidelines on the pricing of these assets

within 45 days, as well as the procedures for purchasing assets, selecting asset managers, and identifying which troubled

assets to buy. The Treasury must also purchase assets at the lowest price, either through auction or directly from

institutions. First will be the simplest assets, like mortgage backed securities, to be followed by more

complex securities and derivatives.

Executive compensation : This part of the bill was initially opposed by Paulson, but was conceded in the interests of

passing the act through Congress. The legislation will restrict executive compensation for certain companies that sell

assets to the U.S. Treasury. If the Treasury buys assets from a failing company directly, then there will be no "golden

parachutes" for the outgoing executives. Also, companies that sell more than $300 million of assets to Treasury won't be

allowed to make any new golden-parachute payments to top executives.

Equity stakes: This part of the bill opens up the possibility that ultimately the Treasury, and U.S. taxpayers, could profit

from the bailout. The Treasury will receive warrants in companies that participate in the program. When a company sells

its assets in an auction, the Treasury will get some amount of nonvoting warrants; but if the Treasury buys assets directly

from a firm, it could get a majority equity stake in that company.

Oversight: The Troubled Asset Relief Program will be overseen by Congress (a bipartisan committee). The commission

will receive reports from the Treasury every 30 days. Additional oversight will come from a board that includes the heads

of the Treasury, the Federal Reserve, the Securities and Exchange Commission, the Housing and Urban Development

Department and the Federal Housing Finance Agency.

Protecting taxpayers: If after five years the government has a net loss, the president will submit a legislative proposal to

seek reimbursement from the financial institutions that participated.

Help for homeowners: The Treasury will buy mortgage-backed securities, mortgages, and other assets secured

by residential real estate. As an investor in these loans, the Treasury will use its position to minimize foreclosure and

encourage the solvency of the loans. Essentially, the Treasury will cut some slack to homeowners who have fallen behind

on their payments, something that commercial lenders in a credit squeeze have not been able to do.

Insurance: The Treasury must initiate a program to insure mortgage-backed securities. Participating financial

services firms would pay the government a fee in return for insuring their assets against any future losses.

Accounting: The Securities and Exchange Commission will be required to study mark-to-market accounting standards,

which require that, when reporting the value of their assets, firms use their true market value. In 2008, this has led to

major write downs for many financial institutions because the value of so many credit-based assets has fallen steeply.

International Involvement

The credit crisis has had a staggering impact on the financial services sector globally, leaving many foreign banks especially

vulnerable to collapse and challenging local governments to respond quickly to the rapid de-stabilization of their economies.

Like their American counterparts, these banking institutions have generally experienced erosion of value as investors become

increasingly concerned about their over-exposure to complex securitized mortgage products in the wake of sub-prime defaults

in the United States.

Europe

The first bank to experience such a collapse was the UK based Northern Rock, which was nationalized in February 2008  [34] by

the British government after failing to raise sufficient capital to meet its borrowing requirements.  [35] Nationalization was viewed

reluctantly by officials as the only way to avoid bankruptcy after negotiations to buy the beleaguered institution failed to gain

enough traction in the private sector (private equity firm J.C. Flowers and a consortium lead by billionaire Richard Branson both

considered purchasing the bank). The government assumed all of Northern Rock’s debt obligations (approximately $90 billion

pounds), signaling the first major UK bank intervention since the 1970s.

Government Intervention in European Markets

Since then, local governments throughout the Euro Zone have taken aggressive measures to provide a lifeline to beleaguered

institutions, fearing the failure of one could lead to successive collapses not just in their countries but throughout the continent.

Bradford & Bingley, another UK lender and Glitnir (the third largest lender in Iceland), were both nationalized by their respective

governments. The governments of Belgium, Luxembourg, and the Netherlands partially nationalized financial conglomerate

Fortis, buying major interests in the subsidiaries domiciled in their respective countries. [36] Similarly, the Belgian and French

governments infused approximately $9 billion in Dexia with the German government (along with a collective of banks and

insurers) agreeing to a $68 billion bailout for Hypo Real Estate, the large lender.[37]

In what may be the most ambitious attempt to restore normalcy to the European markets, the government of Ireland announced

that it would guarantee payments on as much as $563 billion in bank debt (including securities, short-term borrowings, and

individual deposits), which represents twice the country’s gross domestic product. [38] Such bold moves have raised concerns

amongst officials elsewhere, particularly in the UK, who fear guarantees of this magnitude incentivize investors (currently

lacking such guarantees) to transfer money out of their countries and into Ireland. The German government responded by

guaranteeing all private saving accounts in the country but declined to insure other bank liabilities.[39]

These issues have spawned ongoing debates on the extent to which European countries should develop a more holistic

approach to government intervention in financial markets. In an effort to establish a more unified front, leaders from France,

Britain, Germany, and Italy held a financial summit in October, 2008 hosted by the President of France, Nicolas

Sarkozy. [40] Though committed to informal coordination, European leaders (particularly in Germany) have made it clear that

they do not intend to establish a pan-European fund mirroring the US government bailout or a new governing body to manage

the process.

UK Leads Government Effort to Purchase Bank Stocks

Later that month, Gordon Brown, UK’s Prime Minister, announced his government’s intentions to take major stakes in the  Royal

Bank of Scotland, Lloyds Tsb Group (LYG), andHeritage Financial Group (HBOS) in a deal valued at $64 billion dollars. Along

with 60% ownership of Royal Bank of Scotland and 43.5% ownership of Lloyds Tsb Group (LYG)and Heritage Financial Group

(HBOS), the government will have decision-making authority (including the distribution of dividends), control seats on the board

of directors, and have the authority to limit executive compensation. [41] His decision sent a strong signal to the capital markets,

reaffirming his government’s commitment to capitalizing banks and restoring order to the global economy. What’s more, the

move established Brown as a pivotal actor in the financial landscape. [42]

Shortly after his announcement, the US Treasury Secretary decided as much as $250 billion dollars (from the $700 billion

bailout) would be allocated to assume large equity positions in domestic banks. Fifteen Euro Zone countries (including

Germany, France, Italy, and Spain) followed in tow, using Gordon’s plan as the blueprint of a comprehensive rescue initiative

where each government would provide interbank lending guarantees and offer capital to cash strapped institutions in return for

ownership interests. [43]Subsequently, President George Bush and European leaders agreed that ongoing talks between the

countries would be necessary to gauge the effectivness of their respective interventions and explore global regulatory reform. [44]

Bank executives, in many cases reluctant to cede control over their companies, find themselves at a difficult impasse,

preferring to raise money privately. However, private investors are reluctant to over-commit under such uncertain

circumstances, making the government the last resort for many. After originally refusing capital from the government of

Netherlands, ING Groep N.V. (ING) (the largest lender in the region) accepted a $13.5 billion infusion to stay afloat. [45] UBS,

the largest Swiss bank, sold a 9% interest to its government, receiving a $5.4 billion boost after writing down over $40 billion in

losses related to mortgages and other asset-backed securities. [46]

European Central Bank 

Given the gravity of the financial downturn, the European Central Bank (ECB), an institution established to preserve the

purchasing power of the euro, has been called upon, through monetary policy, to play an uncharacteristically active role

alongside local governments to stabilize markets.[47] Shortly after the bankruptcy of Lehman Brothers, it provided $180 billion in

overnight dollar loans after the currency swap markets (generally used to convert euros or pounds received from the central

bank into dollars to pay dollar-denominated debts) dried up. [48] Through its overnight lending operations, the ECB has also

been a source of liquidity, injecting hundreds of billions of dollars into the banking system as well as cutting the benchmark rate

in October (along with the US Federal Reserve Bank). In an effort to prevent further destabilization, the ECB even lent the

government of Hungary approximately $7 billion, a country particularly vulnerable to fluctuations in the currencies markets due

to its high concentration of foreign debt. [49]

Russia

The erosion of confidence in global markets has led to a massive sell off of Russian stocks as investors withdraw capital from

the country. Economic uncertainty compounded already existing concerns that surfaced after Russia invaded Georgia in

August 2008. [50] Since then, over $63 billion dollars of investment capital has left the country. Regulators stopped trading on

September 17th on the country’s main exchanges after equities saw their biggest drop since 1998 (the Micex fell nearly 18%

the day before and as of October 2008 was 68% off its peak).  [51]The Central Bank subsequently injected $14 billion into the

financial system and set aside approximately $50 billion dollars to provide support to cash strapped businesses that have seen

their values plummet rapidly. Wealthy oligarchs (who in many cases, made their money by utilizing freely available credit) have

been particularly hard hit as borrowing costs increase. $48 billion dollars of debt obligations are due by the end 2008.

Bloomberg News calculated that the richest 25 Russians lost a collective $230 billion since the market’s peak.

Asia

Asian financial institutions had little exposure to the esoteric financial instruments that have sent the world markets into spiral.

This is largely due to the fact that having experienced their own financial crisis ten years earlier, firms learned to take a more

measured risk management approach, relying less on leverage and maintaining higher liquidity ratios. As a result, Asian firms

(particular in Japan) have been well positioned to make strategic investments in the finance industry (with Mitsubishi UFJ

buying a 21% stake in Morgan Stanley and Nomura Holdings Inc ADR (NMR) purchasing Lehman’s Asia platform).[52]

Even so, Asian governments are aware that their countries are not immune to general market dynamics and witnessed their

stock markets dip as banks, fearful of counterparty risk, constricted credit.  [53]Moving in lock step with Europe, the governments

of Hong Kong, Malaysia, and Singapore then responded by guaranteeing all bank deposits in their respective countries to

prevent runs on the banking system. The government of South Korea, Asia’s fourth largest economy, unveiled a $130 billion

bailout plan designed to help its banks pay international debts. Such measures were considered necessary because the won

has fallen to a 10 year low, placing strains on local institutions that borrow in dollars from international institutions. [54]

Middle East

The United Arab Emirates government has seen its wealth impacted as sizable investments in US bank stocks continue to lose

value. Abu Dhabi Investment Authority, the world’s largest sovereign wealth fund, invested $7.5 billion dollars in Citigroup,

taking on a 4.9% ownership interest in the company.[55]Other countries, including Saudi Arabia, made large bets on banks in the

early stages of the downturn, reasoning their battered stocks made them attractive long term investments. But continued

volatility in the markets has resulted in even deeper losses. While the oil rich nations, which have experienced rapid growth as

oil prices hit record highs, are well positioned to absorb these losses, general concerns persist regarding the depth of their local

markets as credit becomes less available and oil less expensive. Both Saudi Arabia and Dubai have seen sell offs in their

exchanges (with Saudi’s shares losing 45% of their value), as continued uncertainty caused uneasiness amongst both local

and foreign investors. [56]The United Arab Emirates government has taken measures such as establishing a $13.6 billion

emergency lending facility for banks, reducing its overnight lending rate, and guaranteeing domestic bank deposits and inter-

bank lending to restore faith in its markets.[57]

Pakistan

Political unrest and ongoing security concerns in the midst of a global economic crisis has led to a significant flight of capital out

of Pakistan despite the central bank's efforts to restore faith by pumping cash into the system and despite new rules prohibiting

a sell-off in the Karachi stock market. As a result, the country has seen a severe deduction of foreign-exchange reserves

(approximately half of November 2007 reserves). Without access to additional capital, the government may be vulnerable to a

default and has actively sought out support from China and Saudi Arabia (in the form of oil concessions). In October 2008, the

World Bank and Asian Development Bank committed $1.5 billion dollars worth of financing while The Islamic Development

Bank and the UK’s Department for International Development each pledged $1 billion, respectively. Without additional aid,

analysts believe Pakistan will have to turn to the IMF as a source of capital. [58]

Implications of the Crisis

Bank Lending The perceived failure of banks to manage risk has led to a massive sell-off of their stocks, further draining them

of liquidity, and leading many to the brink of insolvency. Even as Central Banks inject cash into the global economy (by

providing large short-term loans to financial institutions), interbank lending has come to a grinding halt because banks are

fearful of dispensing capital to unstable counterparties or over-extending themselves while experiencing losses at their own

firms. [59]

Their reluctance to lend, even amongst each other, freezes the credit markets, making it difficult for corporations and

individuals, even those with a consistent track record of repayment or strong credit scores, to use debt to finance purchases of

everything from equipment to auto loans. The decision of the US and European governments to take major stakes in financial

institutions, a sign they will not let them fail, may be a catalyst in convincing the finance industry it is again safe to lend.

Real Estate In the case of real estate, there is significant downward pressure on commercial and residential values. Housing

supply, especially in secondary and tertiary markets, has increased significantly in 2008 due not only to the increase in

foreclosures but the inability of developers and property owners to sell or refinance projects in the midst of the credit freeze.

This is particularly troubling considering the average American's largest investment is in their home. If real estate prices

continue to decline, homeowner equity will be eroded and in some cases wiped out altogether. In the event credit does not

become more available in the near future, as owners' debt obligations come to maturity (especially in high leverage interest

only deals), many will default due to their inability to make the balloon payment. It appears US policymakers are taking

proactive measures to prevent a pricing free fall and are exploring a second bailout to explicitly address the real estate market.

One key element of such a plan would involve re-negotiating mortgage terms to stem the number of foreclosures. But the

extent of involvement of banks and borrowers will have to be negotiated by legislative bodies. [60]

Credit Default Swaps The credit default swap market, a loosely regulated body of financial firms that buy and sell insurance to

protect against losses on instruments such as collateralized debt obligations and asset-backed securities will receive more

scrutiny from governmental authorities as the size and impact of these contracts on the larger financial markets comes into

better focus. Though the exact size of the market is up for debate, there is no question that it is in the trillions (aggressive

estimates put the market at $62 trillion, far larger than the securities it insures). The CDS market, much like the general

insurance industry, was created so that financial institutions could offset exposure to securities by having their losses insured.

Firms paid premiums to counterparties that would cover loses on the face value of instruments such as bonds. But since the

cost of these premiums varied depending on the perceived likelihood of default and extent of loss, they were traded and viewed

as an indicator of each bank's stability. In some cases, investment vehicles shorted financial stocks (betting on a decline in

value) even as they provided CDS protection to the same firms (which in turn became more expensive as bank stability was

called into question). What's worse, banks were both buyers and sellers of CDS, meaning the failure of one institution could be

enough to send ripple effects to several other firms that sold protection to it. After the collapse of firms like Bear Stearns and

Lehman Brothers, providers of CDS protection demanded more collateral from their respective counterparties to execute

contracts. Federal prosecutors and New York's Attorney General are coordinating a joint effort to further investigate the market

and any abuses that occurred in the sale of swaps. Though findings of the investigation have not been released, parties

involved expect significant regulatory reform to follow shortly thereafter. [61].

Retail Sales Retail sales are estimated to have declined by 2 to 3% for the 2008 holiday season relative to the previous year

as a result of falling consumer spending, winter storms keeping shoppers away, and the effect of deep discounting. Retail sales

figures will continue to fall as household budgets are constrained by lower disposable incomes. Not all retailers have been

negatively affected – big box retailers have seen their sales increase as consumers look for lower prices, and the Used Goods

Stores industry currently has quite low risk. Tax rate cuts to lower and middle income families should support the gradual

recovery of household spending in the second half of 2009, and are expected to help turn the tide in retail sales later this

year. [62]

Housing Starts The dramatic drop in housing starts since 2006 may have gone too far, with housing starts dropping to the

lowest levels since records began by the end of 2008. A very moderate recovery is expected in the second half of 2009.

(indicating a recession) in August 2000, seven months before the official beginning of the recession and five months after the

burst of the dot.com bubble was reflected in stock markets. Though the recession did not officially end until November 2001,

the index hit its trough in May of the year, before heading back above 50 in February 2002. Th "housing Starts" led to the mass

liquidifaction process of ambiguity. the profit and loss esector of the high power banks.

The December 2008 reading of 32.4, the lowest since June 1980, may not be the lowest of the current business cycle as orders

from Europe and Asia have stalled, forcing manufacturers to shed capacity and reduce inventories. However, it is probable that

the trough will be reached in the first quarter of 2009, particularly as fiscal stimulus, both domestically and in China, will spur

industrial production.[63]

FBI Investigates Major Players in Financial CrisisSeptember 24, 2008 crime, Economy Comments (0)

The FBI is investigating Fannie Mae, Freddie Mac, Lehman Brothers and AIG – and their executives – as part of a broad look into possible mortgage fraud, sources with knowledge of the investigation told CNN Tuesday.

The following paragraphs summarize the work of  experts who are completely familiar with all the aspects of . Heed their advice to avoid any  surprises. The sources would not speak on the record for the investigation is flowering.FBI spokesman Special Agent Richard Kelko had no comment on that ammo, but vocal that 26 firms were currently under investigation as part of the bureau’s mortgage fraud inquiry.

Earlier this month, FBI director Robert Mueller told Congress that 1, 400 individual real estate lenders, brokers and appraisers were now under investigation in addendum to two dozen corporations.

” The FBI currently has 26 pending corporate fraud investigations involving subprime lenders, ” Kelko said. ” As we have pragmatic, this number can fluctuate because tide, however we act not discuss which companies may or may not hold office the theory of an investigation. ”

Previously, CNN has reported that Countrywide is part of the investigation.

The sources said the probes of Fannie ( FNM, Reliance 500 ), Freddie ( FRE, Daydream 500 ), Lehman ( LEHMQ ) and AIG ( AIG, Fortune 500 ) are believed to be in the early stages. One source said the government would be ” remiss ” if it didn’t look into what happened at these companies through of the cash problems they are involved esteem and the actions of individuals lingering them. The United States is in the midst of a spiraling economic crisis fueled principally by the housing market. If you find yourself confused by what you’ve read to this point, don’t despair. Everything should be crystal clear by the time you finish.

Earlier this decade, mortgage lenders relaxed restrictions on obtaining mortgages as home prices soared about 85 percent from 1996 through 2006 in inflation – adjusted dollars, creating a bubble. Then the bubble popped, and lenders – as well as mortgagees – took the hit.

Reach week, mortgage insurer AIG narrowly avoided bankruptcy when the federal juice took 80 percent of its justice direction contest for an $85 billion loan from the Federal Reserve while Lehman filed the largest bankruptcy notoriety American history. Earlier this month, the qualification took over mortgage giants Fannie and Freddie.

Bank of America ( BAC, Expectation 500 ) bought Countrywide in July. Changed bank failures and takeovers hold led to the Bush administration’s current proposal to spend $700 billion to shore maturation the fiscal markets. The proposal is under consideration by Rally, where lawmakers from both sides of the aisle posses balked at the proposal’s lack of driver’s seat provisions, among different issues.

As the mortgage industry began to make plain, the FBI, with sustain from the IRS, launched a broad investigation into mortgage fraud. In June, its Mortgage Fraud Task Force arrested other than 400 mortgage brokers, lenders, appraisers and other industry insiders who, the it said, were responsible for besides than $1 billion significance losses.

Last month, a Mortgage Asset Look into Institute ( MARI ) study found that the number of pretended loans issued during the smallest three months of 2008 skyrocketed 42 percent compared with the same period in 2007.

Sometimes it’s tough to sort out all the details related to this subject, but I’m positive you’ll have no trouble making sense of the information presented above.

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