Now, you’d be better off buying a copy of “Nassim Taleb’s The Black Swan”:http://ko.offroadpakistan.com/2008/05/nassim_nicholas_taleb_the_black_swan.html and reading that, but here is the extremely simplified version of one aspect of the giant monolith which was the American financial house of cards:
Back in the days, we had these things called banks. They took in money from people, and lent it out to other people, who did something with that money and thus were able to pay it back with interest. Now, even back than, banking wasn’t this simple, but this portion constituted a significant part of what banks did back then. Sure, they bought lots of stuff, and invested all over the place, but as JP Morgan, the most powerful banker ever, famously said, “If you can’t draw it on a napkin with a crayon, don’t buy it”.
By and large, besides funding a war here and there, bankers stuck to the basics and made money hand over fist. Till such time they lost it all, which happened periodically, like the great depression in 1939, and Black Monday in 1987.
So this is the image which people have of things to this day – that banks take in deposits, give out loans, and make money on the interest paid on loans. Now, sure, banks and the other bank like institutions still do this, but this has been a small part of their business for the last couple of decades now. This is the part which is the toughest for people to grasp – that none of the large American banks are banks in the traditional sense of the word. Here someone might ask, if not banks, than what the hell are they?
The plain answer is that no one knows.
The short answer is that the American financial system is the greatest pyramid scheme ever, a house of cards stacked so high over the entire world that it’s collapse is going to be wrecking havoc for years to come.
How did this pyramid scheme function? Well, in truth the actual murky details are so many, that no one quite understands. The thing is, computers enabled banks to set up multiple self propagating schemes, which fed on themselves and kept spawning new, ever more mutated children, which further mated with themselves to produce more and more offspring. Think of a pair of rabbits mating away, which soon outgrow the local environment…
One example is the subprime crisis, where banks lent money to people who couldn’t ever afford to pay it back. Now, while this is one of the major issues, the real issue is what the banks did with these loans – they bundled up multiple “subprime” loans, created a new “security” out of them, and sold these securities to all and sundry. Now already you’re one step removed from the actual loan, so it’s getting murky enough. However, one degree of separation isn’t enough – buyers could see that these loans were indeed risky, so bought them cautiously.
Here is where a bunch of liars and thugs (i.e bankers) jumped in, and said what if we take a bunch of equities based on loans, package the together again, insure them with fraud insurance to make them smell sweeter, and create new securities based on them. And hey, to make sure no one, including ourselves can ever figure it out, how bout doing this ten times over, using loans from all over the place? And what about lying about the loans also, and bribing the ratings agency to rate them as first class loans instead of shit loans? And so, what was a pile of shit in the first place, got multiplied manifold, and each multiple smelled ever sweeter…
The shit thickens here… cause when you sell a 100 dollar loan x times, you end up expanding the money supply also… a money supply based on outright fraud and grand larceny to boot.
Now, obviously, all the bonds, equities, mortgages, whatever created by the banks were pretty shit, so one of the ways they made them smell better was to insure them against default – here is a “shining example of the type of insurance deals made”:http://www.reuters.com/article/newsOne/idUSN1837154020080918?pageNumber=3&virtualBrandChannel=0:
bq.. In one notorious case, a small hedge fund agreed to insure UBS AG (UBSN.VX: Quote, Profile, Research, Stock Buzz), the Swiss banking giant, from losses related to defaults on $1.3 billion of subprime mortgages for an annual premium of about $2 million.
The trouble was, the hedge fund set up a subsidiary to stand behind the guarantee – and capitalized it with just $4.6 million. As long as the loans performed, the fund made a killing, raking in an annualized return of nearly 44 percent.
p. See, it’s much more profitable to insure stuff if your business plan doesn’t include the possibility of ever paying out anything! Not only that, the cost of the insurance is much cheaper too! It’s a win-win situation everywhere, long as the good times keep rolling, or the pyramid keeps getting piled higher.
bq.. “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.”
The market for the credit default swaps has been enormous. *Since 2000, it has ballooned from $900 billion to more than $45.5 trillion – roughly twice the size of the entire United States stock market.*
p. The thing about credit default swaps (CDS) is that at the end of the day, in a deteriorating market they are pretty much valueless. The only way insurance is useful when the insurer is able to cover at least a tiny percentage of what it’s insuring, and assuming only a tiny bit of whats insured fails, the insurance company can afford to pay that out and everyone is happy.
Here is a “simplified view of the current crisis”:http://www.nytimes.com/2008/09/22/opinion/22krugman.html?_r=1&hp&oref=slogin:
bq.. 1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.
2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.
3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.
4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”
p. So while there is a straight forward collapse in the financial sector due to the above, Krugman misses out the outright fraud inherent in much of the American financial sector, with hedge funds and banks and insurance companies selling complete crap based not just on sub-prime mortgages, but just about anything which an army of MBA’s could dream up and package.
bq. “They booked all these derivatives assuming bad things would never happen. It was like writing fire insurance, assuming no one is ever going to have a fire, only now they’re turning around and watching as the whole town burns down.” “#”:http://www.reuters.com/article/newsOne/idUSN1837154020080918?pageNumber=4&virtualBrandChannel=0
The really interesting stories of outright fraud and theft will trickle out over the next few years, as regulators and journalists poke through the mess left behind. While a number of people have been saying for years that the American financial industry is a house of cards, Warren Buffet one of the more well known ones:
bq. Five years ago, billionaire investor Warren Buffett called derivatives a “time bomb” and “financial weapons of mass destruction” and directed the insurance arm of his Berkshire Hathaway Inc to exit the business.
Nassim Taleb has been calling “the banking industry charlatans, frauds, liars, and at best incompetent”:http://business.timesonline.co.uk/tol/business/economics/article4022091.ece?token=null&print=yes&randnum=1222082058734.
bq.. Last May (2007), Taleb published The Black Swan: The Impact of the Highly Improbable. It said, among many other things, *that most economists, and almost all bankers, are subhuman and very, very dangerous.* They live in a fantasy world in which the future can be controlled by sophisticated mathematical models and elaborate risk-management systems. Bankers and economists scorned and raged at Taleb. He didn’t understand, they said. A few months later, the full global implications of the sub-prime-driven credit crunch became clear. The world banking system still teeters on the edge of meltdown. Taleb had been vindicated. “It was my greatest vindication. But to me that wasn’t a black swan; it was a white swan. I knew it would happen and I said so. It was a black swan to Ben Bernanke [the chairman of the Federal Reserve]. I wouldn’t use him to drive my car. These guys are dangerous. They’re not qualified in their own field.”
In December he lectured bankers at Société Générale, France’s second biggest bank. He told them they were sitting on a mountain of risks – a menagerie of black swans. They didn’t believe him. Six weeks later the rogue trader and black swan Jérôme Kerviel landed them with $7.2 billion of losses.
p. Now while the US govt. is crying fraud and shovelling trillions of dollars at bankers, economists are “wondering where the credit crunch is in the real economy”:http://www.marginalrevolution.com/marginalrevolution/2008/09/where-is-the-cr.html:
bq. Now here is a hypothesis. It may be that there just aren’t that many firms in need of funds. First, one reason that bank lending is up may be that firms with good projects have already turned to the substitute bridge of ordinary bank loans. Second, I wonder how much real lending was actually being generated by asset backed securities. Could it not be that the most of the funds generated were used to buy more asset backed securities? (The growth in these securities is certainly suggestive of that possibility). If that is the case then it explains why the real economy has been remarkably resilient to the “credit crunch.”
It seems much of the fake money generated by Wall Street was just used to buy up fake securities generated by Wall Street, which was then used to make more fake securities, which was once again bought by Wall Street and sundry governments around the world. Repeat a few times, and you have trillions of trillions of this crap floating around the world. The good part is, that as much of it evaporates, it shouldn’t cause too much damage to the real world, except it will, as too many people and companies bought into Wall Street and ended up owning too much of the shit generated by Wall Street before it died.
* “RGE Monitor”:http://www.rgemonitor.com/
* “Time: How Financial Madness Overtook Wall Street”:http://www.time.com/time/business/article/0,8599,1842123,00.html
* “The Promise and Perils of Credit Derivatives”:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=929747
* “The Total Stupidity of Crowds: Bad Mortgages and Circular Solutions”:http://scienceblogs.com/goodmath/2007/12/the_total_stupidity_of_crowds.php
* “Debtor’s Prison”:http://online.wsj.com/article/SB122186623794958779.html