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The Financial Tsunami, Part IV by F. William ENGDAHL

by : Internationalnews
Friday February 8, 2008 - 18:59

GlobalResearch.ca

Financial Crisis: Asset Securitization— The Last Tango

Endgame: Unregulated Private Money Creation

What had emerged going into the new millennium after the 1999 repeal of Glass-Steagall was an awesome transformation of American credit markets into what was soon to become the world’s greatest unregulated private money creation machine.

The New Finance was built on an incestuous, interlocking, if informal, cartel of players, all reading from the script written by Alan Greenspan and his friends at J.P. Morgan, Citigroup, Goldman Sachs, and the other major financial houses of New York. Securitization was going to secure a "new" American Century and its financial domination, as its creators clearly believed on the eve of the millennium.

Key to the revolution in finance in addition to the unabashed backing of the Greenspan Fed, was the complicity of the Executive, Legislative and Judicial branches of the US Government right to the Supreme Court. In addition, to make the game work seamlessly, it required the active complicity of the two leading credit agencies in the world—Moody’s and Standard & Poors.

It required a Congress and Executive branch that would repeatedly reject rational appeals to regulate over-the-counter financial derivatives, bank-owned or financed hedge funds or any of the myriad steps to remove supervision, control, transparency that had been painstakingly built up over the previous century or more. It required that the major government-certified rating agencies give their credit AAA imprimatur to a tiny handful of poorly regulated insurance companies called Monolines, all based in New York. The monolines were another essential part of the New Finance.

The interlinks and consensus behind the massive expansion of securitization among all these institutional players was so clear and pervasive it might have been incorporated as America New Finance Inc. and its shares sold over NASDAQ.

Alan Greenspan anticipated and encouraged the process of asset securitization for years before his actual nurturing of the phenomenal real estate bubble in the beginning of the first decade of the new Century. In a pathetic attempt to deny his central role after the fall, Greenspan last year claimed that the problem was not mortgage lending to sub-prime customers but the securitization of the sub-prime credits. In April 2005, he sung a quite different hymn to sub-prime securitization. Addressing the Federal Reserve System’s Fourth Annual Community Affairs Research Conference, the Fed chairman declared,

"Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country. With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers…The mortgage-backed security helped create a national and even an international market for mortgages, and market support for a wider variety of home mortgage loan products became commonplace. This led to securitization of a variety of other consumer loan products, such as auto and credit card loans."

That 2005 speech was about the time he later claimed to have suddenly realized securitization was getting out of hand. In September 2007 once the crisis was full force, CBS’ Leslie Stahl asked why he did nothing to stop "illegal or shady practices you knew were taking place in sub-prime lending." Greenspan replied, "Err, I had no notion of how significant these practices had become until very late. I didn’t really get it until late 2005 and 2006…" (emphasis added-w.e.)

As far back as November 1998, only weeks after the near-meltdown of the global financial system through the collapse of the LTCM hedge fund, Greenspan had told an annual meeting of the US Securities Industry Association, "Dramatic advances in computer and telecommunications technologies in recent years have enabled a broad unbundling of risks through innovative financial engineering. The financial instruments of a bygone era, common stocks and debt obligations, have been augmented by a vast array of complex hybrid financial products, which allow risks to be isolated, but which, in many cases, seemingly challenge human understanding."

That speech was the clear signal to Wall Street to move into asset-backed securitization in a big way. After all, hadn’t Greenspan just demonstrated through the harrowing Asia crises of 1997-98 and the systemic crisis triggered by the August 1998 sovereign debt default that the Federal Reserve and its liquidity spigot stood more than ready to bailout the banks in event of any major mishap? The big banks were, after all, clearly now, Too Big To Fail—TBTF.

The Federal Reserve, the world’s largest and most powerful central bank with what was arguably the world’s most liberal market-friendly Chairman, Greenspan, would back its major banks in the bold new securitization undertaking. When Greenspan said risks "which seemingly challenge human understanding," he signaled that he understood at least in a crude way that this was a whole new domain of financial obfuscation and complication. Central bankers traditionally were known for their pursuit of transparency among banks and conservative lending and risk management practices by member banks.

Not ‘ole Alan Greenspan.

Most significantly, Greenspan reassured his Wall Street securities underwriting friends in the Securities Industry Association audience that November of 1998 that he would do all possible to ensure that in the New Finance, the securitization of assets would remain for the banks alone to self-regulate.

Under the Greenspan Fed, the foxes would be trusted to guard the henhouse. He stated:

"The consequence (of the banks’ innovative financial engineering-w.e.) doubtless has been a far more efficient financial system…The new international financial system that has evolved as a consequence has been, despite recent setbacks, a major factor in the marked increase in living standards for those economies that have chosen to participate in it.

It is important to remember—when we contemplate the regulatory interface with the new international financial system—the system that is relevant is not solely the one we confront today. There is no evidence of which I am aware that suggests that the transition to the new advanced technology-based international financial system is now complete. Doubtless, tomorrow’s complexities will dwarf even today’s.

It is, thus, all the more important to recognize that twenty-first century financial regulation is going to increasingly have to rely on private counterparty surveillance to achieve safety and soundness. There is no credible way to envision most government financial regulation being other than oversight of process. As the complexity of financial intermediation on a worldwide scale continues to increase, the conventional regulatory examination process will become progressively obsolescent—at least for the more complex banking systems. (emphasis added-w.e.)

One might naively ask, why then surrender all those powers like Glass-Steagall to the private banks far beyond possible official regulatory purview?

Again in October 1999, amid the frenzy of the dot.com IT stock market bubble mania, a bubble which Greenspan repeatedly and stubbornly insisted he could not confirm as a bubble, he once again praised the role of financial derivatives and "new financial instruments…reallocating risk in a manner that makes risk more tolerable. Insurance, of course, is the purest form of this service. All the new financial products that have been created in recent years, financial derivatives being in the forefront, contribute economic value by unbundling risks and reallocating them in a highly calibrated manner. He was speaking of securitization on the eve of the all-but certain repeal of the Glass-Steagall Act.

The Fed’s "private counterparty surveillance" brought the entire international inter-bank trading system to a screeching halt in August 2007, as panic spread over the value of the trillions of dollars in securitized Asset Backed Commercial Paper and in fact most securitized bonds. The effects of the shock have only begun, as banks and investors slash values across the US and international financial system. But that’s getting ahead of our story.

Deregulation, TBTF and Gigantomania among banks

In the United States, between 1980 and 1994 more than 1,600 banks insured by the Federal Deposit Insurance Corporation (FDIC) were closed or received FDIC financial assistance. That was far more than in any other period since the advent of federal deposit insurance in the 1930s. It was part of a process of concentration into giant banking groups that would go into the next century.

In 1984 the largest bank insolvency in US history threatened, the failure of Chicago’s Continental Illinois National Bank, the nation’s seventh largest, and one of the world’s largest banks. To prevent that large failure, the Government through the Federal Deposit Insurance Corporation stepped in to bailout Continental Illinois by announcing 100% deposit guarantee instead of the limited guarantee FDIC insurance provided. This came to be called the doctrine of "Too Big to Fail" (TBTF). The argument was that certain very large banks, because they were so large, must not be allowed to fail for fear of the chain-reaction consequences it would have across the economy. It didn’t take long before the large banks realized that the bigger they became through mergers and takeovers, the more sure they were to qualify for TBTF treatment. So-called "Moral Hazard" was becoming a prime feature of US big banks.

That TBTF doctrine was to be extended during Greenspan’s Fed tenure to cover very large hedge funds (LTCM), very large stock markets (NYSE) and virtually every large financial entity in which the US had a strategic stake. Its consequences were to be devastating. Few outside the elite insider circles of the very large institutions of the financial community even realized the doctrine had been established.

Once the TBTF principle was made clear, the biggest banks scrambled to get even bigger. The traditional separation of banking into local S&L mortgage lenders, large international money center banks like Citibank or J.P. Morgan or Bank of America, the prohibition on banking in more than one state, one by one were dismantled. It was a sort of "level playing field" but level for the biggest banks to bulldoze over and swallow up the smaller and create cartels of finance of unprecedented scope.

By 1996 the number of independent banks had shrunk by more than one-third from the late 1970s, from more than 12,000 to fewer than 8,000. The percentage of banking assets controlled by banks with more than $100 billion doubled to one-fifth of all US banking assets. The trend was just beginning. The banks’ consolidation was a direct outgrowth of the removal of geographic restrictions on bank branching and holding company acquisitions by the individual states, formalized in the 1994 Interstate Banking and Branch Efficiency Act. Under the rubric of "more efficient banking" a Darwinian survival of the biggest ensued. They were by no means the fittest. The consolidation was to have significant consequences a decade or so later as securitization exploded in scale beyond the banks’ wildest imagination.

J.P.Morgan blazes the trail

In 1995, well into the Clinton-Rubin era, Alan Greenspan’s former bank, J.P. Morgan, introduced an innovation that was to revolutionize banking over the next decade. Blythe Masters, a 34-year old Cambridge University graduate hired by the bank, developed the first Credit Default Swaps, a financial derivative instrument that ostensibly let a bank insure against loan default; and Collateralized Debt Obligations, bonds issued against a mixed pool of assets, a kind of credit derivative giving exposure to a large number of companies in a single instrument.

Their attraction was that it was all off the bank’s own books, hence away from the Basle Accord’s 8% capital rules. The goal was to increase bank returns while eliminating the risk, a kind of "having your cake and eating it too," something which in the real world can only be very messy.

J.P.Morgan thereby paved the way to transform US banking away from traditional commercial lenders to traders of credit, in effect, into securitizers. The new idea was to enable the banks to shift risks off their balance sheets by pooling their loans and remarketing them as securities, while buying default insurance, Credit Default Swaps, after syndicating the loans for their clients. It was to prove a staggering development, soon to hit volumes measured in the trillions for the banks. By the end of 2007 there were an estimated $45,000 billion worth of Credit Default Swap contracts out there, giving bondholders the illusion of security.

That illusion, however, was built on bank risk models of default assumptions which are not public and, if like other such risk models, were wildly optimistic. Yet the mere existence of the illusion was sufficient to lead the major banks of the world, lemming-like, into buying mortgage bonds collateralized or backed by streams of mortgage payments from unknown credit quality, and to accept at face value a Moody’s or Standard & Poors AAA rating.

Just as Greenspan as new Fed chairman turned to his old cronies at J.P. Morgan when he wanted to grant a loophole to the strict Glass-Steagall Act in 1987, and as he turned to J.P. Morgan to covertly work with the Fed to buy derivatives on the Chicago MMI stock index to artificially manipulate a recovery from the October 1987 crash, so the Greenspan Fed worked with J.P. Morgan and a handful of other trusted friends on Wall Street to support the launch of securitization in the 1990’s, as it became clear what the staggering potentials were for the banks who were first and who could shape the rules of the new game, the New Finance.

It was J.P. Morgan & Co. that led the march of the big money center banks beginning 1995 away from traditional customer bank lending towards the pure trading of credit and of credit risk. The goal was to amass huge fortunes for the bank’s balance sheet without having to carry the risk on the bank’s books, an open invitation to greed, fraud and ultimate financial disaster. Almost every major bank in the world, from Deutsche Bank to UBS to Barclays to Royal Bank of Scotland to Societe Generale soon followed like eager blind lemmings.

None however came close to the handful of US banks which came to create and dominate the new world of securitization after 1995, as well as of derivatives issuance. The banks, led by J.P. Morgan, first began to shift credit risk off the bank balance sheets by pooling credits and remarketing portfolios, buying default protection after syndicating loans for clients. The era of New Finance had begun. Like every major "innovation" in finance, it began slowly.

Very soon after, the new securitizing banks such as J.P. Morgan began to create portfolios of debt securities, then to package and sell off tranches based on default probabilities. "Slice and dice" was the name of the new game, to generate revenue for the issuing underwriting bank, and to give "customized risk to return" results for investors. Soon Asset Backed Securities, Collateralized Debt Securities, even emerging market debt were being bundled and sold off in tranches.

On November 2, 1999, only ten days before Bill Clinton signed the Act repealing Glass-Steagall, thereby opening the doors for money center banks to acquire brokerage business, investment banks, insurance companies and a variety of other financial institutions without restriction, Alan Greenspan turned his attention to encouraging the process of bank securitization of home mortgages.

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