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The Trillion Dollar Crisis

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The financial crisis that erupted throughout the world in autumn 2008 and since then has developed into a global economic crisis with an uncertain outcome did not come out of thin air and it is not the first of its kind. However the magnitude of it is utterly unique.

This DVD tells the chronicle of how it happened. It is the story of a house of cards, based on the real housing market in the USA, that was built higher and higher until it finally collapsed, wiping out money, security and confidence on an unprecedented scale.

Contents:

  • 1 Intro
  • 2 The Trillion Dollar Crisis
  • 3 The investors have too much money
  • 4 The American Dream and mortgages
  • 5 The banks
  • 6 Credit securitisation
  • 7 The idea has a forerunner
  • 8 Derivatives: credit default swaps – insurance turns into betting
  • 9 Variable interest rates
  • 10 Subprime mortgages

 

The trillion dollar crisis – From the US real estate bubble to the global economic crisis

The cause of the crisis; bad US real estate loans. For years, mortgage brokers and banks gave loans to consumers amounting to billions of dollars without any kind of security. In a procedure that was not even transparent to financial experts, they were converted to safe securities and sold by US investment banks around the world to institutions, companies and private investors without them having any idea of the risk lying dormant in their portfolio. These securities are called Collateralized Debt Obligations or CDOs for short. On the trading floor they are known as toxic waste.

 

Business that was booming for years crashes on 15 September 2008.

 

"I feel horrible, about what has happened to the company and its effects to so many..."

 

After 158 years in business, Lehmann Brothers, the fourth largest American bank, declares insolvency with losses of 613 billion dollars. Goldman Sachs, Merrill Lynch and Morgan Stanley are the next to be hit. Taken over by commercial banks, the US special legal form of investment banks comes to an end.

 

Their downfall triggers an economic earthquake throughout the world. Anyone who is suspected of having done business with them faces financial ruin overnight, regardless of whether this involves financial toxic waste or not. Even the Reserve Primary Fund, one of the oldest American money market funds, is affected. Although not burdened by bad investments, investors quickly sell off shares with a value of around 800 million dollars so that, for the first time in history, funds can not be paid back to the remaining investors at the original amount paid.

 

Shortly afterwards AIG, the largest insurance company in the world, collapses. It becomes clear that not only individual financial companies are in the epicentre of the crisis. Nearly all participants in the money market from different economic sectors are interrelated by these explosive securities. The most feared monster of the financial world is unleashed: insecurity.

 

The loss of confidence in the stability of the financial system combined with the fear that the next business partner could also be encumbered with toxic waste and become insolvent cause investors throughout the world to panic and return share certificates and investment securities worth 100 billion dollars. Suddenly the money market, practically the cash machine for banks, corporations and insurance companies, is in a fix - the credit crunch.

 

Suddenly large companies can no longer borrow any money for their businesses where before they could borrow millions of dollars in a matter of hours. As a result, 21 banks declare bankruptcy, 11 major banks have to be saved by the government and 62 hedge fund companies are bankrupt in the USA by the end of the year. An unmanageable wildfire breaks out that threatens the entire global economy that up to now has caused 50 trillion dollar losses on all stock markets in the world.

 

"Those who create and issue money and credit direct the policies of government and hold in the hollow of their hands the destiny of the people".

Reginald McKenna, former chairman of the Midlands Bank of England

The investors have too much liquidity

The story starts with money. A lot of money. In fact, 36 trillion dollars in total. This sum includes the savings of insurance companies, public authorities, banks, companies and private investors from all over the world. It also includes countries that suddenly became rich such as India, China and Saudi Arabia. They are all looking for a lucrative investment or, in other words, a solvent debtor because as we all know you only make money by lending it at a higher price.

 

One of the most interesting debtors is the United States. The USA is one of the largest debtors in the world and the US dollar is an unsecured currency with the withdrawal of gold coverage in 1973. US government bonds are one of the most popular investments as they promise acceptable returns at the US base rate and at a low risk. For this reason, investors head for the USA for the safest rate of return in the world.

 

However at this point in time Allan Greenspan, chairman of Federal Reserve, reduces the US base rate from 6.5 to 1 percent. He must urgently stimulate consumption with cheap consumer credit to strengthen the crisis-ridden markets that are no longer moving in the right direction since the new economy bubble burst and 11 September 2001.

 

While investors sit on more and more money, Greenspan clearly rebuffs them with the reduction of the base rate. At this juncture, almost 40 trillion dollars is available with nowhere to go. And every day there is more money with fewer and fewer investment opportunities. Because no-one wants to invest in shares or corporate bonds as they are considered to be risky and not very lucrative in these uncertain times. A profitable but safe investment is needed.

 

The large investment banks on Wall Street in New York promise to help. For years, banks such as Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley and Lehman Brothers have been successfully making profits with the sale of shares in mortgage loans known as Mortgage-Backed Securities or MBSs for short.     

And these banks now promise investors a safe investment with MBSs and sense an opportunity for big business in the process. Houses, apartments and large building projects are ultimately behind these securities whose prices are going in one direction: upwards.

 

Throughout the world, financial institutions and investors like the Deutsche Bank, Swiss UBS, French Crédit Agricole, British Royal Bank of Scotland and Japanese Mizuho Group all get on board with their sights set on the US real estate market that is now inflating into a dangerous speculation bubble. A market with millions of Americans who are eager to apply for ever-increasing loans to fulfil their American dream thanks to the low interest rate.

 

We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash, or credit. If the banks create ample synthetic money, we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is.

Robert H. Hemphill, Credit Manager, Federal Reserve Bank Atlanta

The American dream and mortgages

The dream of being a homeowner is deeply anchored in the American self-image.  Everyone in America wants this dream to come true. As a rule, anyone who wants to build a house or purchase real estate takes out a loan. Thanks to the historically low basic interest rate, the costs for "normal" mortgages which are loans that are invested over a fixed interest period of usually thirty years are now cheaper than ever.

When mortgages are awarded as the state promotion of home loans, they are considered as prime mortgages – first class mortgages that give the creditor protection by the state. If the borrower becomes insolvent and the house can not be sold at a foreclosure sale at the mortgage price, the state steps in and reimburses the creditor.

As a result, most private construction projects in the USA are financed with little or no capital resources. This sounds risky but is actually desirable. Normal mortgages can be cancelled at anytime by the borrower so that a system of continual debt rescheduling has established.

 

As soon as interest rates drop, expensive loans are regularly repaid by cheaper ones. As a result, the monthly payment is reduced by the loan as long as the value of the house increases. And the difference between the loan amounts can be retained as assets.

This is called home equity extraction and is used by US citizens to finance a second car or additional consumer goods.

 

Instead of saving money, many US borrowers get into debt with higher and higher loans. In most cases, this even happens with the recommendation of the bank with the aim being to increase consumption with credit. This is because 70% of the US economy depends on consumer spending. So it is not surprising that when the proportion of homeowners in the USA reached its peak in 2004, the house builders could release around 600 billion dollars for consumption by refinancing their loans.

 

"That is what our money system is. If there were no debts in our money system, there wouldn?t be any money".

Marriner S. Eccles, Chairman and Governor of the Federal Reserve Board

The banks

For the commercial banks, a lucrative business segment opened with investor interest in the US real estate market. They looked for partners who would supply them with new customers. Some found mortgage brokers and others investment banks in Wall Street, New York, who had the necessary contacts to international financial markets and so investors from all over the world.

Money was now extremely cheap.

 

The commercial banks bought money at the FED for just 1 percent to pass it on in the form of low interest loans to companies and private households so that nearly every American could afford a loan.

But low interest credit demands regularly reduce saving deposits while at the same time the need for financial capital for loans rises. In addition, the banks have to cover possible credit default risks with a minimum amount of their own capital resources. This minimum reserve rate is currently 8 percent in the USA. For example, this means that loans amounting to 1 billion dollars compel a bank to keep 80 million dollars of its own reserves as equity capital.

In relation to normal commercial banking volumes, this is not a large amount.

But from the point of view of the banks, this is too much unemployed capital that they would rather invest.

For this reason, loopholes are always sought to get around requirements such as the minimum reserve according to the motto "rules are for fools".

For this purpose, banks established special purpose vehicles that bought off their bank loans, made tradable securities from them and sold them on to investment banks.

This procedure is called credit risk transfer. The instruments for this provide financial products such as credit derivatives and credit securitisations.

Credit securitisation

Securitisation means:

"The creation of tradable securities from the debt claims or rights of property".

 

The seller transfers the debt claims to the buyer. And the buyer refinances this purchase by issuing securities. The debt to be securitised must guarantee a continual payment flow to cover the buyer's refinancing. For this reason, bank loans are particularly suitable as the interest payments and repayments to be made guarantee a continual capital inflow.

 

There are different debt claims that are summarised in the following groups:

 

  • "Asset Backed Securities“ (ABS) in the strict sense include securitised receivables of loans such as student loans, credit card receivables, automobile instalment credit and consumer receivables.
  • "Mortgage-Backed Securities" (MBS) only include receivables from mortgage loans.
  • "Collateralized Debt Obligations" (CDOs) include a combination of ABSs and MBSs as well as other kinds of loans and bonds. For this reason, they are considered to be extremely complex and non-transparent.

 

The aim of securitisation is to save the bank from credit defaulting. Using securitisation, banks can take debt claims from their balance sheets, sell credit and not have anything more to do with the credit in the event of loss. The investor bears the risk and takes on the loan. The credit institution becomes purely a credit broker.

 

In the next stage, the special purpose vehicles sell the securities created to investment banks who in turn sell them to investors. The securities acquired are restructured and reassessed. The risk-relevant parts of thousands to tens of thousands of credit agreements such as the debtor's financial position, the handling expenditure of the loan, its interest rate and maturity are examined closely. The contracts are divided up into different groups that correspond to certain risk levels. This gives rise to asset-based securities that are given to and checked by a credit assessment agency (a rating agency). They assign a quality seal for each individual sector or so-called tranche. These tranches include the AAA or prime tranche assessment for particularly safe investments whose returns are not so high. In contrast, the lowest C-tranche is considered to be risky but promises high returns. In this way, the instalments from the homeowner builder flow to the investors of the respective tranche. The safest A-tranche is serviced first and the risky C-tranche last according to the terrace principle. So payments for the risky C-tranche dry up first if the debtor has financial difficulties.

 

"One thing to realize about our fractional reserve banking system is that, like a child?s game of musical chairs, as long as the music is playing, there are no losers.

Andrew Gause, monetary historian

The idea has a forerunner

The spread of credit risks in the form of asset-backed securities was already used at the start of the 20th century. Back then, shares were securitized in a pool of mortgage loans. And Franklin D. Roosevelt also took up this idea again with his New Deal to counteract the global economic crisis of the time. In 1934, he started a national program for homeowner financing called the Federal Housing Administration or FHA for short. The program safeguarded securities with mortgages which were also safeguarded by state guarantees that in turn were sold to investors by the then state-owned Fannie Mae bank which was later privatised.

Roosevelt's program was enormously successful for two reasons: on the one hand, the proportion of homeowners increased by 20% since the introduction of the program so that in 1960 over 60 percent of Americans were proud homeowners. On the other hand, securities already traded under the name of mortgage-backed securities were a popular investment option. They were considered as a not very profitable but risk-free investment.

The success of these securities called private financial companies into action by 1985. They found the financial techniques for other kinds of bank loans and ultimately promoted the development of MBSs into ABSs until everything was combined in the form of CDO's.

 

"Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal".

Warren Buffet, 2003

Derivatives: Credit Default Swaps – Insurance turns into betting

In 1997, against the backdrop of bad loans, an internal work group of J.P. Morgan developed an instrument that together with CDOs was to revolutionise the world of finance: an insurance that transfers the risk of credit losses from the banks to investors: Credit Default Swap or simply CDS.

 

If a lender has doubts about the solvency of his borrower, he can protect himself against the risk by paying a premium to the insurance company. However, the CDS market is totally unregulated and turns the original insurance into a bet on whether a loss occurs or not.  Everyone can insure anyone else against the risk regardless of whether the parties are in possession of the receivables or not and the policies can be sold on to third parties at any time.

 

Earlier, securities were put in the safe until the value increased after time and were then sold on. Now, using derivatives including CDSs, we can speculate at an accelerated pace. It is therefore not surprising that the total stock of CDSs in the capital market amounts to 60 trillion dollars with underlying loans of only 5 trillion dollars. In other words: 5 trillion dollars were insured with 60 trillion dollars.

 

With massive marketing by Blythe Masters from J. P. Morgan, CDSs were celebrated as the solution to the oldest risk in banking. CDSs can be used to simply write off losses from bad loans. The supposed certainty misled investment banks into combining CDOs that were becoming less and less transparent as well as packaging and providing security for more and more CDOs until no one knew anymore who had insured whom against which risks.

Variable interest rates

But to be able to check the interest losses that are difficult to calculate resulting from the premature calling in of mortgages, mortgage loans with variable interest rates were increasingly offered at the height of the US real estate boom. These are called Adjustable Rate Mortgages or ARMs. Thousands of possible borrowers were approached and convinced of the advantages of variable interest rates in advertising campaigns.

 

The bait: the same low interest as for fixed interest mortgages. The catch: the low interest rate is only valid for the first two years of the credit period. Afterwards, the mortgage interest rate increases by the interest rate at which banks lend money to each other – the so-called LIBOR rate. For example, this means a mortgage that has a 7 percent interest rate for two years increases to 11 percent  (7 percent plus the LIBOR rate of 4 percent) from the third year.

 

A risky business. Because in 2003, when these offers were increasingly thrown on the market, the LIBOR rate and the US basic interest rate were extremely low with rising house prices. And no one wanted to imagine that it would ever be otherwise. But in 2004, the basic interest rate increased with the LIBOR rate. And by 2006 when the short periods of the first ARMs expired, even borrowers with good credit ratings experienced financial difficulties.

 

But for now the investment bankers had not miscalculated.

The mortgage business was to be the best of Wall Street since the New Economy bubble.

But when business started to take off, the prime mortgage market threatened to dry up.

 

Amongst solvent consumers, there was hardly anyone without a mortgage. But the market and investors alike demanded more.

Subprime mortgages

Original sound clip from George W. Bush

"So now it is my honour, right here at this important department, the department responsible for encouraging homeownership in America, to sign the "American Dream Downpayment Act".

 

In 2003, President George W. Bush signed the American Downpayment Act that promised to support home buyers on lower income levels. As a result, the issuance directives for mortgages became more and more lax.

People who would never have been capable of servicing their loans in the long-term because they had no income, no job and no assets now received millions of dollars in loans that were sometimes even for junk property.

It was the birth of the so-called NINJA loan - no income, no jobs, no assets.

At the same time, the entire American homeowner promotion instrument was urged to support the subprime market and lenders were asked not to demand complete documentation from subprime customers. Despite the risks, the subprime market developed immensely.

In the middle of 2006, the inevitable happened. The first borrowers can no longer pay their instalments and more and more houses are auctioned at foreclosure sales. As a result, the prices of the previously booming real estate market drop for the first time and the entire construct breaks down.

At the same time, payment defaults result in the first C-tranches of asset-backed securities no longer receiving any returns. Finally the cash flow dries up to such an extent that investors only find worthless items in their portfolios. This is the moment when investment banks such as Lehmann Brothers can no longer get rid of their packages. But they still owe the special purchase vehicles the purchase price of the securities that was to be generated from the resale to investors. The debts mount up resulting in the largest bank of America collapsing.

 

"Whoever controls the volume of money in any country is absolute master of all industry and commerce. And when you realise that the entire system is very easily controlled, one way or the other, by a few powerful men at the top, you will not have to be told how periods of inflation and depression originate". (James A. Garfield, assassinated President of the USA)

 

What started in 2006 as a real estate crisis and then developed into a banking and financial crisis that hit the headlines in 2008 finally ended up as a global economic crisis. Despite a billion dollar rescue package, the money market has not recovered from the Lehmann bankruptcy. Even today, many companies have problems borrowing money. Above all, long-term loans are checked with eagle eyes and then most of them are refused as banks would rather hoard their money in view of these insecure times. The crisis has cost 50 trillion dollars up to the start of 2009. Unemployment of up to around fifty million people is estimated throughout the world with a massive decline in the real economy. Comparisons are made with the global economic crisis of the 1930s.

It was not so long ago when the world experienced a similar crisis.

The saving & loans crisis cost the American tax payer 124 billion dollars between 1986 and 1995. It took around nine years until the crisis was overcome. Just twelve years later, we are experiencing the same thing but on a much bigger scale.

"All the perplexities, confusion and distress in America arise, not from defects in the Constitution or Confederation, not from want of honour or virtue, so much as from the downright ignorance of the nature of coin, credit and circulation" (John Adams, author of the American Constitution)


"Whoever controls the volume of money in any country is absolute master of all industry and commerce. And when you realise that the entire system is very easily controlled, one way or the other, by a few powerful men at the top, you will not have to be told how periods of inflation and depression originate".

James A. Garfield, assassinated President of the USA
Signet Sunflower Foundation