"Not (Yet) a ‘Minsky Moment’"

Charles W. Calomiris, the Henry Kaufman professor of financial institutions at Columbia’s business school, has an interesting but ultimately frustrating post at VoxEU in which he argues that the trouble we are seeing in the credit markets is not yet a Minsky moment (in very simplistic terms, the point at which an overlevered and highly speculative lending setting goes into contraction, leading to a collapse of asset prices). The post summarizes an article he wrote for the American Enterprise Institute (!), which I confess I have not yet read but plan to.

The post is schizophrenic. The first part gives a very good overview of how we got where we are, and includes a discussion of collateralized debt obligations, a topic too often neglected despite the size of that market. Calomiris even describes “LSS trades” and their role in the asset backed commercial paper market. I felt a bit chagrined to be learning about this for the first time, but felt a bit better when punched “LSS trades” into Bloomberg, Google, and the Financial Times. Nothing on Bloomberg, 15 references on Google (two of which were Calomiris’ work) and only one on the FT. And only Calomiris gave the ABCP connection.

After such a well informed start, it was jarring to have him give eight reasons why things really are not bad at all, and no counter-argument. The goes from analysis to advocacy while trying to maintain a posture of objectivity. Had Calomiris given both sides of the argument and taken a position in his concluding remarks, the piece would have been more convincing. But many of the eight reasons are a stretch, and one is intellectually dishonest, undermining the credibility he established in the set-up (my objections come after his post).

The piece certainly reads as if Calomiris subscribes to the AEI party line. From VoxEU:

The Subprime troubles caused a liquidity shock, but there is little reason to believe that a substantial decline in credit supply under the current circumstances will magnify the shocks and turn them into a recession. We have not (yet) arrived at a Minsky moment.

The late Hyman Minsky developed theories of financial crises as macroeconomic events. The economic logic he focused on starts with unrealistically high asset prices and buildups of leverage based on momentum effects, myopic expectations and widespread overleveraging of consumers and firms. When asset prices collapse, the negative wealth effect on aggregate demand is amplified by a “financial accelerator”; that is, collapsing credit feeds and feeds on falling aggregate demand credit. A severe economic decline is the outcome. Many bloggers refer to this as a “Minsky moment” (see Minsky 1975 for the real thing.)

I am sympathetic to the view that “Minsky moments” can happen (indeed, I have written numerous studies that give some support to that claim). But in my view, the correct application of the Minsky model to the current data indicates that we are not facing a Minsky moment – at least not yet. This column, which draws on a much longer that analysis I have posted at the AEI, summarises my reasoning.

At the moment, it is not obvious that housing or other asset prices are collapsing, or that leverage is unsustainably large for most firms or consumers. That is not to say that the economy will avoid a slowdown, or possibly even a recession. My main focus is not on forecasting changes in housing prices or consumption, per se, which are very hard to predict. I am interested in assessing the likelihood that financial weakness will substantially magnify aggregate demand shocks through a “financial accelerator” (otherwise known as a credit crunch).

The current liquidity shock

We are currently experiencing a liquidity shock to the financial system, initiated by problems in the subprime mortgage market, which spread to securitisation products more generally – that is, mortgage-backed securities, asset-backed securities, and asset-backed commercial paper. Banks are being asked to increase the amount of risk that they absorb (by moving off-balance sheet assets onto the balance sheet), but the related losses that the banks have suffered are limiting somewhat the capacity of banks to absorb those risky assets. The result is a reduction in aggregate risk capacity in the financial system as losses force those who are used to absorbing risk to sell off or close out their positions.

The financing of many risky activities unrelated to the core mortgage market shock has been reduced relative to their pre-shock levels. There are, at least temporarily, lots of “innocent bystanders” that are affected due to the aggregate scarcity of equity capital in financial intermediaries relative to the risk that needs reallocating.

The housing finance sector shock that started the current problems was small relative to the economy and financial system (estimated losses on subprime mortgages range from $200 billion to $400 billion). It was magnified because of the increased and imprudent use that has been made of subprime mortgage-backed securities in the creation of other securitisation conduits, and because of the connection of the instruments issued by those conduits to short-term asset-backed commercial paper.

From 2000 to 2005, the percentage of non-conforming mortgages that became securitised increased from 35% to 60%, and the volume of non-conforming origination also rose dramatically. Subprime mortgage originations rose from $160 billion in 2001 to $600 billion in 2006. And many of these securitised mortgages became re-securitised as backing for collateralised debt obligations (CDOs). As of October 2006, 39.5% of existing CDO pools covered by Moody’s consisted of MBS, of which 70% were subprime or second-lien mortgages. Why did subprime issuance boom from 2002 to 2006? Foreclosure rates for subprime mortgages actually peaked in 2002, but remarkably, that experience led to a sharp acceleration in the volume of subprime originations because the 2002-2003 foreclosures did not produce large losses. Losses from foreclosure were low in the liquid and appreciating housing market, and ratings agencies wrongly concluded that the forward-looking risks associated with subprime foreclosure were low. Instead, ratings should have recognised that this was an unusual environment, and that there was substantial risk implied by high foreclosure rates.

Despite CDOs’ increasing reliance on subprime mortgage-backed securities, and the observably low quality of these assets (i.e., high subprime foreclosure rates), CDO pools issued large amounts of highly rated debts backed by these assets. The CDO problem became magnified by the creation of additional layers of securitisation involving the leveraging of the “super-senior” tranches of CDOs (the AAA-rated tranches issued by CDO conduits). These so-called leveraged super-senior conduits, or “LSS trades,” were financed in the asset-backed commercial paper (ABCP) market. Some banks structured securitisations that levered up their holdings of these super-senior tranches of CDOs by more than 10 times, so that the ABCP issued by the LSS conduits was based on underlying organiser equity of only one-tenth the amount of the ABCP borrowings, with additional credit and liquidity enhancements offered to assure ABCP holders and ratings agencies. When CDO super-senior tranches turned out not to be of AAA quality, the leveraging of the CDOs multiplied the consequences of the ratings error, which was a major concern to ABCP holders of LSS conduits.

We have learned from the recent turmoil that mistakes in the pricing of fundamental risks in one market can have large consequences for the global financial system. In some ways, the global dimension of the shock is a sign of progress. Over the last two decades, securitisation had produced great progress in the sharing of risk and the reduction of the amount of financial system equity capital needed to absorb risk, by establishing mechanisms for transferring risk from banks’ and finance companies’ balance sheets to the market, and by establishing those mechanisms in creative ways that reduced adverse selection and moral hazard costs associated with more traditional securities markets.

That progress was real and these technological innovations will persist. Mistakes were made as part of what could be called a process of ‘learning by losing’ (the history of the last two decades has seen many temporary disruptions to the process of financial innovation in securitisation, as discussed in Calomiris and Mason 2004, of which the current liquidity shock is clearly the most severe). Securitisations have had a bumpy ride for two decades, which is inherent in innovation, but overall the gains from reshaping risk, sharing risk, and creating mechanisms that reduce the amount of equity needed per unit of risk (through improved risk measurement and management) have been large and will remain large, even if there is a substantial permanent shrinkage in securitised assets.

Risk reallocation has already produced a decline in the supply of available credit for some purposes, and this will not be fixed overnight. The financial system was devoting too little equity to intermediating risk in the mortgage securitisation market. There is likely to be a long-term reduction in the amount of credit that can be supplied per unit of equity capital in the financial system.

Furthermore, the shock occurred at a time when credit spreads seemed unreasonably low to many of us, reflecting the unusually high level of liquidity in the marketplace and the willingness of investors consequently not to charge sufficiently for bearing risk. In this sense, it is quite possible that credit spreads, once disturbed from those unrealistically low levels, will remain somewhat elevated after the shock dissipates.

But these adjustments, at least for now, do not a financial crisis make. It is possible that the financial system and economy could follow the patterns of 1970, 1987, and 1998 and recover from financial disturbances quickly without experiencing a recession, even without any further monetary policy stimulus by the Fed.1

Reasons to be cheerful

My view of the limited fallout rests on eight empirical observations:

1. Housing prices may not be falling by as much as some economists say they are.

Too much weight is being attached to the Case-Shiller index as a measure of the value of the US housing stock. Stanley Longhofer and I, along with many others, have noted (Calomiris and Longhofer 2007) that the Case-Shiller index has important flaws. Most obviously, it does not cover the entire US market, and the omitted parts of the US market seem to be doing better than the included parts. A comparison between the Case-Shiller and OFHEO housing price indexes shows that the Case-Shiller index provides a strikingly different, and less representative, picture of the US housing stock than OFHEO’s index. According to the OFHEO index, as shown in Figure 2, housing prices continued to rise on average through June 2007.

2. Although the inventory of homes for sale has risen, housing construction activity has fallen substantially.

The reduced supply of new housing should be a positive influence on housing prices going forward. Single-family housing starts dropped 7.1% in August relative to July and are down 27.1% on a year-to-year basis. Building permits for single-family homes slumped 8.1% in August (the largest decline since March of 2002) and are down 27.9% on the year. This decline in residential investment responded to an apparent excess supply problem; homeowner vacancy rates, which had averaged 1.7% from 1985 to 2005, jumped to 2.8% in 2006. The decline thus far in residential investment by the household sector as a share of GDP has been comparable by historical standards to the declines in the 1950s, 1960s, 1970s and 1980s (most, but not all, of which preceded recessions), as shown in Figure 8.

Note: Recessions are shaded.
Sources: Federal Reserve Statistical Release Z.1, Table F.6
(http://www.federalreserve.gov/releases/z1/Current/data.html); National Bureau of Economic Research, Business Cycle Expansions and Contractions (http://www.nber.org/cycles.html/)

3. The shock to the availability of credit has been concentrated primarily in securitisations rather than in credit markets defined more broadly (for example, in asset-backed commercial paper but not generally in the commercial paper market).

As Figure 9 shows, almost the entire decline in commercial paper in recent months has come from a contraction of asset-backed commercial paper, while financial commercial paper has contributed somewhat to the decline, and nonfinancial commercial paper has remained virtually unchanged.

This shows that the fallout from the shock has mainly to do with the loss in confidence in the architecture of securitisation per se, and secondarily with rising adverse-selection costs for financial institutions, but has not produced a decline in credit availability generally.

4. Aggregate financial market indicators improved substantially in September and subsequently. Stock prices have recovered, treasury yields rose in September as the flight to quality subsided, and bond credit spreads have fallen relative to their levels during the flight to quality (although Tbill yields remain low relative to other money market instruments).

5. As Figure 15 shows, nonfinancial firms are highly liquid and not overleveraged. Thus, many firms have the capacity to invest using their own resources, even if bank credit supply were to contract.

Note: Gross corporate leverage is defined as liabilities divided by assets. Net corporate leverage is defined as liabilities, less cash, divided by assets. Cash is defined as total financial assets, less trade receivables, consumer credit, and miscellaneous assets.
Sources: Federal Reserve Statistical Release Z.1, Table B.102

6. As David Malpass (2007) has emphasised, households’ wealth is at an all-time high and continues to grow. So long as employment remains strong, consumption may continue to grow despite housing sector problems.

7. Of central importance is the healthy condition of banks. As Fed Chairman Ben Bernanke noted from the outset of the recent difficulties, financial institutions’ balance sheets remain strong, for the most part, even under reasonable worst-case scenarios about financial sector losses associated with the subprime fallout. Bank lending has been growing rapidly, which is accommodating the transfer of securitised assets back onto bank balance sheets. The high capital ratios of banks at the onset of the turmoil is allowing substantial reintermediation to take place without posing a threat to the maintenance of sufficient minimum capital-to-asset ratios.

8. Banks hold much more diversified portfolios today than they used to. They are less exposed to real estate risk than in the 1980s, and much less exposed to local real estate risk, although US banks’ exposure to residential real estate has been rising since 2000 (Wheelock 2006).

In previous episodes of real estate decline (the 1920s, 1930s, and 1980s) much of the distress experienced by the banking sector resulted from its exposure to regional shocks, because of the absence of nationwide branch banking. In the 1980s, shocks associated with commercial real estate investments in the northeast, and oil-related real estate problems in the southwest, were particularly significant sources of banking distress. During the last two decades, however, banks have become much more diversified regionally, owing to state-level and federal reforms of branching laws. Banks also have a more diverse income stream due to the expansion of bank powers, which culminated in the 1999 Gramm-Leach-Bliley Act.

I conclude from this evidence that the consequences of the recent shocks for the supply of bank credit may turn out to be modest.


The current financial market turmoil resulted from a moderate shock to the housing and mortgage markets, which was magnified by the uses of subprime mortgages in a variety of securitisations vehicles, which produced a collapse of confidence in the architecture of securitisation and led to a sudden need to reallocate and reduce risk in the financial system. The liquidity risks inherent in maturity mismatched asset-backed commercial paper conduits substantially aggravated the short-term problem. Despite these disruptions, the fallout thus far in the financial system has been limited and appears to have been contained by a combination of market discipline and short-term central bank intervention. It is hard to know whether new financial shocks will occur (e.g., large housing price declines, or substantial increases in defaults on other consumer loans), or whether consumption demand will decline independent of financial system problems, but there is little reason to believe that a substantial decline in credit supply under the current circumstances will magnify the shocks and turn them into a recession. We have not (yet) arrived at a Minsky moment.

Of course, if housing prices fell by 50% nationwide (as some have argued is “entirely possible”) there is no question that the impact on consumers would be severe, both directly (via the decline in wealth) and indirectly (through its effects on the financial system). Judging from previous episodes of real estate price collapses, it would take years to sort out the losses. Real estate in liquidation is notoriously illiquid and hard to value; in the 1980s and early 1990s, banks and Savings and Loans that were stuck with large inventories of real estate took years to liquidate it, and given the valuation challenges associated with that real estate, found it costly to raise equity capital in the meantime. A real estate collapse would not only cause a decline in consumption via a wealth effect, it could produce a major financial accelerator effect.

Let’s quickly go through Calomiris’ arguments.

In 1. Calomiris claims that the housing recession isn’t that bad; OFHEO indices show that housing prices rose in 2007. Measurement is always a problem in markets that lack central reporting. Real estate industry participants who have an incentive to say things are fine are instead saying they are terrible. For example, Wells Fargo’s CEO deemed this housing market to be the worst since the Depression. Goldman Sachs is now forecasting a 15% to 20% fall in housing prices peak to trough.

In 2. he says housing construction has fallen (implication: overhang is not all that bad). Per these charts, overhang is much worse than in 1988-1989, and rental vacancies are considerably higher as well. So you can’t take too much comfort from the fall off in housing starts.

In 3. he claims the credit contraction is limited to the securitization market, and not “credit markets defined more broadly.” This is intellectually dishonest, particularly from someone who is a professor of financial institutions. Securitization has been taking market share from traditional credit intermediation (bank lending) for the last 30 years. Corporate lending, commercial and residential real estate loans, auto and credit card receivables and LBO loans are all securitized to a considerble degree. Residential real estate now depends on securitization; if there is no rebound in securitization, we will see a heap of trouble. That’s why policymakers are so keen to revive it. It isn’t such a great system in its current form (too much information loss, mis-aligned incentives, inability to pin liability on parties that are arguably culpable, like rating agencies) but it’s one on which we have come to depend.

4. says markets have recovered. Events subsequent to the writing of his paper prove make this view inaccurate. The S&P 500 is on the verge of giving up its gains for the year. Bloomberg today reports that Treasuries are enjoying their longest rally in 5 years as investors seek safety.

5. reports that non-financial firms are healthy and not highly leveraged. I’m not sure what his sample is. Average ratings of corporate issuers have declined, with nearly half the bonds now junk rated.

6. argues that houshold net worth is at an all time high. It won’t be for very long if housing continues on the trajectory that most anticipate, and will decline even more if the stock market follows.

7. and 8. claim that banks are healthy. Many are believed to be otherwise. Financial stocks hare dropped sharply this year, and large banks are now paying as much as 6% in dividends when Treasuries yield a mere 4%.

The “Conclusion” section sets up a crude straw man. Calomiris concedes that if “housing prices fell by 50% nationwide (as some have argued is “entirely possible”),” bad things would result. 50% is so far outside mainstream forecasts that the unnamed source must be a crank, and by association, those who think the economy could sustain severe damage are also cranks.

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  1. vlade

    Point 3 – credit contraction – I’d suggest he looks at LIBOR spreads over the relevant central bank rate, and then looks at what they used to be before Aug 9.
    4. Equity markets might have (with dow at 12800?), but they are only part of all the markets. For credit markets, see 3.
    7 & 8 – see 3.

  2. Anonymous

    The Minksy debate could be facilitated if one could scope the amount of equity capitalization available in banks and others, available to absorb the total estimated losses. There’s been more focus on estimation of losses than estimation of the total capital cushion.

  3. Anonymous


    Aren’t swaps for super senior synthetic CDOs?

    Aren’t super senior cash CDOs funded by commerical paper?

  4. jck

    There is no such thing as a “super senior cash CDOs”, if you have cash assets you need funding.
    Super senior are specific to synthetics or hybrids CDOs, where some assets like CDS don’t need funding and the risk is transferred directly to a super-senior counterparty via a super-senior CDS.
    In some hybrids a small part of a super senior may have to be funded (around 10%) in hybrid or synthetic for the purpose of meeting mtm collateral requirements and that can be CP or ABCP because it’s not expected to be permanent.This is not equivalent to LSS, the funded super senior has credit protection from other assets down the waterfall.In other words if a super senior has 20-100 attachment points, in case collateral is needed for mtm, you could have 20-30 attach for the funded super and 30-100 for the unfunded super.

  5. Alex Forshaw

    Yves, great post as usual–it’s surreal how anybody can argue at this point that we haven’t passed a Minsky moment.

    JCK, good to see you, your explainers on CDOs and associated debt products have been great too.

    The ‘Ted spread,’ ABX collapse, CMBX spreads, pretty much every credit spread out there is screaming ‘Defcon Five’ in the credit markets; and the 8/8 just indefinitely suspended covered bonds? Academia really do live in an alternate universe.

  6. Anonymous


    The following is from FTAlphaville. I guess the definition of super senior used here is wrong?

    Over the worst months of the credit squall Citi was obligated to nearly double its exposure to subprime CDOs. “Agreements” meant the bank bought an extra $25bn of subprime CDO paper, at a time when the market for CDO debt was crashing. In Citi’s 10-Q filing on Monday, the bank repeated its weekend disclosure of $43bn in CDO super senior debt “backed primarily by subprime collateral.

    … FT Alphaville understands that Citi has numerous agreements in place with CDOs that force the bank, as arranger, to buy CDO commercial paper if they cannot place it. That unplaceable debt has totalled $25bn so far – but there could be more.

    Crucially we should make clear that Citi isn’t necessarily being “forced” into buying that debt: not in the most literal sense of the word. The backstop “agreements” it has in place are not set in stone. It could have said no. But had it done so it may have seen CDOs default, or else a rush to sell assets to meet amortizing CP. In the event, that was evidently too ugly an option to countenance.

    And Citi may only now be ruing that decision. Commercial paper is classed as “super senior” debt in CDOs, and had until October, held out as a secure tranche. But the contagion has spread right up the tree, and the rating agencies have shown now mercy for even the highest grades of debt. Super senior debt is far from secure.


  7. Anonymous

    Adams Square Funding I, a mortgage-related investment vehicle battered by rising defaults among subprime borrowers, is being FORCED INTO LIQUIDATION.

    The CDO forced liquidation is triggered by rating downgrades on the underlying MBS collateral. Watch out for these MBS downgrades.

    2nd excerpt:

    On the heels of Moody’s recent downgrade of $33.4 billion of securities issued in 2006 that are backed by first-lien subprime mortgages, Standard & Poor’s last week lowered the ratings on 402 first-lien U.S. subprime RMBS classes, totaling $4.6 billion, from the first quarter through the third quarter of 2005.

    Last week, S&P also downgraded 1713 classes of U.S. RMBS backed by first-lien subprime mortgage loans, first-lien Alt-A loans, and closed-end second liens that were issued between Jan. 1, 2007 and June 30, 2007. The downgrades amounted to $23.35 billion. Thirty-nine AAA’ rated securities were slashed, though no rating waslowered below A’.

    Among the transactions hit hardest by agency downgrades thus far was Abacus 2007, arranged by ACA Management, which had 84% of its total RMBS collateral downgraded.

    ADAMS SQUARE FUNDING I AND II, arranged by Credit Suisse Alternative Capital, HAD 79% AND 64% OF ITS TOTAL RMBS COLLATERAL DOWNGRADED.

    Octonion CDO, arranged by Harding Advisory, had 80% of its RMBS collateral downgraded, and TABS 2006-5 and TABS 2006-6, arranged by Tricadia CDO Management, had 72% and 76% downgraded, respectively.

  8. jck

    The Alphaville article is quite sloppy.Part of the problem is that whoever wrote the article doesn’t appear to understand that unfunded super senior are notional amount and that under certain circumstances there may be a call for funding either due to mtm moves or losses.In that case the CP is super senior as explained in the latter part of my previous comment and that would happen with synthetic or hybrid CDOs.
    The term super senior is also sometimes used if some new funding takes priority over every other classes.For example if a CDO were to fund via repo, the repo becomes super senior in that it holds and can sell the assets if the cash is not returned.This is not what we are talking about here.
    The big Citi writedown has nothing to do with their super-senior exposure, CP or unfunded, they took a $200ml mark in october and additional $300ml mark in november, out of $8bn to 11bn writedown.

  9. Independent Accountant

    I appreciate your putting me on to voxeu.org. That said, I find much posted there is obscure at best, if not outright nonsense, like the recent post about Feldstein’s View on the Dollar. Feh. The topic at hand. A Columbia professor with a Stanford PhD should be able to do better than Calomiris. I agree, he veers into advocacy leaving analysis. “At this moment, it is not obvious that housing or other asset prices are collapsing, or that leverage is unsustainably large for most firms or consumers”. What evidence does he want? “Banks are being asked to increase the amount of risk that they absorb (by moving off-balance sheet assets onto the balance sheet), but the related losses that the banks have suffered are limiting somewhat the capacity of the banks to absorb those risky assets”. Professor please! The accounting recognition of risk is not, I repeat not, an “increase in the amount of risk” banks may absorb. The only reason the SIVs were not on the banks’ balance sheets all along is: bad accounting! “The financial system was devoting too little equity to intermediating risk in the mortgage securitization market”. What does that mean? I thought financial institutions devote assets to things, not equity? Does the good professor understand basic accounting? Disagreeing with Calomiris, I like Case-Schiller. That Helicopter Ben thinks “financial institutions balance sheets remain strong”, means nothing to me. If Calomiris knew anything, it would be: the powers that be will never, I repeat, never, tell you a big bank is in trouble. Why is Henry Paulson pushing MLEC? That banks “hold more diversified portfolios today” means nothing to me except they now have more opportunities to get in trouble. That Graham-Leach-Billey was passed does nothing for me. I opposed the bill at the time. Calomiris is saying, “Don’t worry. Be happy”. I’m worried and not happy.

  10. Anonymous

    ” The accounting recognition of risk is not, I repeat not, an “increase in the amount of risk” banks may absorb. The only reason the SIVs were not on the banks’ balance sheets all along is: bad accounting! “The financial system was devoting too little equity to intermediating risk in the mortgage securitization market”. What does that mean? “

    Sorry, the professor is correct. The assets were moved off balance sheet to reduce bank capital requirements – not because of bad accounting. They were moved back on due to failed capital models applicable to the off balance sheet vehicles and the banks’ explicit or implicit (reputational) obligation to backstop them. It was failed risk management, not failed accounting. The corollary of failed risk management is inadequate equity capital allocated to the mortgage business – the purpose of equity capital being the absorption of losses when they occur.

  11. Anonymous

    This will probably sound overly cynical, but my only real question upon reading the Calomiris piece was: Which IB paid him a consulting fee to write it?

    It’s almost pure “brokerage economics” — i.e. marketing copy — particularly his eight points of selective data and spin. I’m paid to crank this stuff out, so I definitely recognize the genre when I see it. In fact, several of his “data” points appear to be taken directly from some of Citi’s recent stuff.

    The corruption of the finance academics is one of the as-yet-untold stories of our Age of Securitization. The AEI will definitely rate a chapter when that book is finally written, and it looks like Calomiris might get a footnote.

  12. Yves Smith

    Anon of 3:12 PM,

    Independent Accountant does have a point. If banks felt they had to take the SIVs on to their balance sheets if they got into trouble (something they may not have told the auditors or even admitted to themselves at the time of creation) then the off balance sheet treatment is a fiction. It may have been permitted, bur from an economic standpoint, it was a sham. And accounting is supposed to make a “full and fair” presentation of the financial position of the company as of the date of the financial statements.

    Sarbox was supposed to put an end to this sort of thing. A lot of people like to claim that Sarbox is overreaching, but in this area, it clearly didn’t go far enough.

  13. revolution

    By Joan Veon

    The ruse that has been played out in the stock, bond, and credit markets for the last two months is one of the biggest scams of the century, after the crash of the NASDAQ. At stake is the cementing together of a global economic structure that will not be able to be dismantled.

    At the core of the trumped up credit crunch were a handful of international bankers that helped create a big enough deception which will ultimately lead to Congress exchanging our national regulatory laws for standardized international regulatory laws. Sadly, I have seen the pattern of creating a problem so you can solve it according to your hidden agenda, over and over again in the 27 years I have spent in the investment business. For those who think it is about a new low in the value of the dollar, they are wrong—the dollar has been dropping ever since the twin 1973 currency crises which sent then Assistant Treasury Secretary for International Monetary Affairs Paul Volcker around the world to hammer out a new regime for floating currencies (what a great way to transfer wealth and control countries: currencies). Every time the dollar drops, it is new and historic. For those who think the past two months was about the Rothschild’s cornering the global gold market, no way. They and the same core of international bankers that own the Bank of England, the Federal Reserve, and other major central banks control the value of gold. When central banks sell gold as they did in the late 90s, it is only title that changes, not the owners.

    In the fall of 1983, my husband and I purchased our first home. Several months later he got a job in another city but we were straddled for 2 ½ years with a house we could not sell because interest rates climbed to 22% with mortgages as high as 14-16%. Years later, I found out that our Congress changed “old and outdated” banking laws to render to national and international bankers, one of the most major coups of the century! The law which Congress passed is called the Depositary Institutions Deregulation and Monetary Control Act (1980 Deregulation Act), which basically lifted all restrictions on U.S. banks as to the amount of interest they could pay or charge investors/creditors. At the time this was heralded as being “good” for America since banks would have to pay market rates on savings, which conveniently rose to 22% for a short period of time. That was not a bad short-term price to pay for banks being able to pay very low rates for savings and charge usurious rates for credit cards from 9 ½% to 35% with home equity lines of credit being tied to prime. The high interest rates were appreciated by the serfs who have ceased to remember their joy.

    This globally trumped up liquidity and credit crunch was orchestrated by the key players: the international bankers: Goldman Sachs, Barclays, BNP Paribas, Bear Stearns, Citigroup, JP Morgan Chase, and Bank of America. They would not buy commercial paper from one another or lend to one another. Come on. This was reported as being shocking when in fact, it was the standard insiders game designed to facilitate major changes to U.S. regulations by scaring Congress and the rest of the country first. Once the Security and Exchange regulator has been folded into one agency—like Britain’s Financial Services Authority, instead of having separate regulators for commodities and derivatives, the world will go back to calm—for a little while. The next thing you are likely to hear is that the world needs a global financial regulator. But before that can happen, the national regulatory laws have to be harmonized to prepare the way.

    The supporting players were the hedge funds and complex investment instruments. It is not Joe Average who can afford to invest in these animals. Hedged funds known as “Quants” attempt to profit from price inefficiencies identified through mathematical models. These send buy/sell signals on small variations in price between different securities (Financial Times-FT, 8/13/07). Most of the international bankers have quant funds. In fact while they were crying the blues over a 30% drop in August and external investors lost 20% of their investment, it was reported that Goldman Sachs made $300M last month from the rescue of one of their troubled hedge funds. They injected $2B of their own money while billionaire friends injected another $1B to save it (FT, 9/16/7, 6). The fund was up 15% before the Fed bailout! What great math!

    The investment instruments are no doubt terribly complex. They are called derivatives ($400T in a world where the entire GDP is $40T), off-balance sheet structures known as conduits ($1,400B), and SIV’ or structured investment vehicles.

    The pawns were those who took a sub-prime mortgage and bit the apple in the same way Eve did. According to Fed Chairman Ben Bernanke, “About 7.5 million first-lien subprime mortgages are now outstanding, accounting for 14% of all first-lien mortgages. So-called near-prime loans—loans to borrowers who typically have higher credit scores than subprime borrowers but have other higher-risk aspects—account for an additional 8 to 10 percent of mortgages” (speech 5/17/07). Six months ago, there were $1,300B of subprime loans or about 13% of all outstanding mortgages while the total residential mortgage market is more than $20,000B. In other words, the subprime market is a very small percentage of our total economy. In fact the losses from the Savings and Loan Crisis in the 1990s were much higher.

    Regarding the mortgage market, it should be noted that the practice of banks selling mortgages they use to hold until maturity is over. In the 1980s when there was a mortgage default, it was the bank that took the hit. Now mortgages and loans of every type (auto, credit card, etc.) have been securitized (packaged into group of mortgages), then repackaged in a collateralized debt obligation bond (CDO) and sold to a hedge fund that bought it on leverage (David Hale, FT, 8/14/7, 11). The sophistication and complexity of how you sell mortgages has evolved since the 1980s. Bottom line is that the banks no longer carry mortgages or the risk—they basically act as conduits. It is the market—now the global market that carries the risk. The banks really are not concerned about the risk in the loans they make because all of them are now sold in the bond markets to pension funds, mutual funds, and others.

    While there is much more that could be said about this whole trumped up charade of loss of liquidity, the bottom line is that the Federal Reserve could have solved this problem two months ago by lowering interest rates. They are the ones who create the business cycle and market highs and lows by the amount of money they inject into the banking system. Just like in the 1980s, interest rates could have come down at any time, but there was another agenda. Can the Fed solve the problem of the sub-prime mortgages, no. Congress will have to deal with the inequities.

    At the international level, all of the international organizations: the Bank for International Settlements, the International Organization of Security Commissions, the Group of Seven finance ministers, and the Financial Stability Forum are talking about the need to have capital markets that are globally integrated since no one Central Bank could determine how to proceed. The U.S. is the only major country not to have all of their regulators under one roof (just like the British system which is used in many countries around the world). All countries need to adopt global accounting standards (the US is in the process of moving in that direction, there has been agreement between GAAP and the IASB) and countries must implement the BASEL II Capital Accords (which are new rules for international banks on how much they need to have in reserve for protection), the U.S. is in the process of implementing them. Then once these things are put in place, the world is ready for a global financial regulator!

    Just days after the Fed reduced interest rates by ½ of 1%, it was announced that the Dubai Stock exchange will acquire just under 20% of the Nasdaq stock exchange and 28% of the London Stock Exchange while the Nasdaq purchases the Nordic stock exchange, OMX. Do we see the handwriting on the wall?

    If the IMF is suppose to become a Global Central Bank, then perhaps the Financial Stability Forum is a forerunner of what might be suggested next month when the G7 reports on the problems of supposed credit crunch! All this drama just to integrate world markets and stock exchanges! The ruse is now global! People need to see beyond the lies, deceit, deception, and distortion so that they stop operating in fear and begin living in truth. Lastly, all of the volatility created allowed those in the know to make lots of extra money at the expense of those who sold low and those who lost their homes. Be prepared for more of these trumped up vignettes, they have been occurring from the beginning of time. This one is in our generation.

    Joan Veon is Executive of The Women’s International Media Group, Inc., http://www.womensgroup.org

  14. Yves Smith


    Very helpful comments, but I must confess I feel I still do not understand this LSS trades issue sufficiently well, particularly since the FT item on it (by John Dizard, who is pretty reliable) made it sound like the only conceivable risk was yield curve risk:

    Let’s take a look at one of the common strategies….the investment managers you pay are now ready to fight the last war….

    This time your hedge fund manager will tell you in his monthly letter that he is going to stick to the safest possible slices of the credit market, the so-called “super senior” tranches of pools of bonds and loans. The super seniors will not incur credit losses unless there are defaults that extend below the 30 per cent “attachment point” right up to the 100 per cent point. That means the pool of collateral representing corporate credit will have to lose more than 70 per cent of its value before you, the investor, lose any principal.

    Fine, problem solved.

    Well, yes, but there is now another potential problem, a bad one that could happen very soon. The super senior tranches, because they have so little risk of loss of principal, earn very, very little interest. Maybe a few, as in single digits of basis points, over the swaps curve.

    How to repeal the law of gravity this time? With more leverage, of course, so the Leveraged Super Seniors are created. A large LSS position is created by using a small amount of equity and a large amount of borrowings to buy a big position in super seniors. But that doesn’t matter, does it, because the super seniors won’t default, and this can go on forever.

    Some people who were around five years ago can remember that at the end of the upswing of a financial and economic cycle, yield curves will invert, with short rates going higher than long rates and staying there for a few months.

    When that happens, the 50 or 75 basis points being earned on an LSS position can disappear very rapidly. Remember the super seniors are slices of five- or 10-year credit; they won’t be earning as much as the borrowings used to buy them, and those super senior interest rates are fixed.

    This is the new and dangerous connection between the macroeconomic world and the sophisticated end of the credit markets. Credit market people aren’t always that good at calling macroeconomic turns. They tend to do more bottom-up, company level analysis, or study the documentation for CDSs, CDOs, and credit indices.

    If this inversion lasts for a month, or two, or three, then more of the risk managers of the dealers who sell these positions to hedge funds will issue collateral calls or demand the positions be liquidated. At that point, there may not be all that many buyers, and none at a break-even price, for the super senior tranches. Your equity will disappear somewhere in the middle of this sad process.

    What the hedge fund manager told you will turn out to have been true: the super seniors will not have defaulted. However, they will not be earning enough to pay their way in an inverted curve world….

    As one dealer’s credit strategist tells me: “The leveraged super senior trade blows up after the curve inversion lasts a couple of months. Then all the flows will go one way – no one will want to receive fixed. The risk managers will say ‘We want you to unwind some of these trades’. But who will be willing to buy that paper?”

    Do you have any sources you’d recommend?

  15. Yves Smith

    Anon of 3:31 PM,

    Agreed, except I doubt payment was that direct. That’s what the think tanks are for, both to create distance and an air of legitimacy. I imagine once in a while the likes of Cato and the AEI put out something decent, but at least for for me, they’ve established a negative brand image. They are so confident of their world view that they aren’t shy about being partisan.

  16. jck

    There is yield curve risk but at this point in time this dwarfed by mtm movements.Felix has posted a graph that makes the whole thing easier to understand.

  17. Anonymous

    Yves Smith 3:56 PM

    A couple of broader points on the context for all of this (but not to defend it):

    What’s happened is a limiting case of the institutional risk in the whole idea of ‘securitization’. I would extend securitization here to include more abstractly the entire sphere of derivatives. Securization and derivatives are all about transferring risk, mostly away from bank balance sheets.

    These risk transfers are subject to the scrutiny of regulatory capital requirements. If risk is transferred the way it should be according to the rules, then banks are relieved of the capital requirements that would have underpinned those risks transferred out.

    So this is is not so much about auditors and accountants per se as it is about the rules for minimum capital requirements, which are prescribed by the various Basle accords. Auditors and accountants serve as a check on the implementation of those rules, but they do not make the rules.

    So this is all about risk and capital.

    I don’t know how much of the put of the risk back to the banks is based on reputational obligation versus legal obligation. If its the latter, then it must be covered under capital reqirements. If its the former, then there really is a fundamental question about the treatement of that as a risk.

    I’m not familiar enough with Sarbox to know whether it covers the issue of the accurate depiction of risk as well as the accurate depiction of financial results.

  18. Independent Accountant

    Anonymous is an ignoramus. I know the SIVs were kept off the banks’ balance sheets for Basel capital considerations. HOWEVER, the point is: they should NOT have been. I am a CPA and know my business. Keeping the SIVs off the banks balance sheets, or at least not disclosing them, was improper accounting. The risk is NOT in the accounting, but in the banks contractual arrangements with the SIVs they sponsored. I have an offer for Calomiris. One of my old accounting profs is now an NYU Professor Emeritus. Take the subway from 116th Street down to Washington Square and sit down with George Sorter for about an hour and discuss the SFAS 5 rules concerning the PROPER accounting for the SIVs. If Sorter has forgotten me, I’ll call him and refresh his recollection and see if I can squeeze a favor out of him for the good of the USA.
    I’ll go further: the SEC should already be investigating the banks SIV accounting. This is the same story as Enron and its limited partnerships. Is the Justice Department investigating the banks for securities fraud? If not, why not?

  19. Anonymous

    To the extent LSS positions could (ultimately) be funded in Tokyo, I suspect the carry was not negative, even when the Treasury curve was most inverted. But, add the sudden appearance of default risk to a weakening dollar — and doubts about the adequacy or sustainability of the hedges that covered the currency exposure, PLUS the inverted dollar yield curve, and it was only a matter of time before the rush to the exits began, as it did this summer.

  20. Anonymous

    “I’ll go further: the SEC should already be investigating the banks SIV accounting. This is the same story as Enron and its limited partnerships.”

    The first time I heard about the SIVs my initial thought was: How, exactly, is this different from the “raptor” scams? But I assumed it had to be, because, hey, nobody would be so reckless as to try the same scam AGAIN so soon after the people behind the first one got caught.

    Knowing Citi (at least, the post-2002 Citi)I seriously doubt the powers that be would have signed off on it unless they had a favorable opinion from someone — outside counsel, accounting firm, or both.

    The real task for some enterprising reporter is to find out who those people where.

  21. Anonymous

    Independent accountant is a fulminating fool. He contradicts himself because as a bookkeeper has no understanding of the distinction between risk and accounting. It’s ridiculous to compare this to Enron. Enron was a fraud that buried accounting losses off-balance sheet. This is about off-balance sheet risk – which is an issue as old as securitization itself.

  22. Independent Accountant

    I am a CPA and that a Big Four CPA firm and a Big “Prestigious” NYC law firm sign off on anything means nothing to me. Of course Citigroup had favorable opinions from law firms and KMPG. So what? I’ve seen plenty of law firm tax opinions that weren’t worth the paper they were printed on. Enron had favorable legal opinions on its off balance sheet arrangemets and a Big Five CPA, Arthur Andersen, ever heard of them? So? Have you followed the Ernst & Young Wal-Mart tax fiasco? Big firm, big deal. Favorable opinions can be bought, just like expert testimony and credit ratings. Do you still think an S&P “AAA” means a lot?

  23. Anonymous

    Independent –

    You’re one angry accountant. I have nothing against accountants but you just trashed your entire profession.

    S&P AAA risk has nothing to do with accounting. Or lawyers! It’s about risk. That’s my point. S&P had a bad risk model and/or were conflicted in their relationships.

    This is about financial engineering exuberance gone mad – not about fraud.

    The baby of such exuberance was securitization itself, followed by derivatives, etc. etc. All designed to transfer risk.

    The problem in this case is risk modelling that couldn’t measure up to the complexity of the instruments created – which by the way was EXACTLY the problem created in LTCM – and the only fundamental problem – NOT accounting or legal!

    Enron on the other hand was accounting fraud!

  24. Independent Accountant

    What makes something a fraud is the intent behind the act, not the act itself. S&P “had a bad risk model”. Of course. Why did S&P adopt a “bad risk model”? Was S&P stupid or did it knowingly adopt “a bad risk model” to collect fees? You may not believe there is fraud in Citigroup’s accounting. I do. What do you think one purpose of “financial engineering” is? I believe one is: to facilitate fraud. Do you believe the “20-sigma event” story? I don’t. If the CPA profession deserves to be “trashed”, so be it. You want to call me angry, be my guest, though digusted is more accurate.

  25. Anonymous

    Independent Acc –

    We may be closer on this. I suspect S&P is motivated by greed like most players – which is a conflict in itself – but the catalyst may be incompetence as much as fraud.

    I liken this to LTCM, where partners had their own money on the line for pure risk – Nobel prizes are no hedge for the poor judgement that is later explained away as a 20 sigma event – and no, I don’t believe in the 20 sigma event either.

    I don’t know about fraud at Citi. I know that banks will stretch the regulatory capital rules just about as far as they can. I doubt that’s fraud. Maybe bad judgement in terms of the ultimate consequences – which amounts to stupidity in the long run.

    I think the purpose of financial engineering is to slice and dice capital and risk into deceptively enticing morsels of expected return – maybe that’s moral fraud but probably not financial fraud.

    Disgust is appropriate.

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