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Posted on 10/8/2008, 10:17:24 PM by DivaDelMar
Something very strange is happening in the financial markets. And I can show you what it is and what it means...
If September didn't give you enough to worry about, consider what will happen to real estate prices as unemployment grows steadily over the next several months. As bad as things are now, they'll get much worse.
They'll get worse for the obvious reason: because more people will default on their mortgages. But they'll also remain depressed for far longer than anyone expects, for a reason most people will never understand.
What follows is one of the real secrets to September's stock market collapse. Once you understand what really happened last month, the events to come will be much clearer to you...
Every great bull market has similar characteristics. The speculation must – at the beginning – start with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats.
Some of these limitations are obvious to any intelligent observer... like the need for a substantial down payment, the verification of income, an independent appraisal, etc. But human nature dictates that, given enough time and the right incentives, any endeavor will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate appraisals.
As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further... into fraud.
And this is where AIG comes into the story.
Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.
Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.
So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.
"What would it cost me to insure this subprime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.
Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you're buying against default for five years for say, 2% of face value.
Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.
Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year – long before the actual profit on the contract was made.
With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of subprime "toxic waste." The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral.
It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.
Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk. An enormous amount of capital was created out of thin air and tossed into global real estate markets.
On September 15, all of the major credit-rating agencies downgraded AIG – the world's largest insurance company. At issue were the soaring losses in its credit default swaps. The first big writeoff came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's largest insurance company was bankrupt.
The dominoes fell over immediately. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity.
Most people never understood how AIG was the linchpin to the entire system. And there's one more secret yet to come out...
AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs.
I'd wondered for years how Goldman avoided the kind of huge mortgage-related writedowns that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering.
The collapse of the credit default swap market also meant the investment banks – all of them – had no way to borrow money, because no one would insure their obligations.
To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. To date, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG's failure. Things are so bad at the investment banks, the Fed had to change the rules to allow Merrill, Morgan Stanley, and Goldman the ability to use equities as collateral for these loans, an unprecedented step.
The mainstream press hasn't reported this either: A provision in the $700 billion bailout bill permits the Fed to pay interest on the collateral it's holding, which is simply a way to funnel taxpayer dollars directly into the investment banks.
Why do you need to know all of these details? First, you must understand that without the government's actions, the collapse of AIG could have caused every major bank in the world to fail.
Second, without the credit default swap market, there's no way banks can report the true state of their assets – they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't cover for them anymore.
And third, and most importantly, without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade.
There's no way to replace this massive credit-building machine, which makes me very skeptical of the government's bailout plan. Quite simply, we can't replace the credit that existed in the world before September 15 because it didn't deserve to be there in the first place. While the government can, and certainly will, paper over the gaping holes left by this enormous credit collapse, it can't actually replace the trust and credit that existed... because it was a fraud.
And that leads me to believe the coming economic contraction will be longer and deeper than most people understand.
You might find this strange... but this is great news for those who understand what's going on. Knowing why the economy is shrinking and knowing it's not going to rebound quickly gives you a huge advantage over most investors, who don't understand what's happening and can't plan to take advantage of it.
How can you take advantage? First, make sure you have at least 10% of your net worth in precious metals. I prefer gold bullion. World governments' gigantic liabilities will vastly decrease the value of paper currencies.
Second, I can tell you we're either at or approaching a moment of maximum pessimism in the markets. These kinds of panics give you the chance to buy world-class businesses incredibly cheaply. A few worth mentioning are ExxonMobil, Intel, and Microsoft. I have several stocks like these in the portfolio of my Investment Advisory.
Third, if you're comfortable short selling stocks (betting they'll fall in price), now is the time to be doing it... simply as a hedge against further declines.
Keep the fraud of AIG in mind when you form your investment plan for the coming years. By following these three strategies, you'll survive and prosper while most investors sit back and wonder what the hell is going on.
Good investing,
Porter Stansberry
Economy/AIG ping
The DEMOCRATS did this! Plain and simple. They leaned HEAVY on financial institutions to provide risky loans. They called them racists, bigoted, prejudiced, etc., because banks DIDN’T want to engage in these risky sub-prime loans to people who could NEVER pay them back. Then they set up Fannie Mae and Freddie Mac to buy these risky loans from the banks. Then they STOPPED REAL REFORMS that were needed to stop the problem dead in its tracks BEFORE the housing bubble started to break.
Now it’s “Wall Street”
I’m fed up with so many Americans buying into the big lie. The politicians have completely perfected Goebbels Nazi propaganda, tell a BIG lie, and repeat it often and it will be believed.
It wasn’t “Wall Street” that caused this mess, it was DEMOCRATS! And then they put CORRUPT Democrats in charge of Fannie Mae and Freddie Mac and fleeced HUNDREDS OF MILLIONS in campaign contributions over 10 years. Look even “Gorelick” of the Clinton “wall” fame, who engineered the mechanism for the 9/11 terrorists to avoid detection. SHE was put in charge of one of the institutions and RIPPED OFF the American Public to the tune of some 75 MILLION in bonuses to buy up all those risky trash loans that the DEMOCRATS insisted had to be done.
Is Wall Street innocent? Nope, but this Socialist - Communist inspired class warfare has got to stop. It’s time people started pointing at the REAL root of the problem, the Party that calls itself “Democrat” but does not believe in democracy...
That is somewhat sobering. I worked in an office that had big ties to AIG, a salesman that put a huge insurance program together said there was no way AIG would be able to keep up with the losses based on the premiums they were charging but that was not his problem, he just sold their insurance. AIG has been in the fraud business for some time.
This problem so far has cost me $2xx,xxx.
Thanks a lot, Dems.
So....people can’t trust those STERLING characters at the bank,confidence dropped in lending institutions, the Government leaders have lied to us, they have their lowest approval rating, including Nancy Pelosi, religious leaders have badly let us down? Sports heroes have been everything but a guiding light? Weather Channels enhance Hurricanes, just ask Geraldo, Education, it’s okay to have sex with your students if it is consensual, Hollywood...OH MY GOODNESS....what have we left! I’m thinking of moving to ALASKA
“Why do you need to know all of these details? First, you must understand that without the government’s actions, the collapse of AIG could have caused every major bank in the world to fail. “
So everyone stop all the whining about Socialism...a LOAN (not a “bail-out”) to AIG had to happen.
good posting...thanks for putting out there.
bump
I’m a pretty die hard Capitalist. Against that backdrop I also agree that the government did have to step in. Not because I believe in any kind of socialism, but because of what recent history has taught.
Some time back Asia, and Japan in particular got HAMMERED because of banking problems there. There was no government intervention and it has taken them well over a decade to begin to recover. They are reasonably healthy now, albeit hammered by this mess in the sub-prime market as well.
However, several years back Sweden was in a similar situation and the government there intervened and their economy found its legs and recovered pretty quickly.
There is too much at stake to just let the whole house of cards falls as some advocate. My suggestion is that there should be MASSIVELY STIFF criminal penalties for every stinking, filthy piece of trash politician and corporate head who knew about this garbage. And the likes of Gorelick, and others who were “hand picked” to run these corrupt institutions and made MILLIONS should be in prison and paying back every stinking dime along with punitive damages.
$
I’m a pretty die hard Capitalist. Against that backdrop I also agree that the government did have to step in. Not because I believe in any kind of socialism, but because of what recent history has taught.
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My thoughts exactly.
My understanding is that the Swedish solution involved a temporary and total nationalization of various financial institutions, which were then cleaned up by the regulators. The drawback to implementing such a solution here, however, is that the U.S. banking system is very decentralized.
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“Second, I can tell you we’re either at or approaching a moment of maximum pessimism in the markets. These kinds of panics give you the chance to buy world-class businesses incredibly cheaply. A few worth mentioning are ExxonMobil, Intel, and Microsoft. I have several stocks like these in the portfolio of my Investment Advisory.
“Third, if you’re comfortable short selling stocks (betting they’ll fall in price), now is the time to be doing it... simply as a hedge against further declines....
So should we buy stocks or short them? Maybe some of each?
Voila, a mini hedge fund!
I only we knew which ones to buy and which ones to short, we could pick up a McMansion in Greenwich really cheap....
I'd love to see that too. However President Obama will promote the guilty and prosecute the innocent. He is just a slimmer Hugo Chavez.
PINGADINGDING
“This problem so far has cost me $2xx,xxx.
Thanks a lot, Dems.”
What are you going to do about it?
This is the best and clearest explanation I’ve have read regarding the consequences of not passsing the bailout. Thanks for the post, very informative.
Thay answer is varied and requires too much elaboration.
Praying is at the top of the list.
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