Anatomy of a Financial Crisis: Part II

There are those who say that the housing market is just one segment of our overall economy and bad loans are just a fraction of the housing market, so there is nothing to worry about. This viewpoint is wrong, because the housing market is not sealed off from the rest of the economy. On the contrary, clever Wall Street financiers have managed to convert a serious housing bust into a potentially cataclysmic financial crisis. Here is what happened: The financial whiz-kids generated handsome commissions and fees for themselves through a technique known as “securitization”—the creation of financial instruments comprised of bundles of mortgages. These pseudo-securities were then bought by hedge funds and other financial institutions that used them as security for issuing reams of exotic financial derivatives—a dizzying array of CDOs, SIVs, CLOs, CDSs, CSOs, ABCP, etc., etc.—that were then used as collateral for the creation of additional layers of CDOs, etc. Picture a multi-story edifice of financial instruments with the securitized mortgages as the foundation.

How big is this structure of financial instruments? According to a recent report by the Bank of International Settlements, the total nominal value of financial derivatives in the world is approaching $700 trillion. Yes, TRILLION! Five major banks alone—Bank of American, Citibank, HSBC, JPMorgan Chase, and Wachovia—hold over $130 trillion of derivatives. That amount is ten times our national GDP. The banks assure us that risk is under control. That is exactly what the Nobel laureates behind Long Term Capital Management said in 1998, just before LTCM imploded and almost caused a meltdown of our entire financial system. If a multi-trillion-dollar chain reaction of derivative failures were to occur today, pondering the aftermath boggles the mind.

And how stable is the foundation of this structure? Not very. High-risk debt—which is what many of these securitized bundles of mortgages are turning out to be—is not the kind of rock-solid asset on which to base a pyramid of derivative assets. To cite one specific example of the shakiness of these securitized mortgages: one mortgage-based security packaged and sold by Goldman Sachs consisted of 8,274 second mortgages, 58 percent of which were no- or low-documentation, with an average equity of only .71 percent. One-sixth of those mortgages were in default within months, rendering this security and any derivatives based on it essentially worthless.

Under new regulatory standards that became mandatory for financial institutions in November, mortgage-based securities are generally classified as Level Three (the weakest level)—meaning that there is no reliable way to price these instruments, hence, no bid, no aftermarket for them. When one considers that such pillars of U.S. finance as Goldman Sachs, Bear Stearns, Lehman Brothers and Morgan Stanley have more level three assets than they do capital (Morgan Stanley is the most exposed, with two-and-one-half times as much level three assets as capital), you can begin to sense how precarious our financial situation is.

The financial system of our country may be collapsing before our eyes. How many times this year have you read about major financial institutions writing down billions of dollars of bad debt? Were you aware that several hundred billion dollars’ worth of asset-backed commercial paper has vaporized since August?These could be the early temblors of a catastrophic financial earthquake. That is why the president and the Fed are acting so desperately. When the president proposes stemming the tide of mortgage defaults, he isn’t worried about rewarding reckless behavior or being fair; he’s trying to prevent a financial collapse by shoring up the shaky foundation—the mortgage-backed securities—of our financial house of cards. When the Fed repeatedly pumps tens of billions of dollars into the financial system, it is trying to patch up the crumbling foundation and superstructure of that rickety financial edifice. The Fed would rather inflate like mad than see the financial system of our country freeze up and collapse.

Wall Street is the villain in this ongoing drama. It pains me to say that, because I believe that our capitalist system requires strong, innovative, free financial institutions. But as strongly as I believe in freedom and free markets, I also know that freedom cannot be unlimited.

Just as the right to free speech doesn’t give one the right to shout “Fire!” in a crowded theatre, similarly, the right of private individuals and companies to devise innovative ways to increase profits does not justify their jeopardizing the entire financial and economic well-being of our country. Yet, this is what Wall Street has done by recklessly creating trillions of dollars of derivatives based on the toxic, unsound foundation of mortgage-backed securities. I don’t know if Wall Street is capable of dismantling the structure of derivatives voluntarily before it either collapses or the politicians make an even bigger mess of things, but I hope it can.

Some optimists believe that the worst of the combined housing-financial crisis is behind us. I fervently hope that they are right, but it looks to me like we are still in its early stages. Ladies and gentlemen, fasten your seat belts.