Rodrigue Tremblay: Financial System under Siege


Richard Moore

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A Financial System under Siege

By Prof. Rodrigue Tremblay

Global Research, November 15, 2007

       "If these items [promised benefits in Social Security,
        Medicare, Veterans Administration and other entitlement
        programs] are factored in, the total [debt] burden in
        present value dollars is estimated to be about $53 trillion.
        Stated differently, the estimated current total burden for
        every American is nearly $175,000; and every day that burden
        becomes larger."
        David Walker, comptroller general of the United States

       "The economic forces driving the global saving-investment
        balance have been unfolding over the course of the past
        decade, so the steepness of the recent decline in long-term
        dollar yields and the associated distant forward rates
        suggests that something more may have been at work."
        Alan Greenspan, former Fed Chairman, July 20, 2005

       ³The subprime black hole is appearing deeper, darker and
        scarier than they [the banks] thought. They¹ve worked
        through ... about 40 percent of the backlog of the leveraged
        loan side, and there¹s definitely some signs of thaw there.²
        Tony James, president and CEO of Blackstone Group LP

The global dollar-based financial system is in crisis and is threatening the 
prosperity and stability of many economies. Financial excesses of all kinds have
undermined its legitimacy and its efficiency. The U.S. dollar is losing its 
preeminence as the main international reserve currency while many banks are 
caught in the turmoil of the subprime credit crisis.

The overall background is the unprecedented real estate bubble that took place 
worldwide, from 1995 to 2005. In the United States, for example, owner-occupied 
home prices increased annually by an average of about 9 percent. The market 
value of the stock of owner-occupied homes in the U.S. rose from slightly less 
than $8 trillion in 1995 to slightly more than $18 trillion in 2005. It has been
contracting ever since, confirming the working of the 18-year Kuznets realestate
cycle, which has gone from the top of 1987 to the 2005 top.

What makes this period especially dangerous is the fact that the average 54-year
long inflation-disinflation-deflation Kondratieff cycle is also at play, having 
begun in 1949 after prices were unfrozen. World inflation then rose for twenty 
years, until 1980, which was followed by a period of disinflation under the 
Volcker Fed. The entry of China into the World Trade Organization (WTO) on 
December 11, 2001, with its abundant labor and low wages, unleashed strong 
deflationary forces worldwide. This in turn led to lower inflation expectations 
paving the way for the Greenspan Fed to keep interest rates abnormally low.

Persistent low interest rates and low inflation expectations led to a binge in 
borrowing and to a vast increase in market valuation, not only in real estate 
but also in stocks and bonds. Banks and other mortgage lending institutions took
advantage of the opportunity to introduce some financial innovations in order to
finance the exploding mortgage market. These innovations resulted in the 
severing of the traditional direct link between borrower and lender and the 
reduction in the lending risk normally associated with mortgage loans.

Thus, with the connivance of the rating agencies and of the Federal Reserve 
System, large banks invented new financial products under various names such as 
"Collateralized Bond Obligations" (CBOs), "Collateralized Debt Obligations" 
(CDOs), also called "Structured Investment Vehicles" (SIVs), which had the 
characteristics of unfunded short term commercial paper. In the residential 
mortgage market, for example, mortgage brokers and retail lenders would sell 
their mortgage loans to banks, which in turn would package them together and 
slice them into different classes of mortgage-backed securities (RMBS), carrying
different levels of risk and return, before selling them to investors.

Indeed, these new financial instruments were the end result of a process of 
"asset securitization" and were slices of bundles of loans, not only of mortgage
loans but also of credit cards debts, car loans, student loans and other 
receivables. Each slice carried a different risk load and a different yield. 
With the blessing of rating agencies, banks went even one step further, and they
began pooling the more risky financial slices into more risky bundles and 
divided them again to be sold to investors in search of high yields.

By selling these new debt instruments to investors in search of high yields and 
higher yields, including hedged funds and pension funds, banks were doubly 
rewarded. First, they collected handsome managing fees for their efforts. But 
second, and more importantly, they unloaded the risk of lending to the 
unsuspected buyer of such securities, because in case of default on the original
loans, the banks would be scot-free. They had already been paid and had been 
released from the risk of default and foreclosure on the original loans.

The banks' residual role was to collect and distribute interest, as long as 
borrowers made their interest payments. But if payments stopped, the capital 
losses incurred because of the decline in the value of unperforming loans would 
instead be carried by the investors in CBOs and CDOs. The banks themselves would
suffer no losses and would be free to use their capital bases to engage in 
additional profitable lending. In fact, the end of the line investors became the
real mortgage lenders (without reaping all the rewards of such risky loans) and 
the banks could reuse their capital to pyramid upward their loan operations. 
These were the best of times for banks and they gorged themselves without 
restraint. Some of them paid their employees tens of billions of dollars in 
year-end bonuses.

Indeed, and it is here that the Fed and other regulatory agencies failed, first 
line mortgage lenders became more and more aggressive in their lending, with the
full knowledge that they could profitably unload the risk downstream. This 
explains the expansion of the "subprime" mortgage market where borrowing was 
done with no down payment, no interest payments for a while and no questions 
asked as to the income and creditworthiness of the borrower. These were not 
normal lending practices. Such Ponzi schemes could not last forever. And when 
housing prices started to decline, foreclosures also increased, thus shaking the
new financial house of cards to its foundations. Banks became the reluctant 
owners of some of the foreclosed properties at very discounted values.

Why then are so many banks in financial difficulties, if the lending risk was 
transferred to unsuspecting investors? Essentially, because when the housing 
boom burst, the banks' inventory of unsold "asset-backed securities" was 
unusually high. When the piper stopped playing and investors stopped buying the 
newly created risky investments, their value plummeted overnight and banks were 
left with huge losses still not fully reflected in their financial balance 
sheets. Indeed, banks that did not unload their stocks of packaged mortgages 
were forced to accept ownership of foreclose properties at very discounted 
values. With little or no collateral behind the loans, bad-debt losses became 

Since noboby knows for sure the value of something which is not traded, it will 
take months before banks come to terms with the total losses they have suffered 
in their stocks of unsold pre-packaged "asset-based securities". It is more than
a normal "liquidity crisis" or "credit crunch" (which results when banks borrow 
short term and invest in illiquid long term assets); it is more like a "solvency
crisis" if the banks' capital base is overtaken by the disclosure of huge 
financial losses incurred when the banks are forced to sell mortgaged assets in 
a depressed real estate market.

This is this financial and banking mess which is unfolding under our very eyes 
and which is threatening the American and international financial system. There 
are four classes of losers. First, the homebuyers who bought properties at 
inflated prices with little or no down payment and who now face foreclosure. 
Second, the investors who bought illiquid mortgage-backed commercial paper and 
who stand to lose part or all of their investments. Third, the holders of bank 
stocks who profited when the system worked smoothly but who now face declining 
stock values. And, finally, anybody who stands to fall victim, directly or 
indirectly, to the coming economic slowdown.

Rodrigue Tremblay is a Canadian economist who lives in Montreal; he can be 
reached at  •••@••.•••

Visit his blog site at:
Author's Website:

To Order Professor Tremblay's book,click here

Check Dr. Tremblay's coming book "The Code for Global Ethics" at:

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