Our Advertisers Represent Some Of The Most Unique
Products & Services On Earth!
The Financial Tsunami - Part 4
Asset Securitization - The Last Tango
By F. William Engdahl *
Endgame: Unregulated Private Money Creation
What had emerged going into the new millennium after
the 1999 repeal of Glass-Steagall was an awesome transformation of American
credit markets into what was soon to become the world's greatest unregulated
private money creation machine.
The New Finance was built on an incestuous, interlocking,
if informal, cartel of players, all reading from the script written by
Alan Greenspan and his friends at J.P. Morgan, Citigroup, Goldman Sachs,
and the other major financial houses of New York. Securitization was going
to secure a "new" American Century and its financial domination,
as its creators clearly believed on the eve of the millennium.
Key to the revolution in finance in addition to the unabashed
backing of the Greenspan Fed, was the complicity of the Executive, Legislative
and Judicial branches of the US Government right to the Supreme Court.
In addition, to make the game work seamlessly, it required the active complicity
of the two leading credit agencies in the world-Moody's and Standard &
It required a Congress and Executive branch that would
repeatedly reject rational appeals to regulate over-the-counter financial
derivatives, bank-owned or financed hedge funds or any of the myriad steps
to remove supervision, control, transparency that had been painstakingly
built up over the previous century or more. It required that the major
government-certified rating agencies give their credit AAA imprimatur to
a tiny handful of poorly regulated insurance companies called Monolines,
all based in New York. The monolines were another essential part of the
The interlinks and consensus behind the massive expansion
of securitization among all these institutional players was so clear and
pervasive it might have been incorporated as America New Finance Inc.
and its shares sold over NASDAQ.
Alan Greenspan anticipated and encouraged the process
of asset securitization for years before his actual nurturing of the phenomenal
real estate bubble in the beginning of the first decade of the new Century.
In a pathetic attempt to deny his central role after the fall, Greenspan
last year claimed that the problem was not mortgage lending to sub-prime
customers but the securitization of the sub-prime credits. In April 2005,
he sung a quite different hymn to sub-prime securitization. Addressing
the Federal Reserve System's Fourth Annual Community Affairs Research Conference,
the Fed chairman declared,
"Innovation has brought about a multitude of new
products, such as subprime loans and niche credit programs for immigrants.
Such developments are representative of the market responses that have
driven the financial services industry throughout the history of our country.
With these advances in technology, lenders have taken advantage of credit-scoring
models and other techniques for efficiently extending credit to a broader
spectrum of consumersThe mortgage-backed security helped create a national
and even an international market for mortgages, and market support for
a wider variety of home mortgage loan products became commonplace. This
led to securitization of a variety of other consumer loan products, such
as auto and credit card loans."
That 2005 speech was about the time he later claimed
to have suddenly realized securitization was getting out of hand. In September
2007 once the crisis was full force, CBS' Leslie Stahl asked why he did
nothing to stop "illegal or shady practices you knew were taking place
in sub-prime lending." Greenspan replied, "Err, I had no notion
of how significant these practices had become until very late. I didn't
really get it until late 2005 and 2006" (emphasis added-w.e.)
As far back as November 1998, only weeks after the near-meltdown
of the global financial system through the collapse of the LTCM hedge fund,
Greenspan had told an annual meeting of the US Securities Industry Association,
"Dramatic advances in computer and telecommunications technologies
in recent years have enabled a broad unbundling of risks through innovative
financial engineering. The financial instruments of a bygone era, common
stocks and debt obligations, have been augmented by a vast array of complex
hybrid financial products, which allow risks to be isolated, but which,
in many cases, seemingly challenge human understanding."
That speech was the clear signal to Wall Street to move
into asset-backed securitization in a big way. After all, hadn't Greenspan
just demonstrated through the harrowing Asia crises of 1997-98 and the
systemic crisis triggered by the August 1998 sovereign debt default that
the Federal Reserve and its liquidity spigot stood more than ready to bailout
the banks in event of any major mishap? The big banks were, after all,
clearly now, Too Big To Fail-TBTF.
The Federal Reserve, the world's largest and most powerful
central bank with what was arguably the world's most liberal market-friendly
Chairman, Greenspan, would back its major banks in the bold new securitization
undertaking. When Greenspan said risks "which seemingly challenge
human understanding," he signaled that he understood at least in a
crude way that this was a whole new domain of financial obfuscation and
complication. Central bankers traditionally were known for their pursuit
of transparency among banks and conservative lending and risk management
practices by member banks.
Not 'ole Alan Greenspan.
Most significantly, Greenspan reassured his Wall Street
securities underwriting friends in the Securities Industry Association
audience that November of 1998 that he would do all possible to ensure
that in the New Finance, the securitization of assets would remain for
the banks alone to self-regulate.
Under the Greenspan Fed, the foxes would be trusted to
guard the henhouse. He stated:
"The consequence (of the banks' innovative financial
engineering-w.e.) doubtless has been a far more efficient financial systemThe
new international financial system that has evolved as a consequence has
been, despite recent setbacks, a major factor in the marked increase in
living standards for those economies that have chosen to participate in
It is important to remember--when we contemplate the
regulatory interface with the new international financial system--the system
that is relevant is not solely the one we confront today. There is no evidence
of which I am aware that suggests that the transition to the new advanced
technology-based international financial system is now complete. Doubtless,
tomorrow's complexities will dwarf even today's.
It is, thus, all the more important to recognize that
twenty-first century financial regulation is going to increasingly have
to rely on private counterparty surveillance to achieve safety and soundness.
There is no credible way to envision most government financial regulation
being other than oversight of process. As the complexity of financial intermediation
on a worldwide scale continues to increase, the conventional regulatory
examination process will become progressively obsolescent--at least for
the more complex banking systems. (emphasis added-w.e.)
One might naively ask, why then surrender all those powers
like Glass-Steagall to the private banks far beyond possible official regulatory
Again in October 1999, amid the frenzy of the dot.com
IT stock market bubble mania, a bubble which Greenspan repeatedly and stubbornly
insisted he could not confirm as a bubble, he once again praised the role
of financial derivatives and "new financial instrumentsreallocating
risk in a manner that makes risk more tolerable. Insurance, of course,
is the purest form of this service. All the new financial products that
have been created in recent years, financial derivatives being in the forefront,
contribute economic value by unbundling risks and reallocating them in
a highly calibrated manner. He was speaking of securitization on the eve
of the all-but certain repeal of the Glass-Steagall Act.
The Fed's "private counterparty surveillance"
brought the entire international inter-bank trading system to a screeching
halt in August 2007, as panic spread over the value of the trillions of
dollars in securitized Asset Backed Commercial Paper and in fact most securitized
bonds. The effects of the shock have only begun, as banks and investors
slash values across the US and international financial system. But that's
getting ahead of our story.
Deregulation, TBTF and Gigantomania among banks
In the United States, between 1980 and 1994 more than
1,600 banks insured by the Federal Deposit Insurance Corporation (FDIC)
were closed or received FDIC financial assistance. That was far more than
in any other period since the advent of federal deposit insurance in the
1930s. It was part of a process of concentration into giant banking groups
that would go into the next century.
In 1984 the largest bank insolvency in US history threatened,
the failure of Chicago's Continental Illinois National Bank, the nation's
seventh largest, and one of the world's largest banks. To prevent that
large failure, the Government through the Federal Deposit Insurance Corporation
stepped in to bailout Continental Illinois by announcing 100% deposit guarantee
instead of the limited guarantee FDIC insurance provided. This came to
be called the doctrine of "Too Big to Fail" (TBTF). The argument
was that certain very large banks, because they were so large, must not
be allowed to fail for fear of the chain-reaction consequences it would
have across the economy. It didn't take long before the large banks realized
that the bigger they became through mergers and takeovers, the more sure
they were to qualify for TBTF treatment. So-called "Moral Hazard"
was becoming a prime feature of US big banks.
That TBTF doctrine was to be extended during Greenspan's
Fed tenure to cover very large hedge funds (LTCM), very large stock markets
(NYSE) and virtually every large financial entity in which the US had a
strategic stake. Its consequences were to be devastating. Few outside the
elite insider circles of the very large institutions of the financial community
even realized the doctrine had been established.
Once the TBTF principle was made clear, the biggest banks
scrambled to get even bigger. The traditional separation of banking into
local S&L mortgage lenders, large international money center banks
like Citibank or J.P. Morgan or Bank of America, the prohibition on banking
in more than one state, one by one were dismantled. It was a sort of "level
playing field" but level for the biggest banks to bulldoze over and
swallow up the smaller and create cartels of finance of unprecedented scope.
By 1996 the number of independent banks had shrunk by
more than one-third from the late 1970s, from more than 12,000 to fewer
than 8,000. The percentage of banking assets controlled by banks with more
than $100 billion doubled to one-fifth of all US banking assets. The trend
was just beginning. The banks' consolidation was a direct outgrowth of
the removal of geographic restrictions on bank branching and holding company
acquisitions by the individual states, formalized in the 1994 Interstate
Banking and Branch Efficiency Act. Under the rubric of "more efficient
banking" a Darwinian survival of the biggest ensued. They were by
no means the fittest. The consolidation was to have significant consequences
a decade or so later as securitization exploded in scale beyond the banks'
J.P.Morgan blazes the trail
In 1995, well into the Clinton-Rubin era, Alan Greenspan's
former bank, J.P. Morgan, introduced an innovation that was to revolutionize
banking over the next decade. Blythe Masters, a 34-year old Cambridge University
graduate hired by the bank, developed the first Credit Default Swaps, a
financial derivative instrument that ostensibly let a bank insure against
loan default; and Collateralized Debt Obligations, bonds issued against
a mixed pool of assets, a kind of credit derivative giving exposure to
a large number of companies in a single instrument.
Their attraction was that it was all off the bank's own
books, hence away from the Basle Accord's 8% capital rules. The goal was
to increase bank returns while eliminating the risk, a kind of "having
your cake and eating it too," something which in the real world can
only be very messy.
J.P.Morgan thereby paved the way to transform US banking
away from traditional commercial lenders to traders of credit, in effect,
into securitizers. The new idea was to enable the banks to shift risks
off their balance sheets by pooling their loans and remarketing them as
securities, while buying default insurance, Credit Default Swaps, after
syndicating the loans for their clients. It was to prove a staggering development,
soon to hit volumes measured in the trillions for the banks. By the end
of 2007 there were an estimated $45,000 billion worth of Credit Default
Swap contracts out there, giving bondholders the illusion of security.
That illusion, however, was built on bank risk models of default assumptions
which are not public and, if like other such risk models, were wildly optimistic.
Yet the mere existence of the illusion was sufficient to lead the major
banks of the world, lemming-like, into buying mortgage bonds collateralized
or backed by streams of mortgage payments from unknown credit quality,
and to accept at face value a Moody's or Standard & Poors AAA rating.
Just as Greenspan as new Fed chairman turned to his old
cronies at J.P. Morgan when he wanted to grant a loophole to the strict
Glass-Steagall Act in 1987, and as he turned to J.P. Morgan to covertly
work with the Fed to buy derivatives on the Chicago MMI stock index to
artificially manipulate a recovery from the October 1987 crash, so the
Greenspan Fed worked with J.P. Morgan and a handful of other trusted friends
on Wall Street to support the launch of securitization in the 1990's, as
it became clear what the staggering potentials were for the banks who were
first and who could shape the rules of the new game, the New Finance.
It was J.P. Morgan & Co. that led the march of the
big money center banks beginning 1995 away from traditional customer bank
lending towards the pure trading of credit and of credit risk. The goal
was to amass huge fortunes for the bank's balance sheet without having
to carry the risk on the bank's books, an open invitation to greed, fraud
and ultimate financial disaster. Almost every major bank in the world,
from Deutsche Bank to UBS to Barclays to Royal Bank of Scotland to Societe
Generale soon followed like eager blind lemmings.
None however came close to the handful of US banks which
came to create and dominate the new world of securitization after 1995,
as well as of derivatives issuance. The banks, led by J.P. Morgan, first
began to shift credit risk off the bank balance sheets by pooling credits
and remarketing portfolios, buying default protection after syndicating
loans for clients. The era of New Finance had begun. Like every major "innovation"
in finance, it began slowly.
Very soon after, the new securitizing banks such as J.P.
Morgan began to create portfolios of debt securities, then to package and
sell off tranches based on default probabilities. "Slice and dice"
was the name of the new game, to generate revenue for the issuing underwriting
bank, and to give "customized risk to return" results for investors.
Soon Asset Backed Securities, Collateralized Debt Securities, even emerging
market debt were being bundled and sold off in tranches.
On November 2, 1999, only ten days before Bill Clinton
signed the Act repealing Glass-Steagall, thereby opening the doors for
money center banks to acquire brokerage business, investment banks, insurance
companies and a variety of other financial institutions without restriction,
Alan Greenspan turned his attention to encouraging the process of bank
securitization of home mortgages.
In an address to America's Community Bankers, a regional
banking organization, at a conference on mortgage markets, the Fed chairman
The recent rise in the homeownership rate to over 67
percent in the third quarter of this year owes, in part, to the healthy
economic expansion with its robust job growth. But part of the gains have
also come about because innovative lenders, like you, have created a far
broader spectrum of mortgage products and have increased the efficiency
of loan originations and underwriting. Ongoing progress in streamlining
the loan application and origination process and in tailoring mortgages
to individual homebuyers is needed to continue these gains in homeownershipCommunity
banking epitomizes the flexibility and resourcefulness required to adjust
to, and exploit, demographic changes and technological breakthroughs, and
to create new forms of mortgage finance that promote homeownership. As
for the Federal Reserve, we are striving to assist you by providing a stable
platform for business generally and for housing and mortgage activity.
Already on March 8 of that same year, 1999, Greenspan
addressed the Mortgage Bankers' Association where he strongly pushed real
estate mortgage backed securitization as the wave of the future. He told
the bankers there,
"Greater stability in the supply of mortgage credit
has been accompanied by the unbundling of the various aspects of the mortgage
process. Some institutions act as mortgage bankers, screening applicants
and originating loans. Other parties service mortgage loans, a function
for which efficiencies seem to be gained by large-scale operations. Still
others, mostly with stable funding bases, provide the permanent financing
of mortgages through participation in mortgage pools. Beyond this, some
others slice cash flows from mortgage pools into special tranches that
appeal to a wider group of investors. In the process, mortgage-backed securities
outstanding have grown to a staggering $2.4 trillion, automated underwriting
software is being increasingly employed to process a rapidly rising share
of mortgage applications. Not only does this technology reduce the time
it takes to approve a mortgage application, it also offers a consistent
way of evaluating applications across a number of different attributes,
and helps to ensure that the down-payment and income requirements and interest
rates charged more accurately reflect credit risks. These developments
enabled the industry to handle the extraordinary volume of mortgages last
year with ease, especially compared to the strains that had been experienced
during refinancing waves in the past. One key benefit of the new technology
has been an increased ability to manage risk (sic). Looking forward, the
increased use of automated underwriting and credit scoring creates the
potential for low-cost, customized mortgages with risk-adjusted pricing.
By tailoring mortgages to the needs of individual borrowers, the mortgage
banking industry of tomorrow will be better positioned to serve all corners
of the diverse mortgage market. (emphasis mine-w-e-)."
But only after the Fed punctured the dot.com stock bubble
in 2000 and after the Greenspan Fed dropped Fed funds interest rates drastically
to lows not seen on such a scale since the 1930's Great Depression, did
asset securitization literally explode into a multi-trillion dollar enterprise.
Securitization-the Un-Real Deal
Because the very subject of securitization was embedded
with such complexity no one, not even its creators fully understood the
diffusion of risk, let alone the simultaneous concentration of systemic
Securitization was a process in which assets were acquired
by some entity, sometimes called a Special Purpose Vehicle (SPV) or Special
Investment Vehicle (SIV).
At the SIV the diverse home mortgages, let's say, were
assembled into pools or bundles as they were termed. A specific pool, say,
of home mortgage receivables, now took life in the new form of a bond,
an asset backed bond, in this case a mortgage backed security. The securitized
bond was backed by the cash flow or value of the underlying assets.
That little step involved a complex leap of faith to
grasp. It was based on illusory collateral backing whose real worth, as
is now dramatically clear to all banks everywhere, was unknown and unknowable.
Already at this stage of the process the legal title to the home mortgage
of a specific home in the pool is legally ambiguous, as I pointed out in
Part I. Who in the chain actually has in his or her physical possession
the real, "wet signature" mortgage deed to the hundreds and thousands
of homes in collateral? Now lawyers will have a field day for years to
come sorting out Wall Street's brilliant opacities.
Securitization usually applied to assets that were illiquid,
that is ones that were not easily sold, hence it became common in real
estate. And US real estate today is one of the world's most illiquid markets.
Everyone wants out and few want in, at least not at these prices.
Securitization was applied to pools of leased property,
to residential mortgages, home equity loans, on student loans, credit card
or other debts. In theory all assets could be securitized as long as they
were associated with a steady and predictable cash flow. That was the theory.
In practice, it allowed US banks to skirt tougher new Basle Capital Adequacy
Rules, Basle II, designed explicitly in part to close the loophole in Basle
I that let US and other banks shove loans wholesale into off-the-books
special entities called Special Investment Vehicles or SIVs.
Financial Alchemy: Where the fly hits the soup
Securitization, thus, converted illiquid assets into
liquid assets. It did this, in theory, by pooling, underwriting and selling
the ownership claims to the payment flows, as asset-backed securities (ABS).
Mortgage-backed securities were one form of ABS, the largest by far since
Here's where the fly hit the soup.
With the US housing market beginning back in 2006 in
sharp downturn and rates on Adjustable Rate Mortgages (ARMs) moving sharply
higher across the United States, hundreds of thousands of homeowners were
being forced to simply "walk away" from their now un-payable
mortgages, or be foreclosed on by one or another party in the complex securitization
chain, very often illegally, as an Ohio judge recently ruled. Home foreclosures
for 2007 were 75% higher than in 2006 and the process is just beginning,
in what will be a real estate disaster to rival or likely exceed that of
the Great Depression. In California foreclosures were up an eye-popping
421% over the year before.
That growing process of mortgage defaults in turn left
gaping holes in the underlying cash payment stream intended to back up
the newly issued Mortgage Backed Securities. Because the entire system
was totally opaque, no one, least of all the banks holding this paper,
knew what was really the case, what asset backed security was good, or
what bad. As nature abhors a vacuum, bankers and investors, especially
global investors, abhor uncertainty in financial assets they hold. They
treat it like toxic waste.
The architects of this New Finance, based on the securitization
of home mortgages, however, found that bundling hundreds of disparate mortgages
of varying credit quality from across the USA into a big MBS bond wasn't
enough. If the Wall Street MBS underwriters were to be able to sell their
new MBS bonds to the well-endowed pension funds of the world, they needed
some extra juice. Most pension funds are restricted to buying only bonds
rated AAA, highest quality.
But how could a rating agency rate a bond which was composed
of a putative spream of mortgage payments from 1,000 different home mortgages
across the USA? They couldn't send an examiner into every city to look
at the home and interview its occupant. Who could stand behind the bond?
Not the mortgage issuing bank. They sold the mortgage immediately, at a
discount, to get it off their books. Not the Special Purpose Vehicle, they
were just there to keep the transactions separate from the mortgage underwriting
bank.No something else was needed. Deux Maxima! in stepped the dauntless
Big Three (actually Big Two) Credit Raters, the rating agencies.
The ABS Rating Game
Never ones to despair when confronted by new obstacles,
clever minds at J.P. Morgan, Morgan Stanley, Goldman Sachs, Citigroup,
Merrill Lynch, Bear Stearns and a myriad of others in the game of securitizing
the exploding volumes of home mortgages after 2002, turned to the Big Three
rating agencies to get their prized AAA. This was necessary because, unlike
issuance of a traditional corporate bond, say by GE or Ford, where a known,
physical bricks 'n mortar blue-chip company with a long-term credit history
stood behind the bond, with Asset Backed Securities no corporation stood
behind an ABS. Just a lot of promises on mortgage contracts across America.
The ABS or bond was, if you will, a "stand alone"
artificial creation, whose legality under US law has been called into question.
That meant a rating by a credit rating agency was essential to make the
bond credible, or at least give it the "appearance of credibility,"
as we now realize from the unraveling of the present securitization debacle.
At the very heart of the new financial architecture that
was facilitated by the Greenspan Fed and successive US Administrations
over the past two decades and more, was a semi-monopoly held by three de
facto unregulated private companies who operated to provide credit ratings
for all securitized assets, of course for very nice fees.
Three rating agencies dominated the global business of
credit ratings, the largest in the world being Moody's Investors Service.
In the boom years of securitization, Moody's regularly reported well over
a 50% profit on gross rating revenues. The other two in the global rating
cartel were Standard & Poor's and Fitch Ratings. All three were American
companies intimately tied into the financial sinews of Wall Street and
US finance. The fact that the world's rating business was a de facto US
monopoly was no accident. It was planned that way, as a main pillar of
the financial domination of New York. The control of the credit rating
world was for the US global power projection almost tantamount to US domination
in nuclear weapons as a power factor.
Former Secretary of Labor, economist Robert Reich, identified
a core issue of the raters, their built-in conflict of interest. Reich
noted, "Credit-rating agencies are paid by the same institutions that
package and sell the securities the agencies are rating. If an investment
bank doesn't like the rating, it doesn't have to pay for it. And even if
it likes the rating, it pays only after the security is sold. Get it? It's
as if movie studios hired film critics to review their movies, and paid
them only if the reviews were positive enough to get lots of people to
see the movie."
Reich went on, "Until the collapse, the result was
great for credit-rating agencies. Profits at Moody's more than doubled
between 2002 and 2006. And it was a great ride for the issuers of mortgage-backed
securities. Demand soared because the high ratings had expanded the market.
Traders didn't examine anything except the ratingsa multibillion-dollar
game of musical chairs. And then the music stopped."
That put three global rating agencies-Moody's, S&P,
and Fitch-directly under the investigative spotlight. They were de facto
the only ones in the business of rating the collateralized securities-Collateralized
Mortgage Obligations, Collateralized Debt Obligations, Student Loan-backed
Securities, Lottery Winning-backed Securities and a myriad of others-for
Wall Street and other banks.
According to an industry publication, Inside Mortgage
Finance, some 25% of the $900 billion in sub-prime mortgages issued over
the past two years were given top AAA marks by the rating agencies. That
comes to more than $220 billion of sub-prime mortgage securities carrying
the highest AAA rating by either Moody's, Fitch or Standard & Poors.
That is now coming unwound as home mortgage defaults snowball across the
Here the scene got ugly. Their model assumptions on which
they gave their desired AAA seal of approval was a proprietary secret.
According to an economist working within the US rating
business, who had access to the actual model assumptions used by Moody's,
S&P and Fitch to determine whether a mortgage pool with sub-prime mortgages
got a AAA or not, they used historical default rates from a period of the
lowest interest rates since the Great Depression, in other words a period
with abnormally low default rates, to declare by extrapolation that the
sub-prime paper was and would be into the distant future of AAA quality.
The risk of default on even a sub-prime mortgage, so
went the argument, "was historically almost infinitesimal." That
AAA rating from Moody's in turn allowed the Wall Street investment houses
to sell the CMOs to pension funds, or just about anybody seeking "yield
enhancement" but with no risk. That was the theory.
As Oliver von Schweinitz pointed out in a very timely
book, Rating Agencies: Their Business, Regulation and Liability, "Securitizations
without ratings are unthinkable." And because of the special nature
of asset backed securitizations of mortgage loans, von Schweinitz points
out, those ABS, "although being standardized, are one-time events,
whereas other issuances (corporate bonds, government bonds) generally affect
repeat players. Repeat players have less incentive to cheat than 'one time
Put the other way, there is more incentive to cheat,
to commit fraud with asset backed securities than with traditional bond
issuance, a lot more.
Moody's, S&P's unique status
The top three rating agencies under US law enjoy an almost
unique status. They are recognized by the Government's Securities and Exchange
Commission (SEC) as Nationally Recognized Statistical Rating Organizations
(NRSROs). There exist only four in the USA today. The fourth, a far smaller
Canadian rater, is Dominion Bond Rating Service Ltd. Essentially, the top
three hold a quasi monopoly on the credit rating business, and that, worldwide.
The only US law regulating rating agencies, the Credit
Agency Reform Act of 2006 is a toothless law, passed in the wake of the
Enron collapse. Four days before the collapse of Enron, the rating agencies
gave Enron an "investment grade" rating, and a shocked public
called for some scrutiny of the raters. The effect of the Credit Agency
Reform Act of 2006 was null on the de facto rating monopoly of S&P,
Moody's and Fitch.
The European Union, also reacting to Enron and to the
similar fraud of the Italian company Parmalat, called for an investigation
of whether the US rating agencies rating Parmalat has conflicts of interest,
how transparent their methodologies were (not at all) and the lack of competition.
After several years of "study" and presumably
a lot of behind-the-scenes from big EU banks involved in the securitization
game, the EU Commission announced in 2006 it would only "continue
scrutiny" (sic) of the rating agencies. Moody's and S&P and Fitch
dominate EU ratings as well. There are no competitors.
It's a free country, ain't it?
The raters under US law were not liable for their ratings
despite the fact that investors worldwide depend often exclusively on the
AAA or other rating by Moody's or S&P as validation of creditworthiness,
most especially in securitized assets. The Credit Agency Reform Act of
2006 in no way dealt with liability of the rating agencies. It was in this
regard a worthless paper. It was the only law dealing with the raters at
As von Schweinitz pointed out, "Rule 10b-5 of the
Securities and Exchange Act of 1934 is probably the most important basis
for suing on the grounds of capital market fraud." That rule stated
"It shall be unlawful for any personto make any untrue statement of
a material fact." That sounded like something concrete. But then the
Supreme Court affirmed in a 2005 ruling, Dura Pharmaceuticals, ratings
are not "statements of a material fact" as required under Rule
10b-5. The ratings given by Moody's or S&P or Fitch are rather, "merely
an opinion." They are thereby protected as "privileged free speech,"
under the US Constitution's First Amendment.
Moody's or S&P could say any damn thing about Enron
or Parmalat or sub-prime securities it wanted to. It's a free country ain't
it? Doesn't everyone have a right to their opinion?
US courts have ruled in ruling after ruling that financial
markets are "efficient" and hence, markets will detect any fraud
in a company or security and price it accordinglyeventually. No need to
worry about the raters then
That was the "self-regulation" that Alan Greenspan
apparently had in mind when he repeatedly intervened to oppose any regulation
of the emerging asset securitization revolution.
The securitization revolution was all underwritten by
a kind of "hear no evil, see no evil" US government policy that
said, what is "good for the Money Trust is good for the nation."
It was a perverse twist on the already perverse saying from the 1950's
of then General Motors chief, Charles E. Wilson, "what's good for
General Motors is good for America."
Monoline insurance: Viagra for securitization?
For those CMO sub-prime securities that fell short of
AAA quality,there was also another crucial fix needed. The minds on Wall
Street came up with an ingenious solution.
The issuer of the Mortgage Backed Security could take
out what was known as Monoline insurance. Monoline insurance for guaranteeing
against default in asset backed securities was another spin-off of the
Greenspan securitization revolution.
Although monoline insurance had begun back in the early
1970's as a guarantee for municipal bonds, it was the Greenspan securitization
revolution which gave it its leap into prominence.
As their industry association stated, "The monoline
structure ensures that our full attention is given to adding value to our
capital market customers." Add value they definitely did. As of December
2007, it was reliably estimated that the monoline insurers, who call themselves
"financial guarantors," eleven poorly capitalized, loosely regulated
monoline insurers, all based in New York and regulated by that state's
insurance regulator, had given their insurance guarantee to enable the
AAA rated securitization of over $2.4 trillion worth of Asset Backed Securities.
Monoline insurance became a very essential element in
the fraud-ridden Wall Street scam known as securitization. By paying a
certain fee, a specialized (hence the term monoline) insurance company
would insure or guarantee a pool of sub-prime mortgages in event of an
economic downturn or recession in which the poor sub-prime homeowner could
not service his monthly mortgage payments.
To quote from the official website of the monoline trade
association, "The Association of Financial Guaranty Insurers, AFGI,
is the trade association of the insurers and re-insurers of municipal bonds
and asset-backed securities. A bond or other security insured by an AFGI
member has the unconditional and irrevocable guarantee that interest and
principal will be paid on time and in full in the event of a default."
Now they regret ever having promised that as sub-prime mortgage resets,
growing recession and mortgage defaults are presenting hyperbolic insurance
demands on the tiny, poorly capitalized monolines.
The main monoline insurers were hardly household names:
ACA Financial Guaranty Corp., Ambac Assurance, Assured Guaranty Corp. BluePoint
Re Limited, CIFG, Financial Guaranty Insurance Company, Financial Security
Assurance, MBIA Insurance Corporation, PMI Guaranty Co., Radian Asset Assurance
Inc., RAM Reinsurance Company and XL Capital Assurance.
A cautious reader might ask the question, "Who insures
these eleven monoline insurers who have guaranteed billions indeed trillions
in payment flows over the past five or so years of the ABS financial revolution?"
No one, yet, was the short answer. They state, "Eight
AFGI member firms carry a Triple-A claims paying ability rating and two
member firms carry a Double-A claims paying ability rating." Moody's,
Standard & Poors and Fitch gave the AAA or AA ratings.
By having a guarantee from a bond insurer with an AAA
credit rating, the cost of borrowing was less than it would normally be
and the number of investors willing to buy such bonds was greater.
For the monolines, guaranteeing such bonds seemed risk-free,
with average default rates running at a fraction of 1 per cent in 2003-2006.
As a result, monolines leveraged their assets to build their books, and
it was not being uncommon for a monoline to have insured risks 100 to 150
times the size of its capital base. Until recently, Ambac had capital of
$5.7 billion against guarantees of $550 billion.
In 1998, the NY State Insurance Superintendent's office,
the only regulator of monolines, agreed to allow monolines to sell credit-default
swaps (CDSs) on asset-backed securities such as mortgage backed securities.
Separate shell companies would be established, through which CDSs could
be issued to banks for mortgage backed securities.
The move into insuring securitized bonds was spectacularly
lucrative for the monolines. MBIA's premiums rose from $235m in 1998 to
$998m in 2007. Year on year premiums last year increased 140%. Then along
came the US sub-prime mortgage crisis, and the music stopped dead for the
As the mortgages within bonds from the banks defaulted
- sub-prime mortgages written in 2006 were already defaulting at a rate
of 20 per cent by January 2008-the monolines were forced to step in and
cover the payments.
On February 3, MBIA revealed $3.5 billion in writedowns
and other charges in three months alone, leading to a quarterly loss of
$2.3 billion. That was likely just the tip of a very cold iceberg. Insurance
analyst Donald Light remarked, "The answer is no one knows,"
when asked what the potential downside loss was. "I don't think we
will know to perhaps the third or fourth quarter of 2008."
Credit ratings agencies have begun downgrading the monolines,
taking away their prized AAA ratings, which means a monoline could no longer
write new business, and the bonds it guarantees no longer would hold a
To date, the only monoline to receive downgrades from
two agencies - usually required for such a move to impact on a company
- is FGIC, cut by both Fitch and S&P. Ambac, the second largest monoline,
has been cut to AA by Fitch, with the other monolines on a variety of different
The rating agencies did "computer simulated stress
tests" to decide if the monolines could "pay claims at a default
level comparable to that of the Great Depression." How much could
the monoline insurers handle in a real crisis? They claimed, "Our
claims-paying resources available to back members' guaranteestotals more
than $34 billion."
That $34 billion was a drop in what will rapidly over
the course of 2008 appear to be a bottomless bucket. It was estimated that
in the Asset Backed Securities market roughly one-third of all transactions
were "wrapped" or insured by AAA monolines. Investors demanded
surety wraps for volatile collateral or that without a long performance
According to the Securities Industry and Financial Markets
Association, a US trade group, at the end of 2006 there was a total of
some $3.6 trillion worth of Asset Backed Securities in the United States,
including of home mortgages, prime and sub-prime, of home equity loans,
credit cards, student loans, car loans, equipment leasing and the like.
Fortunately not all $3.6 trillion of securitizations are likely to default,
and not all at once. But the AGFI monoline insurers had insured $2.4 trillion
of that mountain of asset backed securities over the past several years.
Private analysts estimated by early February 2008 that the potential insurer
payout risks, under optimistic assumptions, could exceed $200 billions.
A taxpayer bailout of that scale in an election year would be an interesting
Off the books
The entire securitization revolution allowed banks to
move assets off their books into unregulated opaque vehicles. They sold
the mortgages at a discount to underwriters such as Merrill Lynch, Bear
Stearns, Citigroup, and similar financial securitizers. They then in turn
sold the mortgage collateral to their own separate Special Investment Vehicle
or SIV as they were known. The attraction of a stand-alone SIV was that
they and their potential losses were theoretically at least, isolated from
the main underwriting bank. Should things ever, God forbid, run amok with
the various Asset Backed Securities held by the SIV, only the SIV would
suffer, not Citigroup or Merrill Lynch.
The dubious revenue streams from sub-prime mortgages
and similar low quality loans, once bundled into the new Collateralized
Mortgage Obligations or similar securities, then often got an injection
of Monoline insurance, a kind of financial Viagra for junk quality mortgages
such as the NINA (No Income, No Assets) or "Liars' Loans," or
so-called stated-income loans, that were commonplace during the colossal
Greenspan Real Estate economy up until July 2007.
According to the Mortgage Brokers' Association for Responsible
Lending, a consumer protection group, by 2006 Liars' Loans were a staggering
62% of all USA mortgage originations. In one independent sampling audit
of stated-income mortgage loans in Virginia in 2006, the auditors found,
based on IRS records that almost 60% of the stated-income loans were exaggerated
by more than 50%. Those stated-income chickens are now coming home to
roost or far worse. The default rates on those Liars' Loans, which is now
sweeping across the entire US real estate market, makes the waste problems
of Tyson Foods factory chicken farms look like a wonderland.
None of that would have been possible without securitization,
without the full backing of the Greenspan Fed, without the repeal of Glass-Steagall,
without monoline insurance, without the collusion of the major rating agencies,
and the selling on of that risk by the mortgage-originating banks to underwriters
who bundled them, rated and insured them as all AAA.
In fact the Greenspan New Finance revolution literally
opened the floodgates to fraud on every level from home mortgage brokers
to lending agencies to Wall Street and London securitization banks to the
credit rating agencies. Leaving oversight of the new securitized assets,
hundreds of billions of dollars worth of them, to private "self-regulation"
between issuing banks like Bear Stearns, Merrill Lynch or Citigroup and
their rating agencies, was tantamount to pouring water on a drowning man.
In Part V we discuss the consequences of the grand design in New Finance.
* F. William Engdahl is the author of A Century of War:
Anglo-American Oil Politics and the New World Order (Pluto Press) and Seeds
of Destruction: The Hidden Agenda of Genetic Manipulation, "http://www.globalresearch.ca/"
www.globalresearch.ca. The present series is adapted from his new book,
now in writing, The Rise and Fall of the American Century: Money and Empire
in Our Era. He may be contacted through his website, "http://www.engdahl.oilgeopolitics.net"
Greenspan, Alan, Consumer Finance, Remarks at the Federal
Reserve System's Fourth Annual Community Affairs Research Conference, Washington,
D.C., April 8, 2005, in "http://www.federalreserve.gov/BoardDocs/speeches/2005/20050408/default.htm"
Greenspan, Greenspan Defends Low Interest Rates Interview
CBS 60 Minutes, September 16, 2007, in "http://www.cbsnews.com/stories/2007/09/13/60minutes/main3257567.shtml"
Greenspan, The Markets, Excerpts From Greenspan Speech
on Global Turmoil, reprinted in The New York Times, November 6, 1998.
Greenspan, Alan, Remarks by Chairman Alan Greenspan:The
structure of the international financial system,
at the Annual Meeting of the Securities Industry Association,
Boca Raton, Florida, November 5, 1998.
Greenspan, Alan, Measuring Financial Risk in the Twenty-first
Century, Remarks Before a conference sponsored by the Office of the Comptroller
of the Currency, Washington, D.C., October 14, 1999, in "http://www.federalreserve.gov/boarddocs/speeches/1999/19991014.htm"
www.federalreserve.gov/boarddocs/speeches/1999/19991014.htm. Here Greenspan
states, "...to date, economists have been unable to anticipate sharp
reversals in confidence. Collapsing confidence is generally described as
a bursting bubble, an event incontrovertibly evident only in retrospect.
To anticipate a bubble about to burst requires the forecast of a plunge
in the prices of assets previously set by the judgments of millions of
investors, many of whom are highly knowledgeable about the prospects for
the specific investments that make up our broad price indexes of stocks
and other assets.
Federal Deposit Insurance Corporation, History of the
80s, Volume I: An Examination of the Banking Crises of the 1980s and Early
1990s, in "http://www.fdic.gov/bank/historical/history/vol1.html"
Greenspan, Alan, Mortgage markets and economic activity,
Remarks before a conference on Mortgage Markets and Economic Activity,
sponsored by America's Community Bankers, Washington, D.C., November 2,
1999, in "http://www.federalreserve.gov/boarddocs/speeches/1999/19991102.htm"
Greenspan, Alan, Remarks to Mortgage Bankers' Association,
Washington, D.C., March 8, 1999.
Reich, Robert, Why Credit-rating Agencies Blew It: Mystery
Solved, October 23, 2007, Robert Reich's Blog, in "http://robertreich.blogspot.com/2007/10/they-mystery-of-why-credit-rating.html"
Von Schweinitz, Oliver, Rating Agencies Their Business,
Regulation and Liability, Unlimited Publishing LLC, Bloomington, Ind.,
2007, pp. 35-36.
Ibid. pp. 67-97.
Association of Financial Guaranty Insurers, Our Claims-Paying
Ability, in "http://www.afgi.org/who-fact.htm" www.afgi.org/who-fact.htm.
McNichols, James P., Monoline Insurance & Financial
Guaranty Reserving, in "http://www.casact.org/pubs/forum/03fforum/03ff231.pdf"
Dorfman, Dan, Liars' Loans Could Make Many Moan, The
New York Sun, Dec. 20, 2006.