[R-G] [BillTottenWeblog] Securitization: The Biggest Rip-off Ever

[Bill Totten]

Financial Deregulation has Opened Up A Pandora's box

by Mike Whitney

Global Research (June 05 2009)


Is it possible to make hundreds of billions of dollars in profits on
securities that are backed by nothing more than cyber-entries into a
loan book?

It's not only possible; it's been done. And now the scoundrels who
cashed in on the swindle have lined up outside the Federal Reserve
building to trade their garbage paper for billions of dollars of
taxpayer-funded loans. Where's the justice? Meanwhile, the credit bust
has left the financial system in a shambles and driven the economy into
the ground like a tent stake. The unemployment lines are growing longer
and consumers are cutting back on everything from nights-on-the-town to
trips to the grocery store. And it's all due to a Ponzi-finance scam
that was concocted on Wall Street and spread through the global system
like an aggressive strain of Bird Flu. The isn't a normal recession; the
financial system was blown up by greedy bankers who used "financial
innovation" game the system and inflate the biggest speculative bubble
of all time. And they did it all legally, using a little-known process
called securitization.

Securitization - which is the conversion of pools of loans into
securities that are sold in the secondary market - provides a means for
massive debt-leveraging. The banks use off-balance sheet operations to
create securities so they can avoid normal reserve requirements and
bothersome regulatory oversight. Oddly enough, the quality of the loan
makes no difference at all, since the banks make their money on loan
originations and other related fees. What matters is quantity, quantity,
quantity; an industrial-scale assembly line of fetid loans dumped on
unsuspecting investors to fatten the bottom line. And, boy, can Wall
Street grind out the rotten paper when there's no cop on the beat and
the Fed is cheering from the bleachers. In an analysis written by
economist Gary Gorton for the Federal Reserve Bank of Atlanta’s 2009
Financial Markets Conference titled, "Slapped in the Face by the
Invisible Hand; Banking and the Panic of 2007" {1}, the author shows
that mortgage-related securities ballooned from $492.6 billion in 1996
to $3,071.1 in 2003, while asset backed securities (ABS) jumped from
$168.4 billion in 1996 to $1,253.1 in 2006. All told, more than $20
trillion in securitized debt was sold between 1997 to 2007. How much of
that debt will turn out to be worthless as foreclosures skyrocket and
the banks balance sheets come under greater and greater pressure?

Deregulation opened Pandora's box, unleashing a weird mix of shady
off-book operations (SPVs, SIVs) and dodgy, odd-sounding derivatives
that were used to amplify leverage and stack debt on tinier and tinier
scraps of capital. It's easy to make money, when one has no skin in the
game. That's how hedge fund managers and private equity sharpies get
rich. Securitization gave the banks the opportunity to take substandard
loans from applicants who had no way of paying them back, and magically
transform them into Triple A securities. "Abra-kadabra". The Wall Street
public relations throng boasted that securitization "democratized"
credit because more people could borrow at better rates since funding
came from investors rather than banks. But it was all a hoax. The real
objective was to turbo-charge profits by skimming hefty salaries and
bonuses on the front end, before people found out they'd been hosed. The
former head of the FDIC, William Seidman, figured it all out back in
1993 when he was cleaning up after the S&L fiasco. Here's what he said
in his memoirs:

"Instruct regulators to look for the newest fad in the industry and
examine it with great care. The next mistake will be a new way to make a
loan that will not be repaid." (Bloomberg)

That's it in a nutshell. The banks never expected the loans would be
paid back, which is why they issued them to ninjas; applicants with no
income, no collateral, no job, and a bad credit history. It made no
sense at all, especially to anyone who's ever sat through a
nerve-wracking credit check with a sneering banker. Trust me, bankers
know how to get their money back, if that's their real intention. In
this case, it didn't matter. They just wanted to keep their
counterfeiting racket zooming ahead at full-throttle for as long as
possible. Meanwhile, Maestro Greenspan waved pom-poms from the
sidelines, extolling the virtues of the "new economy" and the permanent
high plateau of prosperity that had been achieved through laissez faire
capitalism.

Now that the securitization bubble has burst, forty percent of the
credit which had been coursing into the economy has been cut off
triggering a 1930s-type meltdown. Fed chief Bernanke has stepped into
the breach and provided a $13 trillion dollar backstop to keep the
financial system from collapsing, but the broader economy has continued
its historic nosedive. Bernanke is trying to fill the chasm that opened
up when securitization ground to a halt and gas started exiting the
credit bubble in one mighty whooosh. The deleveraging is ongoing,
despite the Fed's many programs to rev up securitization and restore
speculative bubblenomics. Bernanke's latest brainstorm, the Term
Asset-backed securities Lending Facility (TALF), provides 94 percent
public funding for investors willing to buy loans backed by credit card
debt, student loans, auto loans or commercial real estate loans. It's a
"no lose" situation for big investors who think that securitized debt
will stage a comeback. But that's the problem; no one does. Attractive,
non recourse (nearly) risk free loans have failed to entice the big
brokerage houses and hedge fund managers. Bernanke has peddled less than
$30 billion in a program that's designed to lend up to $1 trillion. It's
been a complete bust.

To understand securitization, one must think like a banker. Bankers
believe that profits are constrained by reserve requirements. So, what
they really want is to expand credit with no reserves; the equivalent of
spinning flax into gold. Securitization and derivatives contracts
achieve that objective. They create a confusing netherworld of
odd-sounding instruments and bizarre processes which obscure the simple
fact that they are creating money out of thin air. That's what
securitization really is; undercapitalized junk masquerading as precious
jewels. Here's how economist Henry C K Liu sums it up in his article
"Mark-to-Market vs Mark-to-Model":

"The shadow banking system has deviously evaded the reserve requirements
of the traditional regulated banking regime and institutions and has
promoted a chain-letter-like inverted pyramid scheme of escalating
leverage, based in many cases on nonexistent reserve cushion. This was
revealed by the AIG collapse in 2008 caused by its insurance on
financial derivatives known as credit default swaps (CDS) ...

"The Office of the Comptroller of the Currency and the Federal Reserve
jointly allowed banks with credit default swaps (CDS) insurance to keep
super-senior risk assets on their books without adding capital because
the risk was insured. Normally, if the banks held the super-senior risk
on their books, they would need to post capital at eight percent of the
liability. But capital could be reduced to one-fifth the normal amount
(twenty percent of eight percent, meaning $160 for every $10,000 of risk
on the books) if banks could prove to the regulators that the risk of
default on the super-senior portion of the deals was truly negligible,
and if the securities being issued via a collateral debt obligation
(CDO) structure carried a Triple-A credit rating from a 'nationally
recognized credit rating agency', such as Standard and Poor’s rating on AIG.

"With CDS insurance, banks then could cut the normal $800 million
capital for every $10 billion of corporate loans on their books to just
$160 million, meaning banks with CDS insurance can loan up to five times
more on the same capital. The CDS-insured CDO deals could then bypass
international banking rules on capital." {1}


The same rule applies to derivatives (CDS) as securitized instruments;
neither is sufficiently capitalized because setting aside reserves
impairs one's ability to maximize profits. It's all about the bottom
line. The reason credit default swaps are so cheap, compared to
conventional insurance, is that there's no way of knowing whether the
dealer has the ability to pay claims. It's fraud, on a gigantic scale,
which is why the financial system went into full-blown paralysis when
Lehman Brothers defaulted. No one knew whether trillions of dollars in
counterparty contracts would be paid out or not. There are simply more
claims on wealth than there is money in the system. Bogus mortgages and
phony counterparty promises mean nothing. "Show me the money". The
system is underwater, and it cannot be fixed by more of the Fed's presto
liquidity. Here's what Gary Gorton says later in the same article:

"A banking panic means that the banking system is insolvent. The banking
system cannot honor contractual demands; there are no private agents who
can buy the amount of assets necessary to recapitalize the banking
system, even if they knew the value of the assets, because of the sheer
size of the banking system. When the banking system is insolvent, many
markets stop functioning and this leads to very significant effects on
the real economy ..."

Indeed. The shadow banking system has collapsed, not because the market
is "frozen" or because investors are in a state of panic after Lehman,
but because derivatives and securitization have been exposed as a fraud
propped up on insufficient capital. It's snake oil sold by charlatans.
That's why European policymakers are resisting the Fed's requests to
create a facility similar to the TALF to start up securitization again.
Here's a revealing clip from the Wall Street Journal which explains
what's going on behind the scenes:

"Bankers are pushing European policy makers to consider a US-style
program to aid the region's economy by reviving the moribund market for
bundled consumer loans. Officials at the European Securitisation Forum,
a trade group representing banks and other market participants, said
Tuesday that central bankers should consider stepping in with a program
similar to the US Federal Reserve's Term Asset-Backed Securities Loan
Facility, or TALF, which provides loans to private investors who buy new
securities tied to consumer loans ...

"After suffering heavy losses on securities stuffed with poorly made
loans, investors are reluctant to wade back in, and Europe lacks big
players like the Pacific Investment Management Company in the US, whose
buying can mobilize other investors ... The market also faces
uncertainty over how European regulators will change the rules of the
game, in part by imposing tougher capital requirements on banks, the
main buyers of securitized assets in Europe.

"One European Commission proposal would dramatically hike the capital
required of banks holding a securitized asset if the originator allowed
its share of that asset to fall below a five percent threshold ...

"Paul Sharma of Britain's Financial Services Authority said regulatory
action is likely to shrink the investor base for ABS, in part by
increasing the capital cushions banks will have to hold against ABS
holdings in their trading books. He also argued that ABS were
inappropriate for banks to hold as liquid assets, because they have
proven difficult to sell in a market crisis.

" 'There is very much a query in the minds of regulators as to whether
there is a significant future for securitization', said Mr Sharma,
though he added his own view was that the market did have a future role."


See? In Europe regulators still do their jobs and make sure that
financial institutions have money before they create trillions of
dollars in credit. They don't stick with their heads in the sand while
crooked bankers fleece the public. Bernanke's job is to step in and put
an end to the hanky-panky, not add to the problems by restoring a
credit-generating regime that transferred hundreds of billions of
dollars from hard-working people to fatcat banksters and Wall Street
flim-flammers.

Notes:

{1} http://www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf

{2} Henry C K Liu, "Mark-to-Market vs Mark-to-Model" -
http://www.henryckliu.com/page191.html

{3} "In Europe, a US Way To Fix ABS Market?" by Neil Shah and Stephen
Fidler, Wall Street Journal

_____

Mike Whitney is a frequent contributor to Global Research.  Global
Research Articles by Mike Whitney:
http://www.globalresearch.ca/index.php?context=listByAuthor&authorFirst=Mike&authorName=Whitney

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