Sunday, June 14, 2009

Free Lunch, Collateralized Debt Obligations (CDO’s) and the World Economic Order

Ibrahim Athif Shakoor



I assume that our universe did indeed appear from nowhere about 1010 years ago. In answer to the question of why it happened, I offer the modest proposal that our universe is simply one of those things which happen from time to time.

Edward Tryon, Professor of Physics, 1984




That with music loud and long,
I would build that dome in air,
That sunny dome!, those caves of ice !
And all who heard should see them there,
And all should cry, Beware ! Beware !,

S.T. Coleridge, Romantic Poet, 1816



Theoretical physicists seem to believe that something can be had for free. They believe that the universe is the ultimate free lunch; created out of nothing and nobody need to pay for it. Just one of those things that ‘happen from time to time’. Yet, even theologians, the many of them who straddle the continuum of the religious divide, believe that while God created the world out of nothing, we humans have to pay for it by being good. Depending of course, on different versions of being ‘good’.

Yet for almost half a century and more, the developed world has been acting as if not only was there free lunch, but that there was a veritable buffet, free for all, always hot and readily available. It was only the businessmen of the lesser developed countries that had to worry about finance not being available for projects. However, if you are a member of the selected class, money was no objective. You want to develop a whole city with temperate climate and ice rinks lavish enough to host the Winter Olympics in the vast expanse of the sub Saharan desert, no problem. Just come on by and do not forget to bring in enough trucks to take the cash in. Or if and you have friends with even bigger dreams, bring them along.

However, from the beginning of the Industrial Revolution in the 18th the Century and even from before, growth has been about the creation of tangible goods and services you can receive. GDP was about the measure of the national production of items you can touch, count and take home. People were engaged in the manufacturing of items that were concrete, physical and yes, real.


Housing Bubble

There has been, and will continue to be many explanations of the recession that the world is facing. The most cogent and rational arguments refer to the collapse of the housing boom from the mid 90’s until its collapse in 2006. At this point it is beneficial to take a slight detour; a side-road, to understand the housing boom and its origins.


The wealth and ready cash created out of Stock Market Bubble of the 1990’s transformed the mindset of most ordinary folk, turning them into big spenders and reducing the average American saving function from 5% to below 3%. Mark Knopfler’s ‘money for nothing and chicks for free’ was literary true and there was money to burn. A lot of this money was invested into the housing market as people wanted to create tangible assets from money received from intangible means. Something they could touch. Houses seemed a logical choice and an investment for the future. Housing prices that were essentially unchanged for more than a century started to rise and by 2000 has risen by 30% and more.

The reason why it was called a Stock Market Bubble is of course because it was not sustainable. The stock market bubble burst between 2000-2002. But, instead of putting an end to the housing boom, fuelled it instead. Monetary policy used to revive the lagging economy, offered low interest rates and low mortgage rates and people rushing out of the stock market bubble wanted to invest more on solid, concrete assets. The housing market was an obvious one and house prices that had already risen by 30% rose further by another 31% between 2002 and 2006, whence it all came crashing down.


Junk Bonds, derivatives, collateralized debt obligations (CDO’s) and credit default swaps

The above are just a few of the instruments used by the financial wizards (yes, wizards as referring to magic and sorcery) use in the markets today to create wealth. And there are few of who really understand them and their implications. But they made millions, nay billions to millions of people. Money was created out of nothing and then sold to some-one else at a higher price. And the loop continues.

While Hedge Funds and credit derivatives and CDO’s were making millions for many, the voices of caution were being raised and promptly ignored. Warren Buffer called credit derivatives, “financial weapons of mass destruction”. They were extensively used by Enron to finance its hormone fed growth and of, also created its ultimate and inevitable destruction. A June 2008 Financial Times reported that according to some thinkers, that some of these instruments only existed in ‘cyber space’. Those who sounded the warning note were called hide bound traditionalists and old fashioned.

William Blum, does not hold a endowed chair at a large university and his books ‘Killing Hope” and “Rogue state: A guide to the world’s only Super Power”, have their detractors. However, it is revealing to quote here in length from him, just to bring out the flavor of the criticism of the financial instruments being used in the market to create wealth.


All these grown men playing their boys' games. They create an assortment of financial entities, documents, and packages that go by names like hedge funds, derivatives, collateralized debt obligations, index funds, credit default swaps, structured investment vehicles, subprime mortgages, and dozens of other exotic monetary vehicles. They create all manner of commercial pieces of paper, of no known real or inherent value, backed up by few if any standards. Then they sell these various pieces of paper to the public and to each other. They slice and dice mortgages into arcane and risky instruments, then bundle them together, and sell the packages to those higher up in the pyramid scheme. … And much of the buying is not done with the buyer's own money, but with borrowed funds; "leveraged", they call it. … They sell "long", expecting the price to rise; they sell "short", expecting the price to fall; they sell "naked short", which means they neither possess nor own what they're selling; a name for each gimmick.

William Blum, A Boy’s Game, the Origins of the Financial Crisis, October 2, 2008



As the housing market grew, bankers created a sub set of mortgage called sub-prime mortgage. As the name clearly says, the mortgage is below prime and risky. And it should not have been offered. But in the interest of building that “sunny dome with caves of ice”, housing loans and mortgages were given to those who were clearly classified as bad risks by the bank themselves. It is estimated that upto 40% of the housing mortgages were below prime at the height of the housing bubble.

Banks then took these ‘sub-prime’ risks and mixed them with better classes mortgages, other assets and prime bonds and called them ‘collateralized debt obligations’ (the famous CDO’s) and started selling them to each other. Yes, the market was kept alive because, banks started to sell these CDO’s to one another, thereby creating the credit line that kept each other alive. They were all build a sunny dome with caves of ice. In air.

As soon as the housing bubble burst, banks started falling down on one another. Within months giants of the financial world like Merryl Lynch, Lehman Brothers and Wachovia had been destroyed. Some were on a life-line and most, if not all, were in trouble and the banking system had collapsed causing a credit crunch which resulted in halt of business activity and a world in recession.

After attending the World Economic Forum in Davos in January of 2009, BBC wrote in a January 2009, report that, ‘The root causes for the economic crisis were too much debt, a culture of short-term rewards for long-term risk-taking and fatally flawed mathematical risk models. And plain old greed.”

Coleridge’s poem is about an paradise he saw in an opium induced dream which he says he is going to build. In air, a sunny dome with caves of ice. Attractive, but still stuff of dreams. For much of the last century the financial world went crazy. They created money from ‘stuff of dreams’ creating and destroying wealth. The result is what we are seeing today. The voices of caution of yesteryears, who were then labeled conservative and traditionalist are now being called prophets and visionary.

Today, there are signs of regeneration and growth, the most obvious of which unfortunately is the slow but steady rise of oil prices. Yet, as someone famously said, ‘experience enables you to recognize a mistake when you make it again’, but with 7 million left job-less in OECD countries alone and the economy of the world biggest economies due to shrink this year, this is not a mistake we can afford to repeat.

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