While the entire U.S. housing market was on the verge of collapse and corporate America was being systemically undermined, regulators purposely looked the other way.
The truth is that U.S. regulators believed the American public couldn’t handle the truth that what had been allowed to happen, on their watch, was actually happening.
Unfortunately, we now face the same situation with credit default swaps, a derivative security that has the ability to destroy otherwise healthy companies with the virulence of a full-blown plague.
Until the American public understands this, and forces the government to take action, the odds of a repeat performance of what we refer to as the global financial crisis remain very high.
This is not an “Origin of the Species” seminal epic. Rather, it is a short story about the failure of evolutionists to recognize that, while creationism actually starts somewhere, it is actually the failure of regulators to evolve as institutions and markets change that makes monkeys of us all.
Let’s start by looking at the Federal Housing Finance Authority (FHFA), the current regulator of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), two players who were central to the start of the U.S. housing crisis, which became the contagion that grew into a full-blown global crisis.
It’s bad enough that the regulators who came before the FHFA were inept, but what is happening now under the FHFA is far worse, and actually has the potential to exacerbate a crisis that most taxpayers believe is being resolved.
For more than six months, the U.S. Justice Department and the Securities and Exchange Commission (SEC) have been investigating the accounting practices of the two mortgage behemoths. And now the FBI has gotten into the act. It seems that, not long ago, the FHFA hired renowned investigative firm Kroll Inc. [One of the powerful, one-named, spook-like firms – not unlike Blackwater Security Consulting – Kroll is a unit of New York-based insurance powerhouse and “risk advisor” Marsh & McLennan Cos. Inc. (NYSE: MMC)].
Kroll’s confidential report to the FHFA concluded that “inappropriate application” of accounting rules “enabled Freddie to defer billions of dollars of losses incurred from 2001 through 2004.” The source of those losses, according to a Wall Street Journal article, was derivative contracts based on interest-rate swaps.
What’s the big deal you ask? While it’s no surprise that Freddie used an inappropriate set of rules – known as “hedge accounting” – to stretch out losses over several years, rather than just take immediate hits to its profit-and-loss statement, what is frightening is that the FHFA, after hiring Kroll and uncovering the accounting inaccuracies, said it had decided “not to take issue with the accounting,” the Journal reported.
The FHFA labeled it as a “disagreement among the experts.” Call it what you want, but I call it fraud.
Here’s the problem. Fannie and Freddie are incredibly “fragile” right now (the correct financial term is probably “insolvent”). That means that the very two institutions being used by government to halt the catastrophic slide of the U.S. housing industry are so crucial to the bailout of the mortgage industry that to force these two institutions to write off more losses would only spook the financial markets even further.
As large as Freddie and Fannie are in the U.S. housing and mortgage markets, even their combined portfolio value – estimated at about $13 trillion – is dwarfed by an exponentially larger and even more insidious monster running over regulators like they’re not there. I’m talking about the $40 trillion stranglehold that the credit default swap market has on corporations all around the world.
Credit default swaps brought insurance giant American International Group Inc. (NYSE: AIG) to its knees. It was also one of the key catalysts that helped transform a housing bubble into a full-blown global financial crisis.
But here’s the rub: After all that, credit default swaps still aren’t regulated.
Of course that doesn’t mean that regulators don’t try and insert a hand here and there, it just means that the hand they insert has been feeding the monster rather than taming it. But, just recently, a good faith public relations effort was made to show the new interest the revitalized SEC has in reining in the monster from Hades.
It doesn’t matter that Negrin no longer works at Millennium, or that both men say they are innocent, or that the alleged ill-begotten gain was a measly $1.2 million, or that the two men’s lawyers say the SEC has no jurisdiction over derivative contracts, period – let alone derivative contracts tied to European bonds.
Nothing may come of it. But I, for one, will be watching.
It strikes me as tragically ironic that after the credit-default-swap market has been allowed to grow from a few wispy hairs into the tail that wags the dog, the SEC is just now trying to be more than a flea on the tail of this monster.
The real reason we are not hearing more about the catastrophic systemic danger unleashed by credit default swaps is that even the regulators who would like to be overseeing this huge market – if for no other reason than for the regulatory-driven fee income these securities could generate – are afraid to admit this market is still poised to unleash a capitalist plague unlike any that’s ever been seen.
Just as we saw with the role Fannie and Freddie played in the housing market, the credit default swap market has gotten so large and out of control that to admit there is a problem is to admit that the problem is so big and will be so difficult to unwind that the threat can’t be thwarted anytime soon.
But until the public recognizes that credit default swaps can be used to manipulate the credit characteristics, ratings and creditworthiness of corporate borrowers – and also be used to intentionally push down stock prices in a way that destroys good companies, this derivative security will continue to hang over Corporate America and the U.S. stock market like a capitalist sword of Damocles.
It happened with AIG. And it can easily happen again.
The tarnish dulling the prospects of America’s recovery needs to be wiped clean and in its place clear transparency into the workings of the U.S. financial markets needs to be implemented. It’s bad enough that we are in this mess and afraid to admit how deep the hole is. But one thing is for sure, if we don’t create a level playing field, if we don’t expose fraud, if we don’t rein in swashbuckling traders slicing and dicing up America’s corporate backbone, we will discover that this particular hole is bottomless.
But if we’re honest about the problems we still face – as well as what needs to be done – we will find that everyone can see a clear path to steer, and will navigate our way back to economic high ground.
Our leaders might be surprised, if they would only accept one basic fact: We can handle the truth – if we know what it is.
FBI investigates Fannie Mae, Freddie Mac, AIG and Lehman Brothers.
Regulators didn't challenge Freddie's accounting.
What Are Interest Rate Swaps and How Do They Work?
Why CFOs Still Don't Like Hedge Accounting.
Renato Negrin and Jon-Paul Rorech Charged with Insider Trading.
When it Comes to Naming Wall Street’s Worst Invention Ever, Credit Default Swaps Continue to Fill the Bill.
Ban Credit Default Swaps? These Corporate Bankruptcies Show We Should.
SEC Charges Pair With Insider Trading in Swaps.
A "Capitalist plague"? This has nothing to do with capitalism. It has everything to do with a fascist form of socialism. Note that FANY and FREDY are government operations. The driving force behind their derivitives is congress' Community Reinvestment Act. And the force behind that is the philosophy of altruism–a purely anti-capitalist, anti-individualistic philosophy.
Mr. Gilani has put his big, former hedge fund manager, finger on an extremely key point. Let's not forget where the Managers of those companies AND the regulators come from. They are former/current political hacks and/or appointees. It doesn't matter which party, if any, you support, it is politics either way. Throw into the mix good old greed from Wall Street, where many, many political contributions come from, and you have a recipe for disaster.
The decks are awash and the ship is terminal. The same banksters that created this problem(no accident) and the politicians they own, have a plan to destroy the world financial sysytem. When this happens the perps can buy up he planet for a song. The Federal Reserve was created to be the tool for the task. The bankers OWN Congress.
The continued existence of government-sponsored entities that are allowed to engage in the credit default swap business represent the worst of all possible moral hazards. CDSs became a huge problem due to the existence of organizations that were flawed in their construction by being protected from potential failure due to implied government guarantees.
For example, when Glass-Steagall was repealed in 1999, FDIC insurance should have been suspended along with it. By tinkering with the balancing elements of the Act, we created an innate moral hazard (e.g. bankers could now engage in risky investment with government-insured depositor money).
Regulation should only be enacted when there is a clear moral hazard. Otherwise, market forces should be allowed to work their magic.
In a truly free market, bad companies fail before they become too much of a problem. In artificially manipulated markets like we have today, small issues are allowed to bubble (pun intended) into disastrously large worldwide financial debacles due to paradigms that lead to unintended consequences. The intentions are good, but the outcomes horrific.
So, if regulation ostensibly led to the creation of instruments that were not regulated, what is to keep new instruments from springing up out of new regulation?
Constant interference in the free market will only lead to more complex problems. But I guess we're in too deep now, to back up. How unfortunate.
The solution to this problem requires two steps.
1. Declare null and void all credit default swaps.
Place position limits that severely restrict the ability of those without a legitimate business interest to enter derivative markets. If you aren't in the business of oil, you don't get to play oil futures with the big boys. In other words, make sure that "commercials" have precedence and other players have small positions.
Begin to standardize and regulate all derivative contracts. This will take a bit of time, but it's easy to do. Give the CFTC some real power and the ability to use it.
Start RICO investigations of the oil market from $50 to $150 and back down. If ENRON was complicit in the energy and power problems in 1998-2001, the parallel seems to be that there were some "hidden hands" operating in the oil market this time around. Find them and cut them off at the shoulder. This probably means shutting down or restricting such players as J. Aron and Phibro.
While talking of RICO, there appear to be sufficient questions surrounding Goldman Sachs to justify an investigation into its activities. It seems that every time there is a problem and vast amounts of money lost, Goldman is there. Every time vast amounts of money are dispensed, Goldman is there. Whenever we see these vast amounts of money being dispensed, it's being handed out by ex-Goldman partners. Enough is enough.
Start proceedings to break up the largest banks, starting with Citi, BofA, Morgan and Goldman.
This is a start. I'm sure you can come up with more.
It seems to me the reason a lot of this stuff is not being cleaned up is because OUR POLITICIANS' dirty hands are involved in all of it. They have been paid (via lobbying money which is nothing but outright bribery – let's face it) to look the other way or bail these companies out. Do you notice that the President, Sen. Dodd and Cong. Frank NEVER mention Fannie Mae or Franklin Raines when they start harping about executive responsibility and clawbacks? With Dodd, Frank and President Obama having been the #1, #7 and #3 recipients of Fannie Mae lobbying largesse – they have incentive NOT to say anything. Franklin Raines used his millions in severance to become the #1 campaign donor to President Obama's campaign. It is not just executives who are guilty in this mess. Our politicians (and I am not excusing Republicans either since it was them who got rid of Glass-Steagall which accounted for a lot of this as well) have taken lobbying money (bribes) from these banks, mortgage companies, etc. to facilitate legislation in their behalf. There were articles in the New York Times in 1999 and 2003 warning Dodd and Frank that Fannie Mae and Freddie Mac needed some sort of regulation or this credit crisis might erupt. Did they listen, NO! They did not regulate them when given the opportunity (there was an attempt in 2005 to regulate Fannie and Freddie and Dodd, Obama and Frank voted against it). They voted to later bail them out WITH OUR TAXPAYER MONEY and in a conservatorship not a receivership where they could have sold off parts of the company. They expect the American people to pay for this in higher taxes in the future and yet NONE OF THESE BUMS have returned any of that lobbying or campaign money they received from these banks and mortgage companies (and I mean republicans as well) they have bailed out with OUR TAXPAYER money. I call their behaviour if not outright criminal certainly IMMORAL. How can the system be fixed when those who are responsible for this mess are still running things?
I agree! CDS's are still a threat and in the past were in a large part responsible in conjunction with the largely unregulated short sellers to bring the house down around the unknowing equity investors.
it would be beneficial if in your article you defined "credit default swapl . I have read several definitions, all different.
your purpose is to create alarm and negativism across the country!
Your ideas deserve to be heard, and I suggest you make every effort to expand your listeners to those in positions of decision-making.
The continued existence of government sponsored entities that are allowed to engage in the credit default swap business represent the worst of all possible moral hazards. CDSs become a huge problem when companies that are flawed in their construction are implicitly protected from failure due to government guarantees.
For example, when Glass-Steagall was repealed in 1999, FDIC insurance should have been suspended along with it. By tinkering with the balanced elements of the Act, we created an innate moral hazard (e.g. bankers could now engage in risky investment with government-insured depositor money).
This article could provide me an answer to understand President Obama in choosing for his team former financial executives related with the origin of the crisis. I hope someone in the government answers Mr. Gilani.
We need to implement the Lyndon LaRouche plan before it is too late ie Put into formal Bankruptcy all the major Banksters, ie GoldenSacks, B/A, Citebank, etc, and then shut them down, writing off their losses over 100 years, Keep people in their houses by writing down the value and loans (better than them standing empty or being bull dozed down as is happening now Take over the Federal Reserve by the Feds, audit it so iits criminal deeds can be revealed and the perptrators of fraud indicted and convicted, and then operate it as a Public National bank as did the Hamilton and Lincoln did and then fund with Fed investment dollars lbadly needed infrstructure projects immediately such as Nuclear power plants, the only practical non-fossil fuel source of enerby (France is now 909% nuclear and recycles its waste) High speed rail systems whereby all components are manufactured in idle GM and Chrysler plants, at the same time enforcing our Immigration laws Do we get started with this plan and survive and prosper or do we continue down the nonsensical fasciast plan of the Republi-Crats to monetary hyperinflaton doom????
While we spend billions in hunting down terrorists (a relative small group of people who's aim is to destroy the western capitalist system) it seems our really threat of terrorism is in our own back yard. They wear white shirts and suits and make lots of money while they destroy the very country that feeds them. Nice guys. It's time we start looking at the real bad guys and then the outside bad guys will have a country to reckon with instead of a country being eaten up from within.
I greatly appreciate your article, but want to remind that there are far worse consequences of CDS – outside the US.
The economy of Estonia is on the verge of an extremely severe crash due to a high exposure to CDS, now called "the Baltic Debt Trap" by economists all over the world. Its consequences are destroying many good companies, making hundreds of thousand suffer from severe poverty and hunger due to unemployment, and throwing thousands of good people out of their homes due to foreclosures, not only in Estonia but also in many other countries.
We find it fundamentally unfair that this destructive financial bomb, created by American finance gamblers and endorsed by the US government, is allowed to cause severe suffering among hundreds of millions of people outside the US.
The US government is the sole culprit, having eliminated the regulations that were created in the 30-ies to prevent the emergence of another “megabubble” depression.
Every economics and business student in the US, and consequently every financial advisor (including the great deregulator, Larry Summers) has been carefully informed during their studies about the mechanisms of the great depression and the importance of preventive regulation, so don’t say your experts did not know. Therefore, the US government must carry the whole economical responsibility for the consequences of the actions leading to the present crisis.
The US is now like a neighbor who, because of conscious violation of fire prevention rules, has caused your house to catch fire, and then prevented the firemen from stopping the fire (refusing to stop CDSs), finally refusing to pay for the restoration of the house.
Can you understand that any remains of sympathy for the US is rapidly withering away in the world? In Europe, even many non-socialists are now detesting capitalism, describing it as a system of organized, egoistic greed for favoring the already rich at the expense of the people. The governmental policy of bailing out the irresponsible gamblers, the bankers, in stead of using that money (and not just a minor part) for financing constructive projects that could restore the economy and reduce unemployment considerably is a very obvious confirmation of this understanding.
I talked with a friend, the CEO of a real estate company yesterday – she wept out of despair when thinking of the thousands of honest, good people now being thrown out of their houses into misery due to foreclosures. What do you think her feelings is about capitalism and the US?
If the US government does not help defuse the CDS bomb, by taking due responsibility for it, this will generate intense hatred among those billions all over the world, whose “houses it has burnt down due to carelessness, preventing the firemen from stopping it”. Media all over the world have made it very clear why and how it happened, so every literate person knows that the US government solely caused the present depression and enabled the creation of CDS – and persistently refuses to stop them, because its very evident prime, if not only, priority is to foster the interests of the destroyers of world economy – the Wall Street capitalits.
The US can forget exporting anything however cheap and useful when the full impact of the depression becomes evident. Do you believe anyone outside the US will ever want to buy products of a country that has destroyed your country and has thrown you into the severe sufferings of poverty and hunger through enabling reckless casino capitalism?
The people of the US has supported the policies leading to the present severe global crisis by electing these irresponsible politicians.
The US people claims to be the prime defenders of freedom. To people outside the US it looks rather like the defense of the freedom to destroy the economies of other countries.
It is high time that the american people takes the responsibility for its mistakes and demands that the US government takes the full economic responsibility for the destructive financial actions of the US that have cause this global depression and for the defusion of the terrible CDS bomb.