Report on the Derivative Market Crash of 2008

The US President and Congress Must Lead a Worldwide Reform
of Financial, Securities, and Banking Systems

SUMMARY OF THE REPORT

For the complete report click here

For the exhibits click here

This legislation will “mark the beginning of a new relationship between the banks and the people of this country.” -- FDR 1933

“What we had to do last March [1933] was to clear away the dead wood. We had been heading for a bank smash-up for a long time and what we did was a drastic thing, which was to clear away the dead wood and start afresh.” -- FDR 1933

“We are in the midst of a once-in-a century credit tsunami.” -- Alan Greenspan

Just a few years earlier, credit derivatives had been trumpeted by Mr. Greenspan and other financial leaders. In May 2003, Mr. Greenspan said credit derivatives as “critical for economic stability.” The promise of the credit derivative pioneers seemed unlimited: “you or your colleagues could produce a nearly riskless security. Five years later, the entire market collapsed under the financial burden of these credit derivatives.

The world’s major financial institutions, the International Swap and Derivative Association (“ISDA”), and hedge funds were successful beyond their wildest dreams when the credit derivative market claimed to $58 trillion. Unregulated and fueled by the imagination of those controlling the worlds’ wealth, the credit derivative market became a “tangled web of interconnections” where “the failure of any one institution might jeopardize the entire financial system.”

The regulation-free, opaque world of credit derivatives and hedge funds created a zone of moral hazard. Derivatives were “coupled with the device of securitization” and led to the “commoditization of credit risk.” High risk mortgages known as subprime loans were sold to home buyers or home owners in the form of refinanced loans. These loans were taken by the originating banks grouped together in a bundled, or securitized, and sold as an investment vehicle. The buyers of these new securitized loans sought to reduce the risks of the investment. As a result, the owners of the bundled loan securities entered into credit derivatives, known as credit default swaps. This was a principle driving force propelling the credit derivative into the stratosphere of becoming $58 trillion market.

A somber Alan Greenspan admitted in his October 2008 testimony before the Congress that moral hazard was core reason for the Derivative Market Crash of 2008:

The consequent surge in global demand for U.S. subprime securities by banks, hedge, and pension funds supported by the unrealistically positive rating designations by credit agencies was, in my judgment, the core of the problem. Demand became so aggressive that too many securitizers and lenders believed they were able to create and sell mortgage backed securities so quickly that they never put their shareholder’ capital at risk and hence did not have the incentive to evaluate the credit quality of what they were selling. Pressures on lenders to supply more ‘paper’ collapsed subprime underwriting standards from 2005 forward. Uncritical acceptance of credit ratings by purchaser of these toxic assets has led to huge losses.

As time passed, it became clear that homebuyers and homeowners that took the mortgages and loans would never be able to pay back these loans. In turn, it became clear that the securitized mortgages were bad debt. The SEC Chairman made this point in a November 2008 speech and stated that “billions in worthless mortgage paper” had been issued:

"Above all in the current turmoil, the markets and investors need transparency. From the moment that the collapse of lending standards created billions in worthless mortgage paper — and billions more in hidden risk — market participants have had enormous difficulty discovering and pricing that risk. Illiquid instruments that were not long ago rated AAA for credit quality were hidden in off-balance sheet vehicles and elaborately structured securities." -- SEC Chairman 2008

The promise that credit derivatives would hedge risks created a moral hazard zone. Promoters of mortgaged back securities grew careless. Greed took hold and credit derivatives ballooned into a $58 trillion market.

The derivative business grew “between the gaps and seams of the current regulatory system.” It took the credit derivative market only 10 years to reach $58 trillion. It was “more than the gross domestic product of every country on earth, combined.” Under the weight of $58 trillion in credit derivatives, the market collapsed.

Another problem that led to the market failure, credit derivatives allowed banks to circumvent government-imposed capital adequacy requirements for risky loans. Credit derivatives allowed banks to offload risk through a credit derivative transaction. In other words, the creation of credit derivative allowed banks to keep the risk associated with loaned funds off their balance sheets. This allowed the banks to issue more loans.

Credit derivatives have vastly expanded credit for speculation purposes. In a sense, the credit derivative is only the most recent device used to expand credit for speculative purposes. The credit derivative of the 1920’s that helped to dangerously expand credit until the Market Crash of 1929 were “bankers’ acceptances:”

"The general ease and accessibility of credit under the regime which existed prior to 1929 was accentuated by the issue of instrument known as the bankers’ acceptance. In its original purpose this form of lending was intended to include only unquestionably liquid obligations, growing out of the actual sale of goods in foreign trade, so that the acceptance became a short-term claim payable in international funds, usually gold. It was this conception of the instrument which was originally adopted in the Federal Reserve Act, and on which the use of the instrument by the Federal Reserve System was founded. Later amendments to the reserve act, adopted during the World War, broadened the use of the acceptance and opened the door to the application of a conception of its use which was principally that of a finance bill-a bill without reference to the immediately liquid character of a given transaction, and primarily based upon the general power of the parties to it to see that it was liquidated from some source. The use of the acceptance to supply what was called dollar exchange, although doubtless of advantage under proper restrictions, undoubtedly opened a door to grave abuses." -- US Senate Report, 1932

There were voices warning that the true “economic risk” of these invesmnets were not being properly weighted and that a financial house of cards was being set up for disaster. Christopher Whalen, a financial analyst, warned on 30 January 2007 that the “OTC derivatives and kindred structures like collateralized debt obligations (CDO)” were driving “a process whereby assets are being packaged and sold at prices that understate the true economic risk” which is lowing “credit quality for the financial system as a whole.”

STRUGGLING FINANCIAL MARKETS AND GOVERNMENT SUPPORT


The failing financial institutions have sought protection in a rolling-in-place shelter cobbled together by the major market players, with help from the federal government. The shelters consist of four gigantic banks into which the financial institutions suffering some of the greatest derivative losses have been folded.

These banks, standing, albeit on shaky legs are:

1) Bank of America (with Countrywide and Merrill Lynch);

2) Wells Fargo Bank (with World Savings and Wachovia);

3) JP Morgan Chase (Bear Stearns and Washington Mutual); and

4) Citibank.

These and a handful of other smaller financial institutions infected by the credit derivative disease are being kept alive by a multi-trillion dollars life support system from the U.S. Treasury and Federal Reserve System (the “FED”). The U.S. government is struggling to borrow enough money to prop up the ailing financial system. The federal government has been attempting to borrow $150 billion every few weeks.

Goldman Sachs estimates the U.S. government will have to borrow $1 trillion in 2009 to cover its losses – largely tied to bad investments in the credit derivative market. According to Bloomberg news service, the U.S. Treasury “more than tripled its planned debt sales for this quarter (October to December) to help finance a 2009 budget deficit that bond dealers advising the department estimate may swell to almost $ 1 trillion.” On 3 November 2008, the U.S. Treasury Department announced it would borrow $550 billion from October to December 2008 to pay for the bail out.

The Treasury Department appears to have had difficulty borrowing enough in some auctions which highlights the delicate status of the financial industry. Table 1 compares the auction targets with actual amounts raised in the last 8 auctions:

Table 1 Fed Credit Auctions ( Sept–Dec 2008)

Date	Auction Amount	Propositions Submitted	Propositions Accepted	Bidders
10 Sept	$25 B	$46.2	$25 B	53
23 Sept	$75 B	$133.5B	$75 B	85
7 Oct	$150 B	$138 B	$138 B	71
21 Oct	$150 B	$113.2 B	$113.2 B	74
12 Nov	$150 B	$12.6 B	$12.6 B	16
25 Nov	$150 B	$31B	$31B	16
2 Dec	$150 B	$66.4 B	$66.4 B	80

The widespread collapse of the banking system has been averted only because central banks and governments are taking “unprecedented measures” in transferring billions of dollars of federal funds to the troubled banks and insurance firms. The government has committed to as much as $8 trillion in assistance to the troubled financial service companies.

LESSONS FROM 1933 BANKING CRISIS

This report documents the lessons learned and embodied in reform banking legislation passed after the 1933 bank crisis. Those lessons were aptly stated by President Franklin Roosevelt in 1933:

Finally, in our progress toward a resumption of work we require two safeguards against a return of the evils of the old order; there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people's money, and there must be provision for an adequate but sound currency.

This report proposes the United States President and the United States Congress lead a world-wide effort to reform and restore the banking and securities markets to their original purpose “to raise money for productive enterprise and for the support of millions of jobs throughout our economy.”

This Report proposes bank insolvency reorganization for failed banks, regulation of credit derivatives, hedge funds, and prohibition of credit derivative speculation. This report proposes a more strategic use of federal funds and opposes the wholesale transfer of trillions of dollars to the failed banks. The report is built in part on the fundamental principle that it is immoral for the federal government to transfer trillions of dollars of innocent taxpayer funds to relieve sophisticated market players from the market outcomes they created.

The Report urges the President and Congress to adopt legislation that will separate banking into commercial, investment and insurance divisions. It also recommends the idea that further division of the banking industry be considered.
The report recommends that the banks be kept profit seeking ventures but that they be further divided and restrained within specific sectors. Bank regulations would affirmatively establish separate banking sectors e.g. natural resources and energy banks, communication industry banks, and transportation banks. The banking industry would be organized based on the principle of what division would best serve the public interest, within a profit seeking system.

The proposed reforms outlined in this report seek to:

• Repeal the 1999 repeal of the 1933 Glass- Steagall Act;

• Require collateralized derivatives to be registered as securities offerings under the 1933 Securities Act;

• Require hedge funds and hedge fund advisers to be registered under the Investment Company and Investment Advisers Act;

• Define credit default swaps as insurance subject to state insurance regulations;

• Prohibit credit default swap speculation; and

• Strengthen the bank holding company act, by amongst other things extending it to investment banks.

The report also recommends the creation of a Select Committee in the United States Senate that would work to establish a permanent factual record to support needed legislative reforms. It is further recommended that Congressional Policy Committees with jurisdiction over banking and finance hold extensive hearings examining the extent of debt held by financial institutions regarding credit derivatives and how to best reorganize the banking system to serve the public interest.

In reforming the financial services industry, the President and Congress can shift the world’s wealth from wasteful speculation to productive uses that benefit the public interest: such as building systems for renewable energy, reliable water supplies, efficient transportation, modern communication as well as schools, universities, hospitals, libraries, bridges and roads.

This report concludes that the President and Congress can lead the world’s banking system out of crisis by adopting fundamental reforms that will stop the harmful practices that caused the present banking emergency.

President Roosevelt and the 73rd Congress led the nation out of the crisis of their day. They addressed the nation with “a candor and a decision which the present situation of our people impels.” They did not “shrink from honestly facing conditions in our country today.”

This Report urges the President and Congress take the same effective action to lead this nation and the world out of the financial crisis caused by the Derivative Market Crash of 2008. It urges that we have “the courage to grapple with the cardinal economic problem of modern life.”

We must adopt the right regulations and put in place the right enforcement. Even former Fed Chair Alan Greenspan sees there has been a “breakdown of the central pillar of competitive markets” which requires “additional regulator changes.”

Legal Counsel Michael J. Aguirre
22 December 2008