Sovereign Debt Default : Price To Pay For Sub Prime Crisis

Sub Prime crisis seems to be a thing of the past. People are now grappling with Sovereign Debt Default crisis in Europe. Investors are accusing European countries for bringing about gloom and doom in the financial world. But what has caused such deplorable financial condition of European nations, a sphere where everything was hunky dory just a couple of years back? As was the general perception then, conditions in European Union was one of growth and prosperity. As per IMF estimates of 2008 GDP and purchasing power parity among various currencies, the Eurozone was the second largest economy of the world. It was a place which was touted to be making a bipolar world with aspirations of giving a countervailing effect to the financial clout of USA. In fact the Euro was deemed to be the next dollar in the coming years, slowly and steadily replacing the dollar in international trade. Central Banks of many countries were increasing their exposure to Euro as their reserve currency. So much so that in 2007 former US Federal Reserve Chairman Alan Greenspan opined  " it is absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency". Strong opinion that! But then what happened suddenly within a span of two years that Euro has lost all its sheen? Today Eurozone bonds are hurtling towards acquiring junk bond ratings as many European nations are staring at the spectre of being declared insolvent.

How has this sudden capitulation taken place in such strong and vibrant economies? Why Europe, even US is reeling under the pressure of mounting debt. On 30 June 2010, the Congressional Budget Office(CBO) in US predicted that US debt will reach 62% of GDP by year end, which happens to be the highest percentage since just after World War II. Further, China happens to be the biggest creditor to US and also has huge exposure to Euro in its reserve. So you see, with every crisis of US and Europe in terms of debt servicing, China will be wincing in pain. Many South Asian economies will do the same since their economies in turn are China-centric. In other words Asia will be in pain whenever Europe and US feel the heat of sovereign debt default. As for African nations, most of them are already so badly managed economies that they figure in the Forbes list of top ten worst economies of the world. Since they depend on US and its financial organizations giving aid in some form or the other, Africa also will be under the weather with US economy in spot. That leaves us with South American nations. Well most of those economies are fully dependent on trade with US and hence will be effected too, if US is forced to go through austerity drive to curtail its fiscal challenge. In short, the entire world is under threat of an impending economic crisis.

But our central question still remains unanswered. How has this catastrophic situation come about? What has triggered this avalanche of economic woes upon affluent nations? In quest of an answer let us proceed step by step in the following direction :-

• The US sub prime crisis had morphed into global credit crisis of epic proportions. As we had seen in my last post on 12th June 2010 titled "Wall Street Shenanigans - Is Iconic Brand US Under Threat?", billions of dollars had been lost by global financial institutions in the wake of sub prime crisis. Every financial institution worth its name was on the verge of being bankrupt.
• These financial institutions were the backbone of every nation and this backbone was under threat of being broken. That is when Governments had to step in to save these financial institutions. It was a rare display of synchronized actions taken by all nations as they pumped in billions of dollars to save their terminally ill financial institutions. Such heavy injection of steroids(bailout money) is being popularly referred to as "Stimulus Package".
• This unified stand taken by all nations speak of the severity of  threat of annihilation, since politics of nations has never before allowed the world to be united on any single issue. But this time was an exception, a time to unite for survival. On 28Mar2009 in a post titled " Aftermath of Global Slowdown"   I had emphasized that for the leaders of G20 nations, meeting on 02Apr2009, it was their last chance to steer the world away from global catastrophe. And this time leaders of 20 most powerful nations united to deliver what is now popularly known as "Stimulus Package".
• Apart from many actions which increased liquidity, Governments across the globe injected money to bail out their financial institutions who had lost billions to the machinations of Wall Street investment banks.
• This bailout money eroded the coffers of nations making them credit unworthy. Injection of bailout money to save financial institutions at that point was unavoidable, but then measures should have been taken to ensure that this money was used for activities that kickstart economic revival. Instead billions of dollars again ended up in the kitty of people who planned and executed sub prime crisis in the first place. Take the example of AIG taking US tax payers' money as bailout to the tune of $182 billion and immediately paying off counterparties like Goldman Sachs and other Wall Street banks at 100% on the dollar. No negotiations?? Joseph Cassano, former head of AIG's derivatives unit, appearing before Financial Crisis Inquiry Commission, said he could have saved tax payers billions of dollars by negotiating harder with banks. Are the American tax payers paying attention?
• So instead of reviving the economy with activities which create jobs, these billions of dollars of stimulus money were siphoned off  to people who have again used it for more speculative purposes like dollar carry trade. To read more on dollar carry trade do look up my post on 27Nov2009 titled "Dollar Carry Trade - Easy Money in Difficult Times".
• With no revenue generation activities and empty coffers of nations, time had to come when debt servicing and debt repayment by nations was to become difficult. And that time has now come upon the world in the form of impending Sovereign Debt Default. To get a grasp on the implications of Sovereign debt default it is recommended that you visit my post of 18Dec2009 titled "Sovereign Debt Default Scare - Is Dubai Too Big To Fail?".

From April 2009 till date we have witnessed stimulus induced growth in all markets across the globe. That is artificial recovery and has no fundamental moorings. Nothing has changed on ground as far as growth parameters of nations are concerned. Take the latest US Jobs Report for instance. Last Friday the US unemployment data showed that the nonfarm payrolls fell by 125000 in June 2010. Economic activity is just not picking up in US and hence new jobs are not being created. If new jobs are not created then consumption will fall. Consumption falls then inventories increase and so production activities have to be curtailed. Decreased production requires even less jobs and inspires further fall in consumption. Hence we go into a vicious cycle in which you can imagine what happens to the economy.

Stimulus Induced Growth that we have seen for the last one and half year is at its end. Having taken not enough measures to induce structural economic growth, US is on the path of double dip recession. And history tells us that the Great Depression of 1929 got prolonged for similar reasons. You can get more details on stimulus packages in my post of 17Jan2010 titled "Stimulus Induced Growth - Is It Global Recovery On Steroids". At this stage it is judicious to remember that earlier World Wars were basically fought not for ideological or emotional reasons but for economic reasons, sparked by trade wars. I hope the world leaders are listening.

Wall Street Shenanigans - Is Iconic Brand USA Under Threat?

Breach of trust. Isn't that a culpable crime in financial world? How will you feel when your most trusted financial advisor, the one you even played golf with, was to commit breach of trust in order to swindle billions of dollars from you? Further, how would you feel if you happen to be the conscientious fund manager of a large Pension Fund on whom rests the onerous responsibility of ensuring that thousands of Pensioners have a respectable old age through timely pension? For a minute jump into the shoes of such a Pension Fund Manager and then tell me if  breach of trust is not a crime.

That is exactly what happened in the making of Sub Prime Crisis. Investment   bankers of Wall Street inflicted total breach of trust upon unsuspecting Institutional Investors and High Net worth Individuals(HNIs). This is becoming evident from the slew of court cases popping up against Goldman Sachs, the most venerable Investment Bank of Wall Street operating for the last 140 years. In global investment circles, Goldman Sachs' word in the final word on financial investment. And why shouldn't it be? Former employees of Goldman Sachs have headed World Bank, US Treasury Department, New York Stock Exchange, White House Staff, and financial giants like Citigroup and Merrill Lynch. Some such luminaries in recent times are Robert Rubin and Henry Paulson, who were United States Secretary of the Treasury under Bill Clinton and George W Bush respectively.

Here we realize that we are talking of an all powerful global Investment Bank with some very influential links. It is so powerful that in 1995 Robert Rubin, as US Treasury Secretary, could enforce bailout of Mexican Bonds with US taxpayers'  money worth $20 billion. Reason : Goldman Sachs had huge exposure to bonds issued by Mexican Government and Mexico was in economic crisis which threatened to wipe out the value of these bonds. And also remember that Robert Rubin was a former employee of Goldman Sachs, managing  its Mexican investments. So the point is, when Goldman Sachs gives financial investment advice institutional investors around the world take action in accordance. It was this very faith which was smothered by Goldman Sachs, thereby morphing the sub prime crisis into a credit crisis of  magnitude unparalleled since the Great Depression of 1929.

As the plot unravels, deals of Goldman Sachs are continuously tumbling out of cupboard like the proverbial skeletons. From 2004 to 2008 Goldman sold 25 toxic mortgage based Collateralized Debt Obligations(CDO) products labelled Abacus. They even pressured Moody's to rate these products higher. These deals were worth billions and Tetsuya Ishikawa was one of the Goldman investment bankers who was involved in these deals. He later published a book titled " How I Caused the Credit Crunch". However Securities and Exchange Commission (SEC), the regulatory body of markets in US, later sued Goldman Sachs and one of its employees Fabrice Tourre in April 2010. SEC alleged that Goldman sold Abacus 2007-AC 1(a synthetic CDO product of Abacus series) by misrepresenting facts to its investors. It allowed a hedge fund, named Paulson & Co., to select underlying mortgages, which Paulson was shorting, into this synthetic CDO. In this manner Paulson made $ 1 billion in profit from shorting and investors in this Abacus deal lost the same amount. On 30 April 2010 a criminal probe has been launched into Goldman Sachs by Manhattan office of US Attorney General.

SEC is now probing a second Goldman CDO called Hudson Mezannine 2006-1. It underwrote this CDO and itself was the only short investor on all the assets worth $ 2 billion tied to the CDO. Honesty is such a orphaned word!! Last week Basis Capital, an Australian Hedge Fund, sued Goldman Sachs for $1 billion alleging that it fraudulently sold bits of toxic assets in the form of CDO called Timberwolfe-1, while itself shorting the market. When the CDO eventually collapsed with the US housing market, Basis Capital had to shut shop.

Goldman is also in the eye of the storm regarding controversial American International Group(AIG) bailout with $182 billion of taxpayers' money by US Federal Reserves in September 2008. AIG is a massive insurance corporation with almost all global banks having insurance exposure to it. It is alleged that Goldman Sachs engineered the bailout with its lobbying muscles and links inside the Federal Reserves. It is reported that AIG bailout money has finally gone into Wall Street investment banks like Goldman Sachs with overpayment. New York State Attorney General announced on March 2009 that he was investigating whether AIG counterparties improperly received Government money.

Then there is this skeleton of Goldman Sachs having created the recent European Sovereign Debt Default crisis. It is reported that from 1998 to 2009 Goldman has been systematically helping the Greek Government to help mask facts about its true national debt. Then in September 2009 it created a special Credit Default Swap(CDS) index for cover of high risk national debt of Greece. The Greek national bond prices fell drastically, making it difficult for Greece to raise further funds thereby leading the economy to near bankruptcy.

Let us not get carried away by the wrong notion that only Goldman Sachs is to be blamed. What Goldman Sachs did, other Investment Banks on Wall Street also did the same. Take the court cases piling up against Merrill Lynch  where the stories sound exactly similar to those of Goldman Sachs' cases, albeit with different name. One case filed by Rabobank against Merrill Lynch is so similar to Goldman's Abacus case that it is quite unnerving. It is because the entire Investment Bank community on Wall Street was practising what by then had become glorified business of daylight robbery in the garb of global investment opportunities in housing market of Brand USA. Imagine devastating plots being hatched by coterie of investment bankers in smoke-filled-cellars of Wall Street, plots which crippled the financial world and is now ready to take down nations with debt burden.

What is most disturbing in all this is that breach of trust is not being given due importance. No one has been found guilty so far in any meaningful way and hence no one has been sufficiently punished. As I mentioned in my last post of 6th June 2010 titled " Isn't It Anymore Immoral to Loot!- Oh Wall Street Ethics", derivatives is a zero sum game. If trillion dollars have been lost collectively in sub prime crisis by vast majority of global investors, then there will be a handful  who would have gained trillion dollars. Track down these few heroes and investigate their dealings and links with  Wall Street Investment Banks and you will get your answer. Although some investigations are directed towards that but they are yet to bear any fruit. A global crisis which could propel a German billionaire to commit suicide is no mean crisis. What US has build painstakingly as  iconic Brand America over decades is at a risk of being diluted, if not lost, just because Wall Street honchos cannot control their excessive greed. Breach of Trust can have a telling effect on pecking order of financial world , so what if it gets unnoticed in courtroom battles.

In the next post we shall scrutinize the role of nations in pumping steroids into  their respective economies hit by the tsunami of credit crisis. Commonly known as stimulus packages, we will dwell on the fallout of such steroids.

Isn't It Immoral to Loot Anymore? - Oh Wall Street Ethics!

Chief Investment Officer, J P Morgan Chase lashes out on US investors calling them "predictably irrational" and "stupid". This he did  in an interview given to Forbes magazine few days back. What cheek!! Calling majority of 95 million US investors as "stupid" and "predictably irrational"? This is after what the Wall Street bankers did to willfully defraud common investors? We all know what happened to investors in 2008 sub prime mortgage crisis in US. Who were the actual brains behind the global meltdown that followed? To arrive at an answer let us analyse the sub prime crisis step by step that brought the world dangerously close to the Great Depression era. By the way, what we see today as turmoil in financial world across nations is majorly gifted by the sub prime crisis. And Lord knows how much more pain world has to endure before the venom of sub prime crisis gets thrown out completely from the system! But first let us focus on the genesis of sub prime crisis.

Sub prime crisis started with mortgage companies giving loans to American public at near zero interest and with no due diligence and no collateral. This led to a boom in economic activity as homes were sold like hot cakes. The mortgage companies were fully aware that most of these loans were going to default because these loans were mostly given to people with little or no repaying capability. That is why it has been exotically termed as loans to Sub Prime (below Prime) borrowers, meaning borrowers with very poor credit history and below par repaying capacity. They went so far as to having no document check for the sub prime borrowers, with computer generated automated approvals given to loan applications within 30 seconds. In this format you can declare anything as your income and there will be no questions asked.

The mortgage companies therefore knew that there will be payment defaults. Initially when the default started, the housing market in US was booming. So the mortgage companies gave away mortgage loans for second time to defaulting borrowers against their homes to pay off their first mortgage. It was a win-win-situation for all since the property prices were rising fast and furious. The exponential rise in property prices was forming a housing bubble, and any bubble has to burst sometime or the other. This fact was known to financial wizards in the mortgage companies.

Time was running out. So to wriggle out of this imbroglio, these mortgage companies went to the omnipotent and omniscient investment bankers of Wall Street to bail them out of their impending doom. And thus a devious and intricate plot was hatched by big daddys of Wall Street.

Mortgage Backed Securities(MBS) : The investment bankers were quick to securitize the mortgage loans and pass on the risk to the buyers of these securities. Simply put they bought the mortgage loans, made  a  pool of these loans, and issued out bonds against the pool. The mortgage companies got their money back, and again went back to give out more loans to more undeserving borrowers.

Credit Default Swap(CDS) : Not content with passing on the risk to bond holders of MBS plan, they further wanted to make big bucks out of the situation of rising property prices. Thus they thought of exercising the financial instrument of CDS to make a killing. If  you are a bond holder you would like to insure yourself against the huge investment you have made in these bonds. So you get advised to buy CDS as an insurance. Suppose you have bought $1 million as mortgage bonds  and then you buy CDS as insurance,  you are required to pay annual premium of $10000(say) for such an insurance. By doing so you are insured to get your $1million in case the bond fails. CDS also allows that even if you are not the bond holder or property holder you can still participate in the housing market through CDS by speculating. Supposing you have an opinion that property prices will fall and by extension the MBS bonds will fail, then you buy CDS against these bonds, pay the yearly premium of $10000 and make a killing of $1 million as and when the bonds fail.

Collateralized Debt Obligation(CDO) : Still not content with raising mega bucks through MBS and CDS, these investment bankers devised more hideous plans to spread the risk right across the globe. They invoked CDO, a name that now sends shivers through millions of hapless investors on planet earth. All MBS and CDS were grouped into a pool, divided into tranches and sold as bonds of CDO. The tranches with least risk were given highest investment rating of AAA through rating agencies like S&P, Fitch and Moody's. The riskier tranches were given lower ratings in steps starting with AA, A, BBB, BB and B. Riskier the tranche, higher was the promised return and vice-versa. These were then sold to all financial institutions and big investors across continents as financial products, with  investment grade stamp and authority of the most hallowed names in financial world.

CDO Squared : Yet not satisfied that they have done enough, the investment bankers this time made a pool of CDOs itself as underlying asset and issued out CDO Squared. In doing this, slices were taken from CDO proper and mixed so horribly that the riskier tranches got thoroughly mixed with healthy tranches. Now the credit rating agencies had no problems giving AAA ratings to CDO Squared. Further, CDO Squared were put into a pool and made CDO Cubed and bonds issued against them. They have even gone further and sold derivatives of CDO Cubed and so on. No one really knows how far these investment bankers have gone in this game of deceit. All that one knows is that these financial products were manufactured in the factories of Wall Street and sold across the globe with investment grade ratings from the most venerable names in the rating business. Who will not buy these products, made in USA?!!

Synthetic CDO : One step further into the quagmire, Synthetic CDOs were sold which had no asset backing at all. This was the last nail in the coffin, as investment bankers on Wall Street sold Credit Default Swaps(CDS) of the already complex CDOs, terming them as Synthetic CDO.

When the housing bubble finally did burst in US, everything got complicated. The credit unworthy or sub prime borrowers defaulted and this time with their property prices plummeting, no one was ready to
re-mortgage their property. Not being able to pay the loans they vacated their homes. The banks had deluge of foreclosures, but there were no buyers for foreclosed homes. Hence there was distress selling from bankers. This led to further fall in property prices and the malaise slowly spread across to the prime mortgage market.

With such huge defaults from sub prime borrowers all derivative instruments starting with MBS and all hues of CDOs  crumpled. Anyone having exposure to these toxic assets had to book huge losses. Even those who did not have any exposure to such toxic assets were also hit. They were the pensioners in US who found out to their horror that the pension funds had exposure to these toxic assets.

All that is known to all of us. Now the question that begs an answer is this: "If derivatives is a zero sum game then how come the whole financial world is crying fowl?" If majority has lost billions of dollars ( last estimate of loss by IMF was about a trillion dollars) then who are the minority gainers. If the investment banks like Bear Stearns, Goldman Sachs, Lehman Brothers and mortgage companies like Countrywide Financial have all lost billions of dollars and had applied for bankruptcy, then who have profited those lost billions? Surely not the poor sub prime borrowers who are on the street with their homes foreclosed. I would like to provide a clue to the answer. Investment bankers working for these investment banks had in their internal emails described all these derivative instruments like MBS, CDO as worthless papers. And yet they were wilfully selling these worthless papers with gusto and guise to all investors. Before the sub prime crisis all you needed to do was to take credit default swaps(CDS) of all these exotic mortgage derivatives and you would have made billions before you could say Jack Robinson. But for that you have to be an Insider and part of a Cartel !!

I have tried to explain a very complex phenomenon of sub prime crisis in a very simplified manner. Each financial instrument has many degrees of complexity attached, which I have conveniently left out so that it is easy to understand. As sequel to this understanding, I shall be discussing about the ramifications of  sub prime crisis on world economy in my next post. We shall also try to evaluate as to how much more pain is left in the system. Till then trade with caution!