A REMINDER THAT ALL IGNORE
Monday, 6 October 2008
Harold Hoffman News Review with Tamar Yonah of Israel National Radio and two further U.K. assessments.
WHEN WILL YOU ALL WAKE UP? TOO LATE ME THINKS. Just ask why do we have to take the toxic assets off Balance Sheet? Oh! ho! ho! Basle 1 & 2 OF COURSE! Slowly, Slowly we move towards the "PHOENIX".
click to listen
Harold Hoffman interviewed by Tamar Yonah of
Israel National Radio, and two further U.K. assessments of Justin Urqhart, Jeremy Paxman, Irwin Seltzer, Julianne Tett, Joe Stilglitz.
You ain't seen anything yet.
We shall discuss further matters regarding the Financial Tsunami which we are IN.
I shall try to explain in 20 minutes, how this came about, why, and what we are all facing in the IMMEDIATE FUTURE.
The Debt Society and what it is going to lead to.
The ECONOMIST - JUNE 1989 COVER. TO ARRIVE in 2018.
THE PHOENIX
The PLANNED explosion of credit over the past 10-15 years, the financial instruments that excacerbated the problems, CDS and the role of triple A - AAA - rating and AIG ins. Reference to other financial gurus, all promulgating the warnings over past 5-10 years and all on my site.
Inflation - leading to Hyper-Inflation;
The Basle Accord 1 & 2, open arms, the derivative and hedge fund market, of which part will collapse, dollar devaluation, sterling devaluation, the challenge of the EU, the obvious move to a form of marxist/capitalist society, of which the Chinese model IS A DRESS REHEARSAL.
Why 1972/1973 was so important - Yom Kippur war and its' resultants, price of oil tripled, Nixon off the gold tie to the dollar, the establishment of the petro dollar, the establishment of the Tri Lateral Commission by the Rockefellers, the beginning of the end of Viet Nam war, the opening of China markets by Henry Kissinger. The UK joins the EU, after agreement with the US.
Why Kennedy was assasinated and Johnson in 1962.
Connect the dots folks... Happenstance? Coincidence? OR PLANNED?
Acknowledged expert, most notably last December, Prof. Peter Spencer, of the Ernst & Young Item Club, is regarded as "one of Britain's leading economists". It was then that a report of his views said:
…conflicts caused by the Basel system of banking regulations, which determine how much capital banks must raise to keep their books in order, are the root cause of the crunch and were serving to worsen the City's plight.
The regulations meant that banks forced to take off-balance sheet assets from troubled structured investment vehicles on to their books had little choice but either to raise money from abroad or cut back dramatically on their spending, he said.
He warned that, if London's money markets remained frozen and the authorities retain the strict Basel regulations, the full scale of the eventual credit crunch and economic slump could be "disastrous".
Dismissing the assumption that banks are not lending to each other on the money markets because they lack confidence in each others' potential solvency, he argued that they were, in practice, prevented from lending the cash at all because it could leave their balance sheets falling foul of the Basel regulations.
"If these funding routes are not reopened it will have massive consequences for the economy as a whole," he said. "It will make 1929 look like a walk in the park."
This will be my News Review for this week.
Harold Hoffman
They 'made' on the way up. Now they 'make' on the way down. A global run on the Banks. HA! The market's fixed and you and I ain't members of the CLUB!
Today's essay is a little longer than usual... but I think you'll find it well worth reading; credit crisis all year, and I think you'll be far ahead after reading.
How AIG's Collapse Began a Global Run on the Banks
October 4, 2008
Something very strange is happening in the financial markets. And I can show you what it is and what it means...
If September didn't give you enough to worry about, consider what will happen to real estate prices as unemployment grows steadily over the next several months. As bad as things are now, they'll get much worse.
They'll get worse for the obvious reason: because more people will default on their mortgages. But they'll also remain depressed for far longer than anyone expects, for a reason most people will never understand.
What follows is one of the real secrets to September's stock market collapse. Once you understand what really happened last month, the events to come will be much clearer to you...
Every great bull market has similar characteristics. The speculation must – at the beginning – start with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats.
Some of these limitations are obvious to any intelligent observer... like the need for a substantial down payment, the verification of income, an independent appraisal, etc. But human nature dictates that, given enough time and the right incentives, any endeavor will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate appraisals.
As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further... into fraud.
And this is where AIG comes into the story.
Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.
Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.
So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.
"What would it cost me to insure this subprime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.
Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you're buying against default for five years for say, 2% of face value.
Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.
Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year – long before the actual profit on the contract was made.
With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of subprime "toxic waste." The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral.
It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.
Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk. An enormous amount of capital was created out of thin air and tossed into global real estate markets.
On September 15, all of the major credit-rating agencies downgraded AIG – the world's largest insurance company. At issue were the soaring losses in its credit default swaps. The first big writeoff came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's largest insurance company was bankrupt.
The dominoes fell over immediately. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity.
Most people never understood how AIG was the linchpin to the entire system. And there's one more secret yet to come out...
AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs.
I'd wondered for years how Goldman avoided the kind of huge mortgage-related writedowns that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering.
The collapse of the credit default swap market also meant the investment banks – all of them – had no way to borrow money, because no one would insure their obligations.
To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. To date, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG's failure. Things are so bad at the investment banks, the Fed had to change the rules to allow Merrill, Morgan Stanley, and Goldman the ability to use equities as collateral for these loans, an unprecedented step.
The mainstream press hasn't reported this either: A provision in the $700 billion bailout bill permits the Fed to pay interest on the collateral it's holding, which is simply a way to funnel taxpayer dollars directly into the investment banks.
Why do you need to know all of these details? First, you must understand that without the government's actions, the collapse of AIG could have caused every major bank in the world to fail.
Second, without the credit default swap market, there's no way banks can report the true state of their assets – they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't cover for them anymore.
And third, and most importantly, without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade.
There's no way to replace this massive credit-building machine, which makes me very skeptical of the government's bailout plan. Quite simply, we can't replace the credit that existed in the world before September 15 because it didn't deserve to be there in the first place. While the government can, and certainly will, paper over the gaping holes left by this enormous credit collapse, it can't actually replace the trust and credit that existed... because it was a fraud.
And that leads me to believe the coming economic contraction will be longer and deeper than most people understand.
You might find this strange... but this is great news for those who understand what's going on.Knowing why the economy is shrinking and knowing it's not going to rebound quickly gives you a huge advantage over most investors, who don't understand what's happening and can't plan to take advantage of it.
How can you take advantage? First, make sure you have at least 10% of your net worth in precious metals, prefer gold bullion. World governments' gigantic liabilities will vastly decrease the value of paper currencies.
Second, tell your either at or approaching a moment of maximum pessimism in the markets. These kinds of panics give you the chance to buy world-class businesses incredibly cheaply. A few worth mentioning are ExxonMobil, Intel, and Microsoft, have several stocks like these in the portfolio.
The EU's role in our financial crisis
WHEN WILL YOU ALL WAKE UP? TOO LATE ME THINKS. Just ask why do we have to take the toxic assets off Balance Sheet? Oh! ho! ho! Basle 1 & 2 OF COURSE! Slowly, Slowly we move towards the "PHOENIX".click to listen
Harold Hoffman interviewed by Tamar Yonah of
Today's essay is a little longer than usual... but I think you'll find it well worth reading; credit crisis all year, and I think you'll be far ahead after reading.
How AIG's Collapse Began a Global Run on the Banks
October 4, 2008
Something very strange is happening in the financial markets. And I can show you what it is and what it means...
If September didn't give you enough to worry about, consider what will happen to real estate prices as unemployment grows steadily over the next several months. As bad as things are now, they'll get much worse.
They'll get worse for the obvious reason: because more people will default on their mortgages. But they'll also remain depressed for far longer than anyone expects, for a reason most people will never understand.
What follows is one of the real secrets to September's stock market collapse. Once you understand what really happened last month, the events to come will be much clearer to you...
Every great bull market has similar characteristics. The speculation must – at the beginning – start with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats.
Some of these limitations are obvious to any intelligent observer... like the need for a substantial down payment, the verification of income, an independent appraisal, etc. But human nature dictates that, given enough time and the right incentives, any endeavor will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate appraisals.
As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further... into fraud.
And this is where AIG comes into the story.
Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.
Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.
So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.
"What would it cost me to insure this subprime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.
Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you're buying against default for five years for say, 2% of face value.
Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.
Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year – long before the actual profit on the contract was made.
With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of subprime "toxic waste." The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral.
It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.
Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk. An enormous amount of capital was created out of thin air and tossed into global real estate markets.
On September 15, all of the major credit-rating agencies downgraded AIG – the world's largest insurance company. At issue were the soaring losses in its credit default swaps. The first big writeoff came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's largest insurance company was bankrupt.
The dominoes fell over immediately. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity.
Most people never understood how AIG was the linchpin to the entire system. And there's one more secret yet to come out...
AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs.
I'd wondered for years how Goldman avoided the kind of huge mortgage-related writedowns that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering.
The collapse of the credit default swap market also meant the investment banks – all of them – had no way to borrow money, because no one would insure their obligations.
To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. To date, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG's failure. Things are so bad at the investment banks, the Fed had to change the rules to allow Merrill, Morgan Stanley, and Goldman the ability to use equities as collateral for these loans, an unprecedented step.
The mainstream press hasn't reported this either: A provision in the $700 billion bailout bill permits the Fed to pay interest on the collateral it's holding, which is simply a way to funnel taxpayer dollars directly into the investment banks.
Why do you need to know all of these details? First, you must understand that without the government's actions, the collapse of AIG could have caused every major bank in the world to fail.
Second, without the credit default swap market, there's no way banks can report the true state of their assets – they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't cover for them anymore.
And third, and most importantly, without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade.
There's no way to replace this massive credit-building machine, which makes me very skeptical of the government's bailout plan. Quite simply, we can't replace the credit that existed in the world before September 15 because it didn't deserve to be there in the first place. While the government can, and certainly will, paper over the gaping holes left by this enormous credit collapse, it can't actually replace the trust and credit that existed... because it was a fraud.
And that leads me to believe the coming economic contraction will be longer and deeper than most people understand.
You might find this strange... but this is great news for those who understand what's going on.Knowing why the economy is shrinking and knowing it's not going to rebound quickly gives you a huge advantage over most investors, who don't understand what's happening and can't plan to take advantage of it.
How can you take advantage? First, make sure you have at least 10% of your net worth in precious metals, prefer gold bullion. World governments' gigantic liabilities will vastly decrease the value of paper currencies.
Second, tell your either at or approaching a moment of maximum pessimism in the markets. These kinds of panics give you the chance to buy world-class businesses incredibly cheaply. A few worth mentioning are ExxonMobil, Intel, and Microsoft, have several stocks like these in the portfolio.
Israel National Radio, and two further U.K. assessments of Justin Urqhart, Jeremy Paxman, Irwin Seltzer, Julianne Tett, Joe Stilglitz.
You ain't seen anything yet.
We shall discuss further matters regarding the Financial Tsunami which we are IN.
I shall try to explain in 20 minutes, how this came about, why, and what we are all facing in the IMMEDIATE FUTURE.
The Debt Society and what it is going to lead to.
The ECONOMIST - JUNE 1989 COVER. TO ARRIVE in 2018.
THE PHOENIX
The PLANNED explosion of credit over the past 10-15 years, the financial instruments that excacerbated the problems, CDS and the role of triple A - AAA - rating and AIG ins. Reference to other financial gurus, all promulgating the warnings over past 5-10 years and all on my site.
Inflation - leading to Hyper-Inflation;
The Basle Accord 1 & 2, open arms, the derivative and hedge fund market, of which part will collapse, dollar devaluation, sterling devaluation, the challenge of the EU, the obvious move to a form of marxist/capitalist society, of which the Chinese model IS A DRESS REHEARSAL.
Why 1972/1973 was so important - Yom Kippur war and its' resultants, price of oil tripled, Nixon off the gold tie to the dollar, the establishment of the petro dollar, the establishment of the Tri Lateral Commission by the Rockefellers, the beginning of the end of Viet Nam war, the opening of China markets by Henry Kissinger. The UK joins the EU, after agreement with the US.
Why Kennedy was assasinated and Johnson in 1962.
Connect the dots folks... Happenstance? Coincidence? OR PLANNED?
Acknowledged expert, most notably last December, Prof. Peter Spencer, of the Ernst & Young Item Club, is regarded as "one of Britain's leading economists". It was then that a report of his views said:
…conflicts caused by the Basel system of banking regulations, which determine how much capital banks must raise to keep their books in order, are the root cause of the crunch and were serving to worsen the City's plight.
The regulations meant that banks forced to take off-balance sheet assets from troubled structured investment vehicles on to their books had little choice but either to raise money from abroad or cut back dramatically on their spending, he said.
He warned that, if London's money markets remained frozen and the authorities retain the strict Basel regulations, the full scale of the eventual credit crunch and economic slump could be "disastrous".
Dismissing the assumption that banks are not lending to each other on the money markets because they lack confidence in each others' potential solvency, he argued that they were, in practice, prevented from lending the cash at all because it could leave their balance sheets falling foul of the Basel regulations.
"If these funding routes are not reopened it will have massive consequences for the economy as a whole," he said. "It will make 1929 look like a walk in the park."
This will be my News Review for this week.
Harold Hoffman
They 'made' on the way up. Now they 'make' on the way down. A global run on the Banks. HA! The market's fixed and you and I ain't members of the CLUB!
Today's essay is a little longer than usual... but I think you'll find it well worth reading; credit crisis all year, and I think you'll be far ahead after reading.
How AIG's Collapse Began a Global Run on the Banks
October 4, 2008
Something very strange is happening in the financial markets. And I can show you what it is and what it means...
If September didn't give you enough to worry about, consider what will happen to real estate prices as unemployment grows steadily over the next several months. As bad as things are now, they'll get much worse.
They'll get worse for the obvious reason: because more people will default on their mortgages. But they'll also remain depressed for far longer than anyone expects, for a reason most people will never understand.
What follows is one of the real secrets to September's stock market collapse. Once you understand what really happened last month, the events to come will be much clearer to you...
Every great bull market has similar characteristics. The speculation must – at the beginning – start with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats.
Some of these limitations are obvious to any intelligent observer... like the need for a substantial down payment, the verification of income, an independent appraisal, etc. But human nature dictates that, given enough time and the right incentives, any endeavor will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate appraisals.
As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further... into fraud.
And this is where AIG comes into the story.
Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.
Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.
So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.
"What would it cost me to insure this subprime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.
Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you're buying against default for five years for say, 2% of face value.
Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.
Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year – long before the actual profit on the contract was made.
With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of subprime "toxic waste." The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral.
It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.
Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk. An enormous amount of capital was created out of thin air and tossed into global real estate markets.
On September 15, all of the major credit-rating agencies downgraded AIG – the world's largest insurance company. At issue were the soaring losses in its credit default swaps. The first big writeoff came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's largest insurance company was bankrupt.
The dominoes fell over immediately. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity.
Most people never understood how AIG was the linchpin to the entire system. And there's one more secret yet to come out...
AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs.
I'd wondered for years how Goldman avoided the kind of huge mortgage-related writedowns that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering.
The collapse of the credit default swap market also meant the investment banks – all of them – had no way to borrow money, because no one would insure their obligations.
To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. To date, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG's failure. Things are so bad at the investment banks, the Fed had to change the rules to allow Merrill, Morgan Stanley, and Goldman the ability to use equities as collateral for these loans, an unprecedented step.
The mainstream press hasn't reported this either: A provision in the $700 billion bailout bill permits the Fed to pay interest on the collateral it's holding, which is simply a way to funnel taxpayer dollars directly into the investment banks.
Why do you need to know all of these details? First, you must understand that without the government's actions, the collapse of AIG could have caused every major bank in the world to fail.
Second, without the credit default swap market, there's no way banks can report the true state of their assets – they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't cover for them anymore.
And third, and most importantly, without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade.
There's no way to replace this massive credit-building machine, which makes me very skeptical of the government's bailout plan. Quite simply, we can't replace the credit that existed in the world before September 15 because it didn't deserve to be there in the first place. While the government can, and certainly will, paper over the gaping holes left by this enormous credit collapse, it can't actually replace the trust and credit that existed... because it was a fraud.
And that leads me to believe the coming economic contraction will be longer and deeper than most people understand.
You might find this strange... but this is great news for those who understand what's going on.Knowing why the economy is shrinking and knowing it's not going to rebound quickly gives you a huge advantage over most investors, who don't understand what's happening and can't plan to take advantage of it.
How can you take advantage? First, make sure you have at least 10% of your net worth in precious metals, prefer gold bullion. World governments' gigantic liabilities will vastly decrease the value of paper currencies.
Second, tell your either at or approaching a moment of maximum pessimism in the markets. These kinds of panics give you the chance to buy world-class businesses incredibly cheaply. A few worth mentioning are ExxonMobil, Intel, and Microsoft, have several stocks like these in the portfolio.
By Christopher Booker
Last Updated: 12:01am BST 05/10/2008
As the Western world's banking system teeters on the edge of collapse, one crucial factor in this unprecedented crisis has gone almost entirely unnoticed - although David Cameron made a veiled reference to it on Tuesday.
At the heart of this catastrophe lies a drastic change made last year to banking regulations, which has led to the current freezing of the money markets. Without it, most of the banks that have collapsed, such as Lehman Brothers, might have survived.
Last December, a leading City economist, Professor Peter Spencer of Ernst & Young's Item Club, warned that unless something was done urgently to modify the new rules, the resulting paralysis of the banking system would "make 1929 look like a walk in the park".
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Last week, as his prediction seemed to be coming true, the US was moving to change the rules. But in the EU they are enshrined in a directive which could take months, or years, to unpick.
In 2004, partly in response to the Enron debacle, the world's leading economic powers made an agreement known as Basel 2.
It proposed a drastic tightening of the so-called "fair value" or "mark-to-market" rules, whereby banks and other financial institutions define whether they are solvent and fit to continue trading. Brussels, which is fast taking over regulation of our financial services, embodied this in two directives, 2006/48 and 2006/49, known as the Capital Adequacy Directive.
Much of this lays down a complex "Risk Assessment Model", under which a bank at the end of each day's trading must produce a statement of its assets to show whether or not it is solvent. If not, the bank must declare this to the regulatory authorities, such as Britain's Financial Services Authority (FSA), and cease trading.
As informed observers pointed out at the time, this might not cause problems when property and share values were rising but when markets fell the banks would be put in a critical position.
Writing down their assets to the value they would fetch in a "fire sale", without allowing for underlying value or future recovery, their asset base might be so severely undervalued that it would be difficult for them to lend or borrow, freezing those deals which are the banking system's lifeblood.
At worst, though technically solvent, they would have to close their doors.
Since the credit crunch began last year, this is precisely what has happened. Another City economist, Professor Tim Congdon, warned in January that the "scientific precision of the Basel rules" had been shown to be "hocus pocus", explaining how this had already played a key part in the collapse of Northern Rock. As a "solvent but illiquid bank", wrote Prof Congdon, Northern Rock's only hope was to appeal for help to the Bank of England.
In former times, as the Bank's governor, Mervyn King, tried to explain to the Treasury Select Committee in September 2007, he could have sorted it out behind the scenes, in a rescue operation involving other banks - as had often been done before.
But Mr King was hamstrung by EU legislation, such as its directives on takeovers and "market abuse", as shown by Prof Congdon in a devastating pamphlet, Northern Rock and the European Union (published by Global Vision). The EU's role makes nonsense of the claim that Britain's financial regulation is a "tripartite" system - Bank, Treasury and FSA.
In reality it is quadripartite, with Brussels the fourth and in many ways most important player, as we saw when subsequent attempts to sort out the Northern Rock shambles fell foul of EU competition and state-aid rules.
As Ron Sandler, Northern Rock's chairman, said when it was nationalised, "the bank will have to operate according to rules set in Brussels". Because the EU's competition commissioner, Neelie Kroes, failed to grasp the difference between a loan and state aid, one of her first requirements was that the bank should sack 2,000 employees as evidence that it was being "restructured".
Thus the EU has become the gigantic "elephant in the room" of our financial services industry, on which a third of Britain's income depends. Nowhere is the effect more damaging than in those directives implementing the Basel 2 agreement (actively promoted by Britain at the time) that have reduced our banking and lending system to paralysis.
When Mr Cameron admitted last week that a "new international regulation" which "automatically downgrades the value of banks" was "making the financial crisis worse than in previous downturns", he did not dare risk inflaming his party's Eurosceptics by referring to the EU directly. He merely coyly suggested that "our regulatory authorities" should get together with "the European regulators" to "address this difficult issue".
He did not point out that, as the US Securities and Exchange Commission was abandoning the new rules (supported by the bail-out bill before Congress), all we have to look forward to is that Gordon Brown, after his "crisis summit" in Paris yesterday, will air this "difficult issue" at the European Council on October 15.
Even if they decide to follow the US lead, it would entail the tortuous procedure of the Commission drafting a new directive, which could take more than a year. Meanwhile Europe's banking system remains frozen, threatening no one more than Britain - for reasons that none of our politicians dare explain.
With Ed Miliband as energy minister, the future looks dim
It is hard to overestimate the disastrous implications of Gordon Brown's appointment of Ed Miliband as minister for "energy and climate change".
Our former energy minister, John Hutton, was the one member of the Government who took on board the reality of our looming energy crisis, the certainty that within a few years, unless we build at least a dozen new nuclear and coal-fired power stations, our economy will grind to a halt.
Until then, ministers had been carried into cloud cuckoo land by green propaganda and unrealisable dreams of generating our electricity from "renewables".
Mr Hutton recognised that a proper energy policy was so vital that it must take priority even over "renewables targets" set by the EU.
With his lone voice of sanity gone and Mr Miliband in charge - as green, climate change obsessed and Europhile as they come - the prospect of our lights going out seems unavoidable.
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Comments
MMmm Mr Booker, having just read the eureferendum article, I am left with the feeling that Dave Cameron has just rolled over for the abominable and anti-democratic EU. But yes he has at least given us a partial sight into the zoo. Great Britain seems overcrowded with EU elephants it seems to me. There are so many that the legal and illegal immigrants flooding into our little Island home each day are having trouble finding accomodation. A good peice Mr Booker, thank you.
Better off out.
Posted by harry fredericks on October 5, 2008 11:42 AM
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Better off out.
Posted by harry fredericks on October 5, 2008 11:42 AM
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Ah,the EU!Thought their dead hand must have been in this somewhere!As with so much else that goes against commonsense in our national life,the EU has it's finger in this pie also!The question is,why does it take this column to tell us??Why isn't Gordy telling us this?Why not call me Dave?Could it be that support foe the EU project goes before what is best5 for us,the British people?
Posted by ray douglas on October 5, 2008 11:42 AM
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Posted by ray douglas on October 5, 2008 11:42 AM
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Nick Moore 10.21: the different general reactions to EU membership in England and in France are rooted in different national traditions going back centuries.
But don't assume that the general opposition in one is a matter for condemnation, any more than any general acceptance in the other should attract praise.
Posted by CWood on October 5, 2008 11:40 AM
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But don't assume that the general opposition in one is a matter for condemnation, any more than any general acceptance in the other should attract praise.
Posted by CWood on October 5, 2008 11:40 AM
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Contrary to the views of some of those who have made comments, it was never our intention to suggest - and nor do we - that the EU is the cause of the current financial crisis.
Nor indeed can it be argued that the EU is responsible for the Basel II rules which, according to many experts, have had a significant role in intensifying the crisis. The British government was an enthusiastic supporter of the new rules and would have adopted them, even had we not been in the EU.
The problem comes in that, having adopted the Basel rules via EU legislation rather than directly into our legal code, in order to change them we must now go through the laborious and time-consuming EU decision process, with no certainty of outcome.
Thus, while the US Congress has accepted the need for change and given the SEC the authority to suspend the "mark to market" system - which is what Mr Osborne was calling for - and also told the SEC to come up with a report in 90 days on alternatives, the EU has yet formally to consider whether any changes should be made.
The first formal step in this process will come on 15 October at the European Council. The end point of that process is unknown. The likelihood is that, despite the urgency of the situation, it will be many months, if not years, before any changes can be made to what is generally considered to be an inadequate system.
Meanwhile, contrasted with the speed with which the SEC is being required to act, financial services commissioner Charlie McCreevy announced last April that he was to undertake a review of the "mark to market" system. Since than, there has been silence from the commission. What ever happened to his review?
Posted by Richard North on October 5, 2008 11:28 AM
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Nor indeed can it be argued that the EU is responsible for the Basel II rules which, according to many experts, have had a significant role in intensifying the crisis. The British government was an enthusiastic supporter of the new rules and would have adopted them, even had we not been in the EU.
The problem comes in that, having adopted the Basel rules via EU legislation rather than directly into our legal code, in order to change them we must now go through the laborious and time-consuming EU decision process, with no certainty of outcome.
Thus, while the US Congress has accepted the need for change and given the SEC the authority to suspend the "mark to market" system - which is what Mr Osborne was calling for - and also told the SEC to come up with a report in 90 days on alternatives, the EU has yet formally to consider whether any changes should be made.
The first formal step in this process will come on 15 October at the European Council. The end point of that process is unknown. The likelihood is that, despite the urgency of the situation, it will be many months, if not years, before any changes can be made to what is generally considered to be an inadequate system.
Meanwhile, contrasted with the speed with which the SEC is being required to act, financial services commissioner Charlie McCreevy announced last April that he was to undertake a review of the "mark to market" system. Since than, there has been silence from the commission. What ever happened to his review?
Posted by Richard North on October 5, 2008 11:28 AM
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John Loeffler Steel on Steel The Four Stages of Inflation
10/04/2008
The Four Stages of Inflation
click to listen
YOU AINT SEEN ANYTHING. YET.
Bailout bailout bailout. It's hard work ramming something through congress that Americans don't want. Unfortunately politicians and the Fed are between a rock and a hard place now: they can't afford to do something and they can't afford not. This is what happens when a country enters advanced stages of inflation; all pain and no gain.
Today's first guest is Jim Puplava from the Financial Sense Newshour (www.financialsense.com) to explain the four classic stages of inflation since the U.S. and much of the West has set itself on this self-destructive course. Once you're on it, you can't get off.
Then we'll examine the Violence Against Women Act; well-intentioned but now causing a lot of unintended consequences against people it shouldn't. Time to reform the act. Ron Grignol comes on board for this part of the program.
John's boralogue ties up loose ends about the economy, the bailout, socialism and exactly where we're headed despite the blather.
====================
YOU AINT SEEN ANYTHING. YET. A MUST LISTEN
YOU AINT SEEN ANYTHING. YET.
A MUST LISTEN
Harold Hoffman brings you and interview between
By general accord, much of the current financial crisis arises from "regulatory failure", something to which numerous references have been made, not least by the shadow chancellor over the weekend, when he complained that "Gordon Brown's regulatory mechanism has comprehensively failed".
Osborne has though been reticent about identifying the specific failure and it took his boss David Cameronyesterday to hint at the specifics. There is a need, he said, "to break the self-fulfilling cycle that is reducing banks' ability to lend." The problem is this, he added:
That it is an EU directive, though, does not tell the whole story for it is this directive which implements crucial parts of the now notorious Basel II agreement. It is that agreement that which is the heart of the current problems which the banks are experiencing.
That Basel II is the problem – the "smoking gun", so to speak - has been widely promulgated for some time by acknowledged experts, most notablylast December by Prof. Peter Spencer, of the Ernst & Young Item Club, regarded as "one of Britain's leading economists". It was then that a report of his views said:
The Spencer analysis was then essentially repeated at the end of January by another acknowledged expert, Prof. Tim Congdon.
In the context of the Northern Rock affair, Congdon asserted that, "the Basel rules have failed", then arguing that "the scientific precision of the Basel rules was shown to be hocus-pocus." Banks, he wrote:
He did not name the Basel II agreement and, crucially, neither did he identify the more immediate cause of the problem, the EU Capital Adequacy Directive. Had he done so, of course, there would have been uproar, and the EU would have been catapulted to the top of the political agenda, which is the last thing Cameron would have wanted.
And it is the Directive which is now the problem. The reason for this is that, although the original Basel II agreement was produced in June 2004 with the assent of the British authorities – which had pushed hard to their adoption – the sponsoring organisation, the Basel Committee on Banking Supervisiondoes not produce legislation.
Instead, it "formulates broad supervisory standards and guidelines" and recommends statements of best practice in banking supervision "in the expectation that member authorities and other nations' authorities will take steps to implement them through their own national systems, whether in statutory form or otherwise."
Had the UK been an independent country in 2004 and subsequently, the government would have implemented the Basel II agreement into UK legislation, either through an Act of Parliament or through Regulations (SIs) – or a combination of both.
The trouble was that, not only was the UK a member of the European Union, financial services regulation was (and is) a "competence" of the EU and the UK had thereby ceded authority to legislate in this area. Thus, instead of being adopted into British law directly, it was adopted via an EU Directive.
That, at the time, did not present the government with a problem as it has been an enthusiastic supporter of the agreement. But, now that the flaws in the agreement have been exposed, or shown to be "hocus-pocus" as Congdon maintains, the provisions cannot be changed unilaterally by the British government. They are now part of EU law so, in order to achieve change, all we can do, as Cameron euphemistically put it, is have "…our regulatory authorities, together with the European regulators," address "this difficult issue."
And that equivocation is also part of the problem. One might ask why, if Cameron is now so (rightly) certain as to where the problem lies, his shadow chancellor has not raised it before.
To be fair to him, he has. He raised it on 21 April 2008 in the House of Commons in response to a statement by Alistair Darling on "financial stability". But it was only one sentence where he told Darling that the moves he had announced "should include reforms to the Basel accords."
Then, in a Newsnight interview on 17 September, just a few days ago, he mentioned it again, a reference which met with the approval of Telegraphcolumnist Gerald Warner, who noted:
Yesterday, Cameron entitled his speech, "Together we will find a way through". What he did not specify, however, was how he was going to "find a way through" the EU labyrinth to remove a damaging piece of legislation that is at the heart of this crisis.
Thus, while Osborne is accusing Labour of being "in denial" over its role in the financial crisis, the Conservatives too are indulging in their own form of denial.
The elephant has re-acquired its cloak of invisibility.
The picture shows the headquarters of the Bank for International Settlements in Basel, which hosts the Basel Committee on Banking Supervision meetings.
COMMENT THREAD
In what has been a roller-coaster and exhausting week, we've got to a position where we've got part of the story – not the whole story, which is far more complicated – but enough of it to make sense.
Through this blog, in no less than 20 posts since Saturday week last – listedhere (with links in chronological order) - when we cranked up our coverage of the financial crisis, some of the story gradually emerged.
Now, in a masterpiece of compression, Booker has managed to squeeze the story so far into his column published today, accompanied by an inspired piece of photoshopping from The Sunday Telegraph graphics department (above). I suspect this one will get a lot of use.
It almost goes without saying that we are so far ahead of the game that no one is even close when it comes to reporting on the background to this current phase of the financial crisis.
There is no dispute amongst the players that the driving force behind the stress in the banking system at the moment is an almost unprecedented liquidity crisis, which is having a massive knock-on effect in the economy as a whole. What we have to offer is a partial explanation that stands up to scrutiny, one which an awful lot of people don't want told – and as many don't want to hear or believe.
That you will see nothing of this reported so coherently in the general run of media reporting stems, I think, from three things.
Firstly, the media suffers from the fatal flaw of specialisation – and excessive compartmentalisation. In this story, there are four, distinct main elements: the domestic political issues; the technical banking and economic issues; the EU dimension and the US/international element.
The problem for the media is that the political hacks write about national politics and the financial journalists deal with financial issues. The EU dimension is regarded as entirely separate (unless there is a direct domestic input) and the US/international element is handled by the foreign desk. There is very little cross-over so no one sees the whole picture.
Secondly, for a variety of reasons – some good, some bad – the hacks are not up to the job. The political hacks, in particular, are attuned to reporting on the tittle-tattle of the Westminster village. When they come up against a hard-edged issue like this, with a strong technical element, they are simply out of their depth.
As regards the financial journalists, they don't understand the politics and many of them don't understand the technicalities either. Some make the understandable but dangerous mistake of confusing banking with economics. Economics – so some claim – is a science. Banking is not. It is more of a black art, and the two should never be confused.
When it comes to the EU dimension, neither the political nor the financial hacks even begin to understand it (with maybe one exception). Because they don't understand it, they ignore it. Their whole self-esteem is based on their being able to project their own cleverness and, so profound is their ignorance, they cannot admit it, even to themselves.
On the other hand, the very few hacks that cover the EU – and there are very few – are kept out of the loop. They are not invited to the party and are confined to writing bit pieces which, if they have any domestic element, are "Londonised" by the editorial staff and thus butchered out of all recognition.
As for the reporters on the US scene, they are not making the links between the US and the EU, which operate common, harmonised regulatory systems.
Thirdly, there is a very active disinformation programme going on. All sorts of people – David Cameron being one – really do not want you to know anything about the EU dimension, other than what they chose to let out. The Commission and the rest of the "colleagues" certainly do not want you to know the detail. And the general run of europhiliacs would be horrified if the exact role of the EU was known.
That we have pieced together some of the story, therefore, is not to claim any special skill, understanding or knowledge. It is more a matter of perspective – not being bound by the traditional boundaries. Add to that, the application of an enormous amount of time spent researching the internet and talking to a great number of people, some at very high level in the system, and the bits come together.
So far, we have tested the "bones" of the story on a number of experts. None we have spoken to disagree with our basic premise. Some say it is more complicated than we portray. We know that. Some say there are other factors involved which also have considerable influence on the current crisis. We accept that.
But the essence of our thesis is that the "hidden hand" of the EU is making a bad situation much, much worse and, more particularly, hindering attempts to remedy matters. The contrast is easily seen with what is happening in the US, and that contrast will become more apparent as time passes.
One expert we talked to said that, because of the recent action in America, he expected the US economy only to dip into a mild recession and then start to recover within 18 months. The EU, however – because of the inherent inflexibilities in the regulatory system and the tortuous decision process – he expected to tip into a much deeper and more damaging recession, which would last much longer.
If he is right – and we suspect he may be – that will be yet another legacy of Edward Heath who took us into the benighted organisation that is now the EU, in which we have been kept by a succession of politicians who have not the sense to see that, in the final analysis, it will bring us all down.
Prudent Bear and Jim Puplava
Weve been telling you THEN, and NOW, and for the FUTURE
I'll be talking about this weeks developements over the week-end
======
The smoking gun
By general accord, much of the current financial crisis arises from "regulatory failure", something to which numerous references have been made, not least by the shadow chancellor over the weekend, when he complained that "Gordon Brown's regulatory mechanism has comprehensively failed".Osborne has though been reticent about identifying the specific failure and it took his boss David Cameronyesterday to hint at the specifics. There is a need, he said, "to break the self-fulfilling cycle that is reducing banks' ability to lend." The problem is this, he added:
When the value of financial assets falls, a new international accounting regulation called "marking to market" automatically downgrades the value of banks. They are less able to raise the money to carry on their business. That in turn causes further falls in the value of financial assets. And this is making the financial crisis worse than in previous downturns.Cameron himself, however, blurs over the precise cause of this problem and it took The Guardian to add more detail. The paper tells us:
A European Union directive passed in 2001 and adopted as a new accounting standard in the UK in 2006 dictates that banks have to value their assets on a daily basis. To do this they must base their calculations on the market value of each asset if it were liquidated that day. The problem with this is that as share values tumble in response to the credit crisis, millions of pounds are wiped off bank balance sheets causing a spiral of decline in asset values.Actually, The Guardian has got it wrong. The "European Union Directive" in question is Directive 2006/49/EC of 14 June 2006 "on the capital adequacy of investment firms and credit institutions". Its short title is the Capital Adequacy Directive. This must be read in conjunction with Directive 2006/48/EC, the pair of Directives together implmenting the agreement.
That it is an EU directive, though, does not tell the whole story for it is this directive which implements crucial parts of the now notorious Basel II agreement. It is that agreement that which is the heart of the current problems which the banks are experiencing.
That Basel II is the problem – the "smoking gun", so to speak - has been widely promulgated for some time by acknowledged experts, most notablylast December by Prof. Peter Spencer, of the Ernst & Young Item Club, regarded as "one of Britain's leading economists". It was then that a report of his views said:
…conflicts caused by the Basel system of banking regulations, which determine how much capital banks must raise to keep their books in order, are the root cause of the crunch and were serving to worsen the City's plight.This theme was picked up by Ambrose Evans-Pritchard a few days later, who cited Spencer saying that, "the global authorities have just weeks to get this right, or trigger disaster."
The regulations meant that banks forced to take off-balance sheet assets from troubled structured investment vehicles on to their books had little choice but either to raise money from abroad or cut back dramatically on their spending, he said.
He warned that, if London's money markets remained frozen and the authorities retain the strict Basel regulations, the full scale of the eventual credit crunch and economic slump could be "disastrous".
Dismissing the assumption that banks are not lending to each other on the money markets because they lack confidence in each others' potential solvency, he argued that they were, in practice, prevented from lending the cash at all because it could leave their balance sheets falling foul of the Basel regulations.
"If these funding routes are not reopened it will have massive consequences for the economy as a whole," he said. "It will make 1929 look like a walk in the park."
He dismissed as "window dressing" the move announced by central banks around the world this week to pump extra money into the money markets and increase the type of collateral they will accept in return, in an effort to get them running again.
"This won't get to the core of the problem: the fundamental lack of collateral. As these problems drag on, the consequences for the macro-economy of not relaxing [the Basel regulations] are unthinkable."
Not only do the regulations, which stipulate that banks must have a minimum of 8pc capital among their liabilities, deter banks from lending to each other, they will also limit the amount they can lend to households and businesses. This could escalate the anticipated economic downturn next year significantly, he said.
The Spencer analysis was then essentially repeated at the end of January by another acknowledged expert, Prof. Tim Congdon.
In the context of the Northern Rock affair, Congdon asserted that, "the Basel rules have failed", then arguing that "the scientific precision of the Basel rules was shown to be hocus-pocus." Banks, he wrote:
…did not know the true state of each other's capital and, hence, their ability to repay loans. Inter-bank markets seized up. If one bank - such as Northern Rock - ran out of cash, it had only one place to go, its central bank. But the assumption that the central bank would, quickly and reliably, extend a lender-of-last-resort loan to a solvent, but illiquid bank - an assumption written into banking textbooks for decades - was invalidated by the Bank of England's reluctance to lend in crisis circumstances last August.So it was yesterday that Cameron stood up in front of the Conservative Party conference and declared that "…our regulatory authorities, together with the European regulators, need to address this difficult issue."
He did not name the Basel II agreement and, crucially, neither did he identify the more immediate cause of the problem, the EU Capital Adequacy Directive. Had he done so, of course, there would have been uproar, and the EU would have been catapulted to the top of the political agenda, which is the last thing Cameron would have wanted.
And it is the Directive which is now the problem. The reason for this is that, although the original Basel II agreement was produced in June 2004 with the assent of the British authorities – which had pushed hard to their adoption – the sponsoring organisation, the Basel Committee on Banking Supervisiondoes not produce legislation.
Instead, it "formulates broad supervisory standards and guidelines" and recommends statements of best practice in banking supervision "in the expectation that member authorities and other nations' authorities will take steps to implement them through their own national systems, whether in statutory form or otherwise."
Had the UK been an independent country in 2004 and subsequently, the government would have implemented the Basel II agreement into UK legislation, either through an Act of Parliament or through Regulations (SIs) – or a combination of both.
The trouble was that, not only was the UK a member of the European Union, financial services regulation was (and is) a "competence" of the EU and the UK had thereby ceded authority to legislate in this area. Thus, instead of being adopted into British law directly, it was adopted via an EU Directive.
That, at the time, did not present the government with a problem as it has been an enthusiastic supporter of the agreement. But, now that the flaws in the agreement have been exposed, or shown to be "hocus-pocus" as Congdon maintains, the provisions cannot be changed unilaterally by the British government. They are now part of EU law so, in order to achieve change, all we can do, as Cameron euphemistically put it, is have "…our regulatory authorities, together with the European regulators," address "this difficult issue."
And that equivocation is also part of the problem. One might ask why, if Cameron is now so (rightly) certain as to where the problem lies, his shadow chancellor has not raised it before.
To be fair to him, he has. He raised it on 21 April 2008 in the House of Commons in response to a statement by Alistair Darling on "financial stability". But it was only one sentence where he told Darling that the moves he had announced "should include reforms to the Basel accords."
Then, in a Newsnight interview on 17 September, just a few days ago, he mentioned it again, a reference which met with the approval of Telegraphcolumnist Gerald Warner, who noted:
Osborne did not overreact to the crisis by rushing to propose a host of regulations to monitor the stable door now that the horse has bolted. Instead, he proposed revisiting the Basel II Accord, which is now four years old.Thus, while Osborne has belatedly come to the view shared by Spencer and Congdon, and evidently passed this view to his boss, neither he nor Cameron have mentioned Directive 2006/49/EC, nor even the European Union. Yet it is the Directive which must be changed.
Yesterday, Cameron entitled his speech, "Together we will find a way through". What he did not specify, however, was how he was going to "find a way through" the EU labyrinth to remove a damaging piece of legislation that is at the heart of this crisis.
Thus, while Osborne is accusing Labour of being "in denial" over its role in the financial crisis, the Conservatives too are indulging in their own form of denial.
The elephant has re-acquired its cloak of invisibility.
The picture shows the headquarters of the Bank for International Settlements in Basel, which hosts the Basel Committee on Banking Supervision meetings.
COMMENT THREAD
Sunday, October 05, 2008
The story so far …
In what has been a roller-coaster and exhausting week, we've got to a position where we've got part of the story – not the whole story, which is far more complicated – but enough of it to make sense.
Through this blog, in no less than 20 posts since Saturday week last – listedhere (with links in chronological order) - when we cranked up our coverage of the financial crisis, some of the story gradually emerged.
Now, in a masterpiece of compression, Booker has managed to squeeze the story so far into his column published today, accompanied by an inspired piece of photoshopping from The Sunday Telegraph graphics department (above). I suspect this one will get a lot of use.
It almost goes without saying that we are so far ahead of the game that no one is even close when it comes to reporting on the background to this current phase of the financial crisis.
There is no dispute amongst the players that the driving force behind the stress in the banking system at the moment is an almost unprecedented liquidity crisis, which is having a massive knock-on effect in the economy as a whole. What we have to offer is a partial explanation that stands up to scrutiny, one which an awful lot of people don't want told – and as many don't want to hear or believe.
That you will see nothing of this reported so coherently in the general run of media reporting stems, I think, from three things.
Firstly, the media suffers from the fatal flaw of specialisation – and excessive compartmentalisation. In this story, there are four, distinct main elements: the domestic political issues; the technical banking and economic issues; the EU dimension and the US/international element.
The problem for the media is that the political hacks write about national politics and the financial journalists deal with financial issues. The EU dimension is regarded as entirely separate (unless there is a direct domestic input) and the US/international element is handled by the foreign desk. There is very little cross-over so no one sees the whole picture.
Secondly, for a variety of reasons – some good, some bad – the hacks are not up to the job. The political hacks, in particular, are attuned to reporting on the tittle-tattle of the Westminster village. When they come up against a hard-edged issue like this, with a strong technical element, they are simply out of their depth.
As regards the financial journalists, they don't understand the politics and many of them don't understand the technicalities either. Some make the understandable but dangerous mistake of confusing banking with economics. Economics – so some claim – is a science. Banking is not. It is more of a black art, and the two should never be confused.
When it comes to the EU dimension, neither the political nor the financial hacks even begin to understand it (with maybe one exception). Because they don't understand it, they ignore it. Their whole self-esteem is based on their being able to project their own cleverness and, so profound is their ignorance, they cannot admit it, even to themselves.
On the other hand, the very few hacks that cover the EU – and there are very few – are kept out of the loop. They are not invited to the party and are confined to writing bit pieces which, if they have any domestic element, are "Londonised" by the editorial staff and thus butchered out of all recognition.
As for the reporters on the US scene, they are not making the links between the US and the EU, which operate common, harmonised regulatory systems.
Thirdly, there is a very active disinformation programme going on. All sorts of people – David Cameron being one – really do not want you to know anything about the EU dimension, other than what they chose to let out. The Commission and the rest of the "colleagues" certainly do not want you to know the detail. And the general run of europhiliacs would be horrified if the exact role of the EU was known.
That we have pieced together some of the story, therefore, is not to claim any special skill, understanding or knowledge. It is more a matter of perspective – not being bound by the traditional boundaries. Add to that, the application of an enormous amount of time spent researching the internet and talking to a great number of people, some at very high level in the system, and the bits come together.
So far, we have tested the "bones" of the story on a number of experts. None we have spoken to disagree with our basic premise. Some say it is more complicated than we portray. We know that. Some say there are other factors involved which also have considerable influence on the current crisis. We accept that.
But the essence of our thesis is that the "hidden hand" of the EU is making a bad situation much, much worse and, more particularly, hindering attempts to remedy matters. The contrast is easily seen with what is happening in the US, and that contrast will become more apparent as time passes.
One expert we talked to said that, because of the recent action in America, he expected the US economy only to dip into a mild recession and then start to recover within 18 months. The EU, however – because of the inherent inflexibilities in the regulatory system and the tortuous decision process – he expected to tip into a much deeper and more damaging recession, which would last much longer.
If he is right – and we suspect he may be – that will be yet another legacy of Edward Heath who took us into the benighted organisation that is now the EU, in which we have been kept by a succession of politicians who have not the sense to see that, in the final analysis, it will bring us all down.
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