Well, we would not be confronting the real question – that based on regressions, equations and other theories, we invested billions and trillions of dollars, which belonged to millions of individuals all over the world. When the investments started to go wrong, all these millions of people suffered losses while they were unaware and helpless on the mercy of economics.
We have read about and even encountered several financial crises in our recent history, and even in our lifetimes, but analysis shows that a great financial crisis is yet to come, one that may make the global economy cease to exist as we know it. The first part of this essay gives a scientific analysis of how the ‘real’ financial crisis has begun, and the important facts that would be needed to understand before being able to understand the upcoming global crisis. This crisis would hit India and China as well (combined population of both countries is 2.5 billion), while the second dot-com bubblehas already started.
The future is unpredictable; what we think would happen in the next instant might never ever happen. While the complexities in life, even in the most simplest of decisions, areso vast that we can never determine the true causes and the true outcomes of events.
Still, the causality principle is a universal one – an event will lead to another, and so it goes on, such that we cannot imagine anything’s resultant without knowing its origin; and detailed observation of events can become a key to their control. Thatis why our trying again and again results in success – if I try to make good food, with persistence, experience and skills, I might be able to make good food ten or twenty years from now; the same is the case with a lobby of a few individuals who have been greedy and have tried again and again, till they have reached the point of control that would lead to the world’s next financial crisis.
When I started researching on the financial crisis, I was struck with a deep sense of fear and paranoia. Yes! It is true that the economics today is very much complex, and even a doctor in mathematics, with allhis theory and instruments, cannot tell what the economic calculations are, whattheir cause is and – the most vague of the questions – whatthey will lead to.
The most fundamental flaw of Economics
I came to a point where I started to find countless loopholes in our economic system, so complex that even to understand something little and simple, one would have to find causes and effects ten or maybe a hundred years in the past. Nevertheless, the one loophole that came mocking my intelligence was that in the very principleof economics, we presume the absence of any external influences other than those we add to the equation. I will try to explain this absence in the following examples.
There was a time when economies were simple, rather life was simple. There were less consumer goods, the countries had lesser international trade and multinational companies were inconvenient. Today, the world economy has thousands and thousands of companiestrading within a single country, either large or small but relevant. The technology has led to real-time online trading of stocks, bonds, goods, etc. You could buy billions of dollars’ worth of assets and sell them instantly, not knowing what happened to your money in that instant or even to those assets.
If I am the mayor of a small town in a massive country, I fortunately have a big gold mine operating in my town, which has thousands of shareholders and its stocks are being traded in the open market. One day, a scientist convinces me with rational proof that the gold mine is unethical and is destructive; I lose trust in that mine and start a campaign and destroy that mine. (Note that trust is the most important thing in economic trade, as no one knows the future. People, companies and countries speculate for trusting that in the future, their investments will have a positive response). Soon, the investors nearby hear the news and start to hesitate in investing more in the region, while the news surfaces to the locals and they also start campaigning against other mines.
In a matter of days or months, shares of thousands of rational traders will go down, causing them to lose maybemillions of dollars. When more traders will lose trust in investing in that region and gold, hundreds of other associated companies will have losses. Suddenly,from a profit perspective, when the market will start to go down, more and more people will take their money out, creating a trend. If unregulated, it could lead to a recession in the region and the market, leading to billions of dollars of losses.
Should we blame this on the factthat the markets are too complex to understand and that these recessions come once every 25or 50 years? Well, we would not be confronting the real question – that based on regressions, equations and other theories, we invested billions and trillions of dollars, which belonged to millions of individuals all over the world. When the investments started to go wrong, all these millions of people suffered losses while they were unaware and helpless on the mercy of economics.
Our system is flawed!As the tiniest of events, a small shift in a single company’s stocks in the world market will have a cause and will lead to another event; no rational man in Wall Street can ever access what is truly happening in the market and what the increase and drop in all the figures mean. When the great mind of Einstein was confronted with issues like that of the cosmos, he did not leave his judgment narrowed to some rules and knowledge which he had; rather, he went to measure what he did not know by Quantum Physics.
His theory was that by taking samples of any event countless times, one could predict the right outcome almost every time; still, his measurements were only linked with energy. Of course Quantum Physics cannot be used in economics, but we can use advanced algorithms, which will enable us to monitor and regulate events far too complex for any human to understand, so that humans do not have to waste their assets and lifelong savings in world markets, while a few are benefiting and most are at loss. Our economics instruments and tools are flawed, just as a conservative thought may prove to be a flaw to science and spirituality.We cannot play God, but we can definitely be more rational.
How did it begin?
In the 1980s, the financial industry became massive in terms of size, as investment banks went public, while President Reagan’s administration deregulated the saving and loan companies, allowing them to make riskier investments with their depositor’s money. This led to a 124 billion dollar loss in just 10 years, which was all paid by the public.
Still, deregulation continued, and by the end of the 1990s, the financial sector had been monopolized by a few gigantic firms, as failure of even one of these firms could lead to a financial catastrophe. In 1999, The Gramm-Leach-Bliley Act was passed; it repealed part of the Glass–Steagall Act of 1933, removing barriers in the market among banking companies, securities companies and insurance companies that prohibited any one institution from acting as any combination of an investment bank, a commercial bank, and an insurance company. With the passage of the Gramm–Leach–Bliley Act, commercial banks, investment banks, securities firms and insurance companies were allowed to consolidate. The legislation was signed into a law by President Bill Clinton.
The GLB Act permitted the Wall Street investment banking firms to gamble with their depositors’ money that was held in affiliated commercial banks. During a debate in the House of Representatives, Rep. John Dingell argued that the bill would result in banks becoming “too big to fail.” Dingell further argued that this would necessarily result in a bailout by the Federal Government.
President Barack Obama has stated that the GLB led to deregulation that, among other things, allowed for the creation of giant financial supermarkets that could own investment banks, commercial banks and insurance firms, something banned since the Great Depression.
The first dot–com bubblegrew out of a combination of the presence of speculative or fad-based investing, the abundance of venture capital funding for startups and the failure of dot-coms to turn a profit. Investors poured money into internet startups during the 1990s, in the hope that those companies would one day become profitable, and many investors and venture capitalists abandoned a cautious approach for fear of not being able to cash in on the growing use of the internet. Basically, the investment banks helped fuel the bubble in internet stocks, which was followed by a crash in 2001, which led to a 5 trillion dollar loss.
Stock analysts had based their business on profit motive without any conscience; they were misrepresenting; the stocks they were selling were overpriced with companies that had no future. As long as they were making millions, with no regulatory body watching them, they least cared and grew larger as their frauds grew even bigger. In December 2002, Bear Stearns, Credit Suisse, Deutsche Bank, J. P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS, Goldman Sachs and Citigroup had a settlement of 1.4 billion compared to a 5 trillion dollars loss, promising that they will improve their ways.
Still, these companies and individuals did not stop at anything. In fact, if you look at the list of huge corporate frauds, you will find repetitive offenders. I am a firmbeliever that itis not the people who are to blame but the phony law made by a certain group of individuals that lets them commitsuch crime. Still, I have a strong impulse, considering the amount of damage the firms and organizations are inflicting upon humanity, that out of 7 billion, if these few hundred people controlling the policies are given exemplary punishment,the world would instantly become a better place.
In the new millennium,derivatives came into being, thanks to the infrastructure and technology which led to even bigger, better and fiercely carried out frauds. Credit default swaps, the most used credit derivatives, led to new perspectives as they were insuring liabilities, not assets; meaning they gave insurance for a probable default, whereas normally a bank would give a guarantee only against real assets, all while being unregulated and with no collateral requirements. I have written anarticle on the mockery of CDS, relating it to JP Morgan’s recent settlement with Feds for the frauds they committed; read it here.
Alarmingly signed in 2000,The Commodity Futures Modernization Act (CFMA) was the United States federal legislation that officially ensured the deregulation of financial products known as over-the-counter derivatives. It was signed into a law on December 21, 2000, by President Bill Clinton. It clarified the law so that most over-the-counter (OTC) derivatives transactions between “sophisticated parties” would not be regulated as “futures” under the Commodity Exchange Act of 1936 (CEA), or as “securities” under the federal securities laws. Instead, the major dealers of those products (banks and securities firms) would continue to have their dealings in OTC derivatives supervised by their federal regulators under general “safety and soundness” standards.
According to RaghuramRajan, a former chief economist of the International Monetary Fund (IMF), “… It may well be that the managers of these firms [investment funds]have figured out the correlations between the various instruments they hold and believe they are hedged. Yet, as Chan and others (2005) point out, the lessons of summer 1998 following the default on Russian government debt is that correlations that are zero or negative in normal times can turn overnight to one — a phenomenon they term “phase lock-in”. A hedged position can become unhedged at the worst times, inflicting substantial losses on those who mistakenly believe they are protected.”
According to Wikipedia, there have been several instances of massive losses in derivative markets, such as the following:
- American International Group (AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on credit default swaps (CDSs). The United States Federal Reserve Bank announced the creation of a secured credit facility of up to US$85 billion, to prevent the company’s collapse by enabling AIG to meet its obligations to deliver additional collateral to its credit default swap trading partners.
- The loss of US$7.2 Billion by SociétéGénérale in January 2008 through mis-use of futures contracts.
- The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted.
- The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.
- The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG.
- The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.
- UBS AG, Switzerland’s biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September 2011.
This comes to a staggering $39.5 billion.
Warren Buffett called them ‘financial weapons of mass destruction’. A potential problem with derivatives is that they comprise an increasingly larger notional amount of assets, which may lead to distortions in the underlying capital and equities markets themselves. Investors begin to look at the derivatives markets to make a decision to buy or sell securities, and so what was originally meant to be a market to transfer risk now becomes a leading indicator.
Securitization is yet another ground-breaking way of banks to sell faulty loans to an “Investment Bank” who resells them to investors all over the world. Complex derivatives known as Collateralized Debt Obligations (CDO) are used by the investment banks to combine their debts (home loans, car loans, credit card debt, etc.) and sell them to the investors. Instead of the buyer paying back the loan to a lender over a period of a few decades, now the loan payments go straight to the investors of the world.
Another almost worthless toxic loan, yet the highest interest paying loan, is called subprime loans. Subprime lending means making loans to people who may have difficulty maintaining the repayment schedule, sometimes reflecting setbacks such as unemployment, divorce, medical emergencies, etc. Even though the borrower couldnot afford the subprime loan, still, they were put into these loans just because the interest rate was higher. The value of homes from 1996 to 2006 almost went up by 200%. In that period of time, subprime lending went from $30 billion to $600 billion.
The subprime mortgage crisis arose from ‘bundling’ American subprime and American regular mortgages into MBSs, which were traditionally isolated from, and sold in a separate market from prime loans. These ‘bundles’ of mixed (prime and subprime) mortgages were the basisasset-backed securities so the ‘probable’ rate of return looked superb, since subprime lenders pay higher premiums, and the loans were anyway secured against saleable real-estate. So, theoretically, they ‘could not fail’because of the “originate-to-distribute” model followed by many subprime mortgage originators, there was little monitoring of credit quality and little effort at remediation when these mortgages became troubled.
But it seems that the real heart of the problem is the credit ratings. The new, complex securities of “structured finance” used to finance subprime mortgages could not have been sold without ratings by the “Big Three” rating agencies — Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings. Many institutional investors (pension funds, municipal governments and the like) have a fiduciary duty to invest in only the “safest” triple-A bonds. Downgraded bonds, therefore, get dumped on the market, jeopardizing the banks that are still holding billions of dollars worth of these bonds. The pools of debt the agencies gave their highest ratings to included over three trillion dollars of loans to homebuyers with bad credit and undocumented incomes through 2007. In order to save these bonds and keep them floating in the market, the banks have immorally made settings with different credit rating agencies to give good ratings to faulty bonds.
The latest misrepresentation of ratings case was brought by the liquidators of Bear Stearns High-Grade Structured Credit Strategies (Overseas) Ltd and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage (Overseas) Ltd. In reply, all three rating agencies said in statements that the allegations were “without merit”. A federal judge in California signaled that he would allow the U.S. Justice Department to pursue its $5 billion lawsuit against S&P.
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