"Rating agency models do not capture these huge risks, yet the rating agencies never seem to refuse to rate these deals."

  Ultimately, investment banks such as Merrill Lynch, Citigroup, Calyon, Lehman, Bear Stearns, Credit Suisse were stuck with billions in unsold CDOs. Not to worry! They bought "bond insurance," obtained credit protection from hedge funds, and engaged in a variety of leveraged sales. However, ultimately, as failures multiplied, the entire market shut down for legitimate as well as risky investment vehicles. It was just too difficult to distinguish the one from the other. Not to worry! The investment banks could still get their buddies at the Federal Reserve to take their overrated AAA paper.
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  Tavakoli tells us that Buffett doesn't invest in anything he doesn't understand. He does not try to juice up yields with leverage.

  "If you are not leveraged, and your businesses generate enough cash to meet your expenses, you do not have to worry about what anyone else thinks of your financial situation. You never have to sell assets into a distressed market to raise money, and if the stock market closes for years, you do not need to worry, since your assets keep growing and generating value."

  Berkshire Hathaway bent during the Credit Crunch. Indeed, it bent pretty severely. However, it did not break. It is in a position to recover as the economy recovers.
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  FUTURECASTS is always highly optimistic about long term economic prospects for the U.S. and considers fears about a return of the Great Depression evidence of economic ignorance. However, those who ignore the business cycle are equally ignorant. For more than  a decade FUTURECASTS has been repeatedly warning: "Prudence always dictates that we be prepared for a recession as bad as that of 1980-1982."
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  Any management that does not operate on that basis has failed its prudence and due diligence tests. Their entities deserve to fail. They - and those foolish enough to invest with them or extend them credit - should not be bailed out. The right to fail is as important for capitalist markets as the right to succeed.

   Both Buffett and Tavakoli were aware that "the market was overleveraged, rating agencies misrated debt, and investment banking models were incorrect." They - and several other professionals - knew that credit derivatives contributed to the excess leverage. Buffett's periodic shareholder letters - available on his web site - "told investors everything they had to know about overpriced securitizations." This was no mere child shouting that the securitization king was naked. Nevertheless, the "authoritative" people - in Wall Street, Washington and the economics profession - went right on admiring the economy's sartorial splendor.

  "[The] CDO managers are unregulated, and only a handful of managers provide good value for the fees charged. Most do not have the expertise or resources to perform CDO management or surveillance. Many cannot build a CDO model. Many managers rely on the bank arranger both for structuring expertise and to take a lead role with the rating agencies to secure the initial ratings. Rating agencies rarely ask for background checks on CDO managers.

  The Fed bailed out the reckless bond insurance companies like AIG so that the insurers could make payments to investment banks on their reckless insurance contracts. It wasn't AIG - the insurer - that the Fed was protecting. Ultimately, the money provided to AIG simply flowed through to the large investment banks that should have been smart enough to know their insurer was covering more of a single type of high risk security than it could handle if that risk ever eventuated. Not to worry! It's only taxpayer money, and meanwhile everybody banked those large salaries and bonuses. The losses, much of which are being picked up by the taxpayers, have exceeded $1 trillion.

  Moral hazard and conflicts of interest permeate these deals.

  "Conflicts of interest do not mean that there is anyone doing anything wrong, but when the moral hazard is enormous, things never seem to end well for investors. Rating agency models do not capture these huge risks, yet the rating agencies never seem to refuse to rate these deals. I have written books and articles on this problem for years; the ratings on deals with this kind of risk are totally meaningless. Yet the rating agencies continue to defend their indefensible methods."

 Ratings:

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"They take data at face value, slap a rating on a dodgy securitization, and pocket a fat fee."

Equity capital is flexible enough to bend without breaking, debt capital is inflexible and shatters like glass.

  They are thus dependent on the information disclosed to them and on their statistical models. It is the deal sponsors and investment bank underwriters that are responsible for due diligence - but the rating agencies did not even demand evidence that this due diligence was properly performed.  

  "In the mortgage loan securitization market, a statistical sampling of the underlying mortgage loans should verify: integrity of the documentation, the identity of the borrowers, the appraisal of the property, the borrower's ability to repay the loan, and so on."

  All this is essential to understand the character of the risk being modeled. Obviously, new financial instruments with new risk characteristics can't be modeled on the basis of old data on existing instruments. Lacking data on the new instruments or the track record of the instrument managers, the ratings become meaningless guesswork
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  In the three decades before 2007, fewer than 0.1% of the 26,000 structured securities originally rated AAA by S&P subsequently defaulted. However, the game was radically changing in recent years, and the rating agencies failed to change with it. The carnage among deals underwritten in 2005 and thereafter is "unprecedented."

  "The rating agencies protest they are misunderstood rather than miscalculating when it comes to rating structured products. They claim the market misapplies ratings by expecting ratings to indicate market price and liquidity, but the former are merely symptoms of the real problem. They take data at face value, slap a rating on a dodgy securitization, and pocket a fat fee."

  There is an obvious difference between corporate securities and securitized debt obligations. If corporate earnings fall and corporate stock prices decline, a good corporation can always bounce back. However, if earnings for a CDO fall, it means it has suffered some defaults, and those will never recover. Equity capital is flexible enough to bend without breaking, debt capital is inflexible and shatters like glass.
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  When debt obligations are securitized, they are often leveraged 20-to-1 or 30-to-1 or even 40-to-1 and thus exist on a narrow precipice. The credit crunch quickly wiped them out in large numbers - and sometimes wiped out their creditors, too. When a hedge fund collapses, the investment banks that lent it money quickly take back the collateral - which often consists of a vast array of the hedge fund's toxic illiquid assets.
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  The regulators at the SEC, the Fed and the Bank for International Settlements, and a host of private contracts, remain dependent on these ratings for their regulatory purposes. This provides the ratings agencies with a lucrative oligopoly franchise and protection from attack.
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  Even before the Credit Crunch, highly rated "investment grade" securities periodically suffered collapse. Investors must do their own due diligence or hire advisers who can do it for them or confine their investment to underwriters that can be trusted. Recently, many advisers and underwriters failed to live up to their obligations. The author mentions failures of investment grade securitizations backed by credit card receivables, manufactured housing loans, metals receivables, furniture receivables, subprime mortgages, movie receipts, among others. This failure of due diligence should be the basis for SEC investigations of the investment banks. So far, there have been some high level resignations and job loss, but enforcement efforts are just in early stages.

  There is no need to worry about unemployment problems here. These people have valuable experience at gaming the system and have no trouble finding new high level positions with other Wall Street firms.

 Bear Stearns:

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When the collateral of one of the Bear Stearns hedge funds was seized and put up for sale, the low prices on offer were staggering. Disclosure would have demonstrated huge losses for the lenders, but there was determined effort to ignore them.

  The loose investing practices at Bear Stearns and its numerous hedge funds are explained at some length by Tavakoli.
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  By the middle of 2007, Bear Stearns' creditors - Citigroup, Inc., J.P. Morgan Chase & Co., Merrill Lynch & Co., Morgan Stanley, Goldman Sachs Group, Inc. Barclays PLC, Dresdner Kleinwort, Deutsche Bank, among others - were calling for additional margin as the value of collateral plummeted. When the collateral of one of the Bear Stearns hedge funds was seized and put up for sale, the low prices on offer were staggering. Disclosure would have demonstrated huge losses for the lenders, but there was determined effort to ignore them. Bear Stearns "was the first to show everyone's losing cards."
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  The hedge funds collapsed, but top Bear Stearns management had made hundreds of millions of dollars in the years before the collapse. Hedge fund managers, too, had made huge sums, but some were indicted for securities fraud. The little fish found themselves immediately vulnerable.
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Highly leveraged with huge bets on illiquid assets that had no clear market value, investment banks were vulnerable to any loss of confidence in their solvency. The short term financing on which their operations were based could disappear in a flash.

  The Fed was designed to protect banks, Tavakoli points out, not nonbank investment banks and nonbank primary dealers. However, well connected Wall Street interests needed help and the Fed was riding to the rescue. After all, it's just taxpayer money, and the Fed can print up as much as needed.
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  Highly leveraged with huge bets on illiquid assets that had no clear market value, investment banks were vulnerable to any loss of confidence in their solvency. The short term financing on which their operations were based could disappear in a flash. "In fact, the investment bank itself may not know whether or not it is solvent," the author points out. Buffett avoids leverage, she notes, so he is never threatened by occasional panics on Wall Street.

    "By supplying investment banks with liquidity, the Fed introduced huge moral hazard. The Fed rewarded those who brought down the housing market."

  Tavakoli worries that even the Fed can become overextended, undermining faith in the dollar. That can happen, but the world needs the dollar as a reserve currency and that gives the Fed huge - but not unlimited - scope for meeting crises with newly created money. The Fed has in fact more than doubled the basic money supply this last year.
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  As FUTURECASTS has pointed out, the test will come as economic recovery begins and the financial system recovers its ability to multiply the purchasing power of all that new money. Inevitably, as in the 1970s, price inflation will surge before employment levels recover, making it difficult for the Fed to fight on both fronts.
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  The one encouraging note is that, unlike in the 1970s, at least there has been repeated acknowledgement of the existence of this problem from both the Fed and administration officials. Their rhetoric seems to be preparing the public to accept the slow "jobless" recovery that would be the result of the high real interest rates that will be needed to maintain the strength of the dollar on which all else depends. Since the initial surge, expansion of the money supply has practically stopped. The Fed and Treasury continue to guarantee against financial system collapse, but generally seem to be content to let the markets work their vicious way out of the various system bubbles. Considering the extent of these problems, this is occurring with remarkable rapidity.
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  However, the taxpayer is losing massively. The Fed is buying $1.25 trillion in high grade mortgage backed securities and has purchased about $160 billion in government bonds as it frantically monetizes long term debt to constrain interest rates. It is purchasing $200 billion in Fannie Mae and Freddie Mac debt. The loss to the Fed on this "quantitative easing" is already about $5 billion. However, the Fed, too, does not mark to market. It will probably hold on to these securities for the many years until they mature to avoid having to admit its losses. Fortunately, major business media like the Wall Street Journal are all over this story, so FUTURECASTS need not spend much time on it.
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  However, nobody is focusing on Obama's role, here. It remains to be seen whether Obama will provide the needed leadership. He will have to spend political capital supporting policies that will initially result in a slow growth recovery with considerable residual unemployment. Spending restraint from Congress would surely help, but that is too much to hope for. Nor does Bernanke's record provide reason for confidence. He has always exhibited a cavalier attitude towards the purchasing power of the dollar.

  Ultimately, J.P. Morgan Chase was induced to buy Bear Stearns and its toxic assets for $2.2 billion - or $10 per share - and a $30 billion Fed facility for some of Bear Stearns' riskiest assets. J.P. Morgan Chase was also at risk for $1 billion of Bear Stearns losses. The author discounts the Fed's apocalyptic explanations for brokering the bailout and argues that a bankruptcy would have been better, like that involving Drexel Burnham Lambert twenty years earlier. (There is no comparison between the risks of financial contagion then and now.)
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 Nationalizing the losses:

Institutions need only put up some small portion of  their illiquid assets for sale to see what they will bring, so there is no excuse for this retreat from mark to market standards. 

  Lehman Brothers began a feverish deleveraging campaign in 2008, selling $130 billion in assets and raising $12 billion in new capital - but even that reduced its leverage only from 31.7 times to 25 times. It wasn't enough.
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  When no more lenders or buyers could be attracted - and even the Fed declined to offer a bailout - it went bankrupt in September, 2008. Its assets, including those of its clients and creditors - were frozen pending the difficult and painful liquidation process. Just before the bankruptcy, Merrill Lynch concluded a hurried deal by which it sold itself to Bank of America for $29 per share in an all stock deal. The Bank of America stock soon plummeted to single digits under the weight of the Merrill losses. (This troubled transaction was completed under Fed influence, and the results unfolded after this book went to press.)

  "By October 2008, JPMorgan acquired Bear Stearns and Washington Mutual; BofA acquired Merrill; and Wells Fargo acquired Wachovia. Morgan Stanley and Goldman Sachs became bank holding companies. The Treasury invested tens of billions of dollars in each. AIG got a bailout. Lehman was bankrupt. The situation is fluid. Meanwhile, Berkshire Hathaway has limited debt - leverage - and a lot of cash."

 Bond insurers:

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  However, some of the bond insurers simply couldn't resist the fees on offer for insuring subprime home equity loans. Unfortunately, they have nowhere near the funds needed to pay off on their insurance obligations in the face of the wholesale carnage of the Credit Crunch. They, too, had an overconfident outlook on home mortgage obligations and remained determinedly blind to the blossoming housing and mortgage bubbles. The protection offered by this "insurance" was thus fictitious - unless the taxpayers could be stuck with the losses. Why not?
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  Insured municipal bonds were sold through periodic auctions. These bonds were thus called "auction rate securities." The auctions magically transformed these long term obligations into short term obligations which, with bond insurance guarantees in hand, could be floated with a considerably lower interest rate than similar long term bonds.
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  In February 2008, banks and investment banks stopped bidding for auction rate bonds and the $330 billion municipal bond auction-rate securities market froze. Municipalities were faced with having to refinance into fixed rate debt with significantly higher rates. It was a major financial mess.

  "Even pension funds invested in these 'AAA money market' securities. These assets are 'guaranteed,' but many bond insurers are in trouble, so their 'guarantee' is not worth anything. In some cases the underlying assets seem sound - so the 'guarantee' does not matter -, but in other cases there is a genuine risk of principal loss and the guarantee people depended on is worthless because 'sophisticated' bond insurers guaranteed bad products manufactured by investment banks. (emphasis in original)

  Many banks and investment banks have paid fines to settle enforcement actions and have agreed to buy back the auction rate securities at full price. There are obvious conflicts of interest with retail customers that have led to civil suits.
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If the insurance was no good, major banks and investment banks would have to take huge losses on their insured toxic assets.

If the bond insurers failed or lost their triple A ratings, a flood of risk would pour back into investment bank balance sheets.

  The alarm was being sounded by many securities industry professionals in 2007, but Standard and Poor's persisted in rating the largest bond insurers triple A throughout the year. If the insurance was no good, major banks and investment banks would have to take huge losses on their insured toxic assets. Pressure was put on the investment banks to come up with money to help the insurers. After all, the investment banks had the due diligence obligations for these transactions and had clearly failed to fulfill those obligations with respect to the insured toxic assets. If the bond insurers failed or lost their triple A ratings, a flood of risk would pour back into investment bank balance sheets.
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   By the middle of 2008, this fiction could no longer be sustained. The major bond insurers were losing their essential triple A ratings, several crashing all the way below triple B to junk. There are lawyers who will have full and lucrative careers litigating this mess. Moody's announced that it was revising its ratings methods for municipal bonds.
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  Among other things, the ratings agencies had been looking at revenue streams from insurance premiums rather than evaluating whether those premiums would exceed the default losses plus expenses. Since premiums come in first, sometimes years before the losses from defaults, it's easy to generate increased premium revenues and reserves by underwriting risk at too low a price. This in essence is what the bond insurers had been doing when insuring bonds and structured finance instruments against default. This permitted the insurers to chalk up big profits justifying high salaries and big bonuses - until the business cycle made the risks real and collapsed the houses of cards.
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  Berkshire Hathaway is in the insurance business, Tavakoli reminds us. However, it confines itself to "premium business at premium prices." Buffett only insures risks that he understands. He never simply chases revenue streams.
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  When the municipal bond market auction failed in the second week of February, 2008, Buffett stepped in to provide backup insurance against the possibility that the original insurers would not be able to pay. The premiums that Buffett charged for this backup insurance were about twice those received by the primary insurers.
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 Government policy failures:

"Cheap money fueled bad lending, including predatory lending, and cheap money expanded the housing bubble."

The Fed is now discounting long term and illiquid assets that it will never be able to liquidate except at a steep loss.

The Fed is now a backstop not just for the banks but for the entire financial system - and it has no regulatory authority except for the banks and collects no fees for this service.

Unlike deposit insurance, there is no fund maintained to cover losses. It is the taxpayers that bear all the expenses for these government guarantees, while those who indulge in reckless activities reap the rewards while they are successful. 

  The Credit Crunch recession is primarily the result of poor (indeed stupid) government policies rather than market failure. Among many other things:

• Washington is failing at maintaining the purchasing power of the dollar - one of its primary responsibilities..

  "For most of this century, Washington has pumped money into the economy by keeping interest rates low. Easy money tempts crooks. Speculators and fraudsters had a party. Regulators became enablers. Cheap money fueled bad lending, including predatory lending, and cheap money expanded the housing bubble. - - - Bailouts of poorly regulated investment banks and corrupt mortgage lenders mean Washington is printing more money, which weakens the dollar. Inflation adds to the misery. Americans feel poorer."

  The dollar is a strategic weapon of vast importance. Given the standoff in nuclear and conventional forces, the dollar was arguably the determining factor in the Cold War. As long as the dollar is the world's premier hard currency, the United States has the ability to a significant but not unlimited extent to print gold. By its rapid expansion of the money supply, the U.S. government risks loss of the dollar's reserve currency status. This would be a loss of vast proportions.

  "We now shovel $2 billion per day out the door and into the pockets of the rest of the world. It is as if we have a large lot of land and are selling off the fringes of our gardens so we can buy more consumable goods for the house."

• Fannie Mae and Freddie Mac were at the heart of the mortgage madness bubble, but Congress in its usual ham handed manner is eager to double down on this losing bet. Instead of reestablishing sound lending standards, Congress is eagerly trying to reflate the housing and mortgage bubbles by pumping tens of billions of dollars through Fannie Mae and Freddie Mac. These government sponsored entities were leveraged at 50-to-1 and were supposed to support the mortgage market at no cost to the taxpayers.

  "Fannie Mae and Freddie Mac have been pressured to help other lenders out of the mortgage mess. Fannie Mae and Freddie Mac guarantee approximately 40-45 percent of the $11.5 trillion U.S. residential mortgage market. As of March 31, 2008, Fannie Mae and Freddie Mac had combined debt of $1.6 trillion and credit obligations of $3.7 trillion. This is a total of $5.3 trillion, roughly the same as U.S. government bonds. The U.S. government took over Fannie Mae and Freddie Mac on September 7, 2007, and this is the problem that will probably cost taxpayers the most. The government is in charge of financing most of the U.S. mortgage market, and the mortgage market is still under regulated." (emphasis in original)

  The Federal Housing Administration - FHA - is up to its elbows in the bubble reflation effort. Nearly 1/3 of new mortgages are insured by the FHA. Its new limits are about $700,000. Down payments need only be 3.5%. This is 100% insurance, so only the taxpayers have skin in the game. Mortgage origination fees are 2% to 3%, so originators are shoveling them out the door. Unsurprisingly, defaults are rising, so the FHA is likely to need a bailout in the tens of billions of dollars. Congress, in  its infinite wisdom, is again pressuring banks to lower mortgage lending standards.

• "Washington failed to regulate mortgage lenders, and regulators failed to regulate themselves."

• The Fed is now discounting long term and illiquid assets that it will never be able to liquidate except at a steep loss.  The Fed's bailouts are costing billions and are increasing moral hazard. Traditionally, the Fed provides "liquidity" during a crisis by discounting short term high grade but temporarily illiquid assets that it can liquidate at a profit after the crisis is over. However, with long term debt obligations, there are real risks of substantial price declines as interest rates rise. Not to worry! It's only taxpayer money.

• Imprudent practices will again blossom as the economy returns to prosperity.

  The Fed responds to moral hazard complaints by pointing out that the shareholders of the financial institutions it has bailed out have lost big, and that top management are typically major shareholders. However, the chief beneficiaries of the bailouts are the creditors that recklessly chased yield up the risk curve and enabled the investment banks and hedge funds to operate recklessly at 30-to-1 or 40-to-1 leverage levels. These same leverage levels enabled management to bank big salaries and bonuses. Thus: 

  "As long as Wall Street enhances revenues with leverage to prop up kingly bonuses, as long as there are few personal consequences for CEOs - and board members and other top executives - for shoddy risk management, as long as CEOs are allowed to walk away with millions, nothing will change. The fact that shareholders are wiped out is no deterrent, and moral hazard will live on. I see nothing that will change that in the future. In fact, just the opposite. We have handed out hundreds of billions of dollars in taxpayer dollars and have put hundreds of billions more at risk without demanding effective conditions." (The early signs of renewed bubble mania are already observable.)

• The Fed is now a backstop not just for the banks but for the entire financial system - and it has no regulatory authority except for the banks and collects no fees for this service.

  Tavakoli correctly insists that it was vital to let these overextended institutions fail. (The right to fail is as important as the right to succeed for capitalist markets.) Moreover, the bailouts have not as yet come with appropriate regulatory strings and expenses. There is really nothing to prevent similar conduct in the future. Unlike deposit insurance, there is no fund maintained to cover losses. It is the taxpayers that bear all the expenses for these government guarantees, while those who indulge in reckless activities reap the rewards while they are successful.

  Even General Motors ultimately was not "too big to fail." It is vital to establish a procedure for the orderly liquidation or restructuring of major financial institutions. Fannie Mae and Freddie Mac should be liquidated so mortgage interest rates can return to a normal level, but Congress cares not for the taxpayer and keeps shoveling money through these entities.

• Of all the regulators, the SEC had the broadest responsibility and authority for preventing the deceptive securitization practices that are at the core of the mortgage lending crisis.

  "How do we explain the SEC's poor reaction time to the securitization problems at the investment banks it regulates? Could the SEC's conflicts of interest have anything to do with it? Former SEC staffers often seem to land very lucrative jobs working for law firms that represent investment banks, working for law firms seeking expert witnesses to defend investment banks, or working for investment banks needing a new general counsel. Some SEC officials often end up affiliated with a huge private equity fund or start a fund of their own with fundraising help from investment banks. I am sure there are many rationalizations for this." (emphasis in original)

• Tavakoli was previously against regulation of hedge funds and structured investment vehicles. However, now that the Fed is bailing out hedge fund creditors and their troubled assets are flowing back onto the balance sheets of their sponsoring banks, regulation is no longer merely optional. There is currently $5 trillion in such structured assets, not all of which is troubled, but the total of which greatly weakens bank debt-to-equity ratios.

  "We have too many ineffective regulators: the OCC, Fed, OTC, FHFA, SEC, FDIC, and more. Watching the regulatory system is like watching bad doubles tennis players. No one hits the ball thinking the other guy will get it. Investment banks are not suffering from too much regulation. The global capital markets are suffering from too little competent regulation where it counts most. (emphasis in original)

  Without the discipline of the right to fail, we are dependent on government regulation - which inevitably repeatedly disappoints us - and the business cycle - which can only arrive on the scene after considerable damage has been done and can only get increasingly unstable as the government increases its stabilization efforts.

 The Middle East?

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