The Cycle to Financial Disaster

This writer worked 9 years of 20 in derivatives on Wall Street and has a better understanding of this disaster than a majority of the Americans being asked to pay for the greed and disrespect of common sense in financial transactions. If it were easy to unravel this web of related transactions the solution would be simple. But, it isn’t. It has taken years to manufacture this dilemma and it will take years to unravel it.

Let me isolate one transaction and hope to lend some understanding to the complexities of this dire situation. A security certificate of mortgages is created so that two objectives are accomplished. One, give families the opportunity to purchase a home and two sell that mortgage security certificate in the open market to investors utilizing their private capital. Simple so far isn’t it.  A sample transaction is I purchase a GNMA (ginnie mae) security certificate which is insured by the Government National Mortgage Agency known as Ginnie Mae a Government Agency. Each month as people pay their mortgage payments of principal and interest, they are passed on to me the owner of the GNMA security certificate. I purchased this certificate to earn interest income and to have a part of my principal investment returned to me each month. A great investment for retired investors.

 

Most GNMA certificates are securitized in what they call a pool of mortgages, for simplicity a pool of mortgages consist of ten (10) individual mortgages in various amounts that add up to $1,000,000. Each month these ten families make their mortgage payments and the money is than passed on to the investor as I explained earlier. This is as

you can see a very simple transaction in an ideal system. But, and the big but is that because interest rates change on a daily basis the speculator in the process decided that money could be made by betting on interest rate fluctuations. Just buying and selling GNMA securities was boring and not very profitable. No, a derivative needed to be developed to protect investors in GNMA’s. On the Chicago Board of Trade (CBOT) a futures contract GNMA was developed to protect interest rate fluctuations from affecting the profitability of those positions held by investors in GNMA’s. If you owned (were long) $1,000,000 in GNMA certificates you could sell 10 contract of GNMA futures (each contract represents 100,000 face value of GNMA’s). This transaction prevented your investment from Interest Rate fluctuations which affect price values of GNMA securities. Therefore, theoretically if interest rates went up prices would go down, the price of GNMA futures would also go down. So if you sold GNMA futures at 95.00 and rates went up 1% the new price on GNMA futures would go down to 94.00 , your gain would be $1000.00 per contract or $10,000. If you were to liquidate your positions at that point you would loose $10,000 on your GNMA Security position and gain $10,000 on your futures position therefore break even on principal but earn interest income.

 

Income from interest and break even was not acceptable to the speculative investor (arbitrager) investment bankers, insurance companies and yes Banks. Because of the repeal of Glass Stegal in 1999 by Grahm, Leach, Bliley, (The Financial Services Modernization Act) http://banking.senate.gov/prel99/1104grm.htm

the fire walls which prevented insurance companies and banks from participating in non regulated derivatives brought on the speculative atmosphere that has brought us to the financial credit meltdown, and possibly the 21st centuries depression.  

When non performing mortgage backed securities (people not paying their mortgages) securitized by Fannie Mae and Freddie Mack and sold to investors began to loose value, these institutions decided to package bad securities into securitized derivatives and resold them to other investors  and than insured them because the same companies insuring these derivatives previously owned the bad assets backing them.  Wall Street packaged this product which was an exchange of cash flows of principal and interest, backed by a multitude of bad securities of defaulting cash flows.  The strategy that was devised by these Wall Street wizards was an attempt to earn enormous fees on these overvalued derivatives, which provided profits which determined bonuses for CEO’s to Traders.  When the cash flows ended and the insurance policies were cashed in the drain on capital began. Now, they are out of cash and are looking to Washington and the American Taxpayer to re capitalize their operation and pay for their losses after they have taken out compensation rewards and profits all at the expense of the taxpayer. Either we have a congress of incompetents or they are all in the pocket of special interests if they approve such a national theft.

 

The question has been asked by many, why are we being lead by Mr. Paulson, Goldman Sachs, $38 million dollar plant in Washington and our Congress being lead down a path of destruction. The rhetoric being dished out to the American people by those who continue to deceive us say that we the American Public are the ones who are being protected with this bill is ludicrous. The bill isn’t specific enough and only gives Mr. Paulson a blank check to buy derivatives which aren’t assets of any value but a complete  loss to taxpayer’s.

 

Now, most people will respond, you talk a good tune but what is the solution? The solution is to determine the real value of these losses and bad assets excluding derivatives. Let those who created these deregulated derivatives settle their contracts themselves. Use the taxpayer dollars to refinance main streets mortgages to build a foundation of concrete rather than one on sand. This will again generate capital from the bottom up where it originally is generated from.

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