Those Nasty Lumps Under the Carpet
Those nasty lumps under the Carpet is about a problem that was hidden from sight many years ago to be dealt with later. Hopefully, much later. The “powers to be,” at the time, hoped that no one noticed. But, the lumps won’t go away. In fact, they are growing nastier and more dangerous all the time. They will have to be reckoned with soon.
Those Nasty Lumps Under the Carpet
It was 2008 when things came apart on the financial front in America. The Dow Jones Industrial Average (DJIA) had reached a new all-time high in September the year before. Investors were waiting for the correction to end, and the stock market boom to resume. But, there was that nagging problem with sub-prime mortgage loans. Foreclosures were running at a high rate, and banks were struggling to process all of them. Still, things weren’t too bad. The “powers that be” were sending the message through all available channels that “All is well.” The economy had worked through situations like this many times before, after all. But, what if things really were different this time?
It turns out that something really was different.
Years before, the financial community developed a new investment vehicle that they called derivatives, and their related synthetic collateralized debt obligations and credit default swaps. These were contracts that bundled together many other investment vehicles. They were then sold to investors as risk-reduced investments. Some derivatives bundled together currency futures, commercial loans, or home mortgages, and some bundled sub-prime mortgage loans. Investment bankers loved derivatives, because they were generally sold on margin, which boosted the projected yield. Not emphasized, was the fact that margin greatly increases the overall risk. Derivatives were so popular that in 2008 there were nearly $700 trillion of them worldwide according to The Debt Clock and the Bank for International Settlements (BIS.) That’s right, 700 Trillion, with a capital T. For reference, in 2000, there were just $90 trillion in derivatives outstanding.
In 2007, Lehman Brothers, founded in 1850, reported record profit of $4.2 billion on revenue of $19.3 billion. They had a market capitalization of nearly $60 billion, and held $85 billion in mortgage-backed derivatives. In the second quarter of 2008, Lehman reported their first loss of this era. They laid off employees, trimmed their portfolio, and raised money through the second and third quarters. A third quarter loss followed. In September, a deal with state-owned Korea Development Bank was put on hold as the stock price plunged.
The Treasury Secretary, the head of the Federal Reserve, CEO’s of major banks, and other national and world leaders were concerned, to say the least. Liquidity was evaporating, bank reserves were fleeing, and major corporations were going bankrupt. The worldwide economy teetered on the brink of disaster.
On September 15, 2008, Lehman Brothers cried “uncle,” and began the bankruptcy process. At the time, assets were listed as $639 billion, and liabilities were listed as $619 billion. It would seem that there was still some investor equity. The business might be salvageable. So, why the panic?
Why indeed. Well, it turns out that, like so many other cases, not all the facts were revealed. Like the fact that those mortgage-backed derivatives, some backed by sub-prime mortgages, that Lehman Brothers held were going bad at the same rate as mortgages across America. But, derivatives are not like normal investment vehicles. They are souped-up, highly leveraged, and had accounted for a lot of the juice in the real estate boom that had just occurred. And, derivatives containing sub-prime mortgages were really juiced.
Sub-prime real estate loans helped fuel the boom. These were loans where buyers, who could not otherwise qualify for a loan, were able to join the ranks of home owners. The FHA, Fanny Mae, and Freddy Mac all contributed to this situation by offering very low interest rates, low or no down payments, and by guaranteeing loans made by other mortgage lenders. Many buyers became homeowners with marginal capability to repay the loan. And when the boom ended, many lost their jobs, and could no longer make the mortgage payments.
When faced with bankruptcy, the executives at Lehman decided to put the company assets up for auction, and the response must have gone something like this:
“Not so fasts,” said the powers that be. “If we allow you to sell those derivatives at auction, all will know what they are really worth, and then, everyone will have to mark their derivatives to market. This would cause bankruptcy for a lot of other firms, and bring down the world economy. We can’t have that!”
Instead, the country’s leaders, along with bank executives, divided Lehman Brothers assets, and parceled them out to major banks and financial corporations. That way, the issues with derivatives were swept from sight, under the carpet so to speak, and everyone could continue to mark their derivatives at face value. Disaster was avoided for the worldwide economy.
But, oh those nasty lumps.
In order to prevent them from becoming painfully obvious to everyone, the FED gave billions of taxpayer dollars to banks and corporations; $700 billion in the first installment that they called TARP, otherwise known as “bailout” funds. They said it was so the banks could start lending money and restart the economy. But, the banks held on to the money. Billions of dollars of it. Why?
Was it to cover the then current and future losses in those derivatives? Is that why the US Federal Reserve bought all those bonds, and now has an asset balance of over $4 trillion? Collapsing debt is highly deflationary. Is this why inflation is so low, and the economy refuses to grow?
Derivatives, like the loans that back them, have a due date. So, what happens when the due date arrives and more underlying loans are non-performing than there is money to cover the margin?
This is a house of cards, and the wind is starting to blow.
More next time on the current situation and how it might unfold.