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In the article about the
Subprime Mortgage Crisis
the topic of derivatives was introduced
the topic of derivatives along with an explanation of how they played a major, major role
in getting us into the worldwide financial "mortgage crisis."
The
point of that article was that the large Wall Street investment
firms introduced derivatives to purposely cloud the value of the MBS
(Mortage-Backed Securities), CDO (Collateralized Debt
Obligations) and other
structured finance packages that they were creating
and selling to very large investors. Thus the
buyers of these packages had no way of knowing their true value.
Every firm on Wall Street did this purposefully in order to sell packages that
were overpriced. Vastly overpriced. Obscenely overpriced.
The people who worked at these firms collectively made off with
billions and billions of dollars in salaries and bonuses while
they left the buyers of their packages holding the bag. Former
Federal Reserve Chairman
Alan
Greenspan stated that this process of
including derivatives made the financial system stronger because
it "off-loaded" risk. What a blatant lie. Off-loading risk does
not make risk go away, it just transfers the risk to another
group or entity, i.e. from Wall Street to the unsuspecting
buyers of the packages.
And now those same Wall Street firms are scrambling to come up
with some sort of "rescue package" by the government that will
bail them all out. They duped large investors, made off with
billions, and now want the taxpayers to pay for the mess that
they created and profited from immensely. Bailing them out is
called
moral hazard.
Read the article for more details.
Derivatives & Wall Street Greed
There was a not-very-well-publicized
news story at Bloomberg.com
recently, detailing how some school districts in Pennsylvania have
got into financial trouble due to derivative packages sold by Wall
Street investment houses.
Public financing used to be a very low-margin and low-profit branch
of business for Wall Street investment firms in comparison to all the
other branches of business they were engaged in. Public
financing is not very different from the real estate mortgage business
back in the
good old days. (for more information about what Wall Street did
to the mortgage business, please see
The Truth Behind The
Subprime Mortgage Crisis.) In the last 10 to 12 years, however, just as there was a
massive increase in mortgage securitization and MBS products
mixed with derivatives, likewise there has been a large increase
of complex over the counter municipal derivative contracts between
municipalities and investment firms.
The derivatives nightmare is not limited to just mortgages.
How Wall Street Gets Rich
Truly massive fees are not made by merely issuing municipal bonds, but
by adding derivatives into the mix. Let's take a look at one
particular example in details from the
Bloomberg news story.
(This is just one example, but unfortunately, it is not an isolated occurrence.
It is common, but these stories have not made their way into
mainstream
news very much at all.)
Back in 2003, the Erie City School District in Pennsylvania was
in desperate need for cash. One of the schools located in that
district, Roosevelt Middle
School, needed money to buy text books, fix a heating system failure,
repair a leaking roof, and replaced crumbling ceiling tile that was falling on students'
heads. What can a school district do to obtain necessary funds when taxpayers don't have
any more room in their household budgets to pay for additional
taxes? Where can the money be had? Obviously, borrowing the
money.
So, why not turn to one of the most prominent investment banks
on Wall Street, which also happens to be the district's financial
advisory firm. Would this firm be able to obtain financing for the school
district?
Short answer: yes.
However, Wall Street firms only receive relatively small (in
their eyes only) fees and commissions for arranging
straightforward public financing.
Instead, this firm sold the idea that the school board should engage
in a complex derivative swaption contract. This particular
swaption contract, which is a derivative, was created by the
Wall Street firm and was basically
a bet that short term interest rates would stay low and the spread
between the 1 year and 30 year interest rate would widen.
Now,
there are two sides to every transaction, whether it is a real
estate transaction, stock transaction, or derivative
transaction. As a result of entering into this transaction as
the seller, which means that they are bearing the risk, Erie
School District received $785,000 upfront cash, their advisory firm got $60,000,
the bond insurer received $57,000, lawyers and others received
$106,000. This derivative, according to Bloomberg data, was
worth $2 MILLION by selling it at the open derivative market at
that time, so the Wall Street investment firm reaped $1 MILLION
profit without taking any risk!
Full Disclosure or No Disclosure?
However, neither the Wall Street investment firm nor the
financial advisory firm, which is supposed to be working on
Erie's behalf, told the school board how much profit the Wall
Street investment firm was making. Actually it was up to the
investment firm to decide how much of the $2 million it would
give to the school district.
Folks, this is insane. I wish I was making this stuff up.
Sadly, I am not. This has happened time, and time, and time
again.
It was pretty generous of those wonderful Wall Street
philanthropists to give Erie just under 40% of
the proceeds since Erie was taking 100% of the risk, don't you
think? (sarcasm intended)
As you might have guessed, this derivative gamble, and they are
gambles, did not work out in Erie's favor. By June 2006, the
derivative had left Erie with a $2.9 million liability, which
the district couldn't stand the pain any longer and got out of
the deal. In July, 2006, they paid the investment firm $2.9
million to terminate the derivative contract just to get out
from under the financial liability.
This deal was an OTC derivative, meaning it doesn't get
regulated by
Securities
and Exchange Commission, it doesn't go through the public bidding
process, and it is purely a private contract between the two
parties.
Wall Street managed to get the law changed to allow these types
of deals.
Unfortunately, in 2003, after many years of heavy lobbying by
Wall Street investment firms, both the House and Senate in
Pennsylvania passed a law by 197-0 and 45-0 margin allowing
municipal derivatives. Lawmakers unanimously approved the law
based on the claims made by the Wall Street firms that these
products can give the municipalities much needed upfront cash
and "save" them money.
Why in the world do you think these investment firms would spend
hundreds of thousands of dollars hiring lobbyists and
contributing to political campaigns to get this law passed? Was
it for the good of the people out of the kindness of their
heart? Or maybe, just maybe, that 50% fee for
selling something worth $2 million might have had a small role
in it?
Here's an Analogy
For a comparative example, let's say you had a car that you
wanted to sell in order to raise some much needed cash. I offer to sell it on Ebay
for you. It sells for $10,000. I'll keep $5,000 for selling it
for you. Ebay fees, transfer taxes, professional photographs,
etc. add up to $1,075, so you'll be left with $3,925. That's
your share of the proceeds.
Oh yeah,
don't forget that the car comes with a warranty. If anything bad
happens mechanically to the car after it is sold, you'll be the
one responsible to pay for fixing it. Is it safe to assume that
you probably wouldn't be interested in knowing how much I made
from the transaction?
That's a good deal, right?
Yeah, for me!
This is not even the most outrageous deal. Another happened at
Bethlehem's school district. In 2005, the school board had
entered into a derivative deal with this same investment firm and
another prominent Wall Street investment firm jointly, again
without competitive bidding. This time, the district took in
$900,000, the advisory firm made a $630,000 fee, the two Wall
Street investment firms each made $840,000 and $900,000
respectively. Each Wall Street firm made nearly as much from the
deal as the school district received. And the advisory firm
hired to consult on the district's behalf, received far more
than half of what the district received.
Did I say that you received $3,925 for that $10,000 car I sold for you?
My mistake, I think your share was only about $2,300. So sorry.
Warren Buffet called derivatives "Weapons of financial mass
destruction." Folks, I'm not making this stuff up. It's real,
it's happened, and the world financial system really is
crumbling as a result. Looking behind the scenes at the
condition of the world's financial system, it is quite easy to
see an economic depression unfolding.
During the past 4 years in Pennsylvania alone, Wall Street
investment firms have pitched at least 500 deals like this
totaling $12 billion, and most of them have been made without
public bidding, by just taking the advice from their financial
advisory firms. (Isn't it blatantly obvious that Wall Street
firms, financial advisory firms, and rating agencies are all in
the same boat together? It's a case of
I'll-scratch-your-back-you-scratch-mine.) And since these deals are over the counter, and
thus private, we don't know how many and how bad the true
situation with municipal derivatives really is. But as
information leaks out, the evidence is suggests things are very, very bad
indeed.
How will the derivative crisis effect the economy?
What to
Expect
The response so far has been for central banks around the world
to try to paper over the problem. Expect more of the same. More
and more money will be created to try to fix the problem.
Creation of money is the root of inflation. Rising prices are
merely a symptom. Inflation is really the watering down of the
value of money by creating more and more of it. By diluting the
value of money, it takes more and more of it to buy the same
item. This looks like rising prices, but rather it is not that
prices are rising, but the value of the currency is
falling.
This will trend continue and even accelerate. Expect and plan for
prices of the things you buy to rise. Yes, the path currently
being chosen is to "fix" the problem with an inflationary
depression. Of course, the exception
is the prices of homes. Because the secondary mortgage market is
in its terminal phase (due to Wall Street mixing in
derivatives), financing to buy a home is drying up, including
first time home buyer loans. Reduced funds available for
financing, coupled with the fact that there will be hundreds of
thousands of foreclosures, and it is easy to predict the prices
of homes will continue to fall. But the price of everyday items
will continue to go up as the value of money is diluted by the
printing of more of it.
There is a worldwide financial storm brewing. My advice is to
prepare for a rainy day. The storm clouds are on the horizon and
headed rapidly this way.
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