Thu 29 Apr, 2010 04:15 pm
How the Wall Street scam works
1. Banks give loans or mortgages to any person who wants to buy a house or invest in real estate. In the particular case of Wall Street they gave loans to NINJA (No Income, No Job or Assets) clients. The person who sold the mortgages got their bonuses based on how many mortgages they sold. They get a percentage of the sales. Loans are the income instruments of banks. The mortgage holder pays a monthly sum or premium to the bank for the loan. A responsible banker would only give loans to those who can afford them and pay back the loans plus interest. The unscrupulous banker or official who doesn’t plan to be around the bank for long sells mortgages or loans to anyone and works on his commission (percentage of the mortgage sales). Then he leaves the company or bank with unsustainable loans. The bank would stand to lose a lot of money while the scammer made off with his commissions. To overcome this bad situation the bank creates a hedge fund to separate the bad loans from the bank itself.
2. Now if the head of the hedge fund plans to stick around, he must figure out a way to separate his own liability from this sticky situation. What he does is prepare to dissolve this hedge fund thru short selling. He has many connections in Wall Street so he can get shares of his own hedge fund on loans as the share price is climbing due to the volume of mortgage sales and he has a large holding of his own shares of the hedge fund as the originator of the hedge fund. He sells a huge of shares so the price drops and there is a panic and he makes a killing as he returns the shares he borrowed and on the shares he sold. The hedge fund goes bankrupt and dissolved and the hedge fund originator goes scot-free after masterminding a great bank robbery from the inside. There is a need to hold this bank robber accountable and laws should be made to claw back these ill begotten gains by this breach of trust by bank officials. There should be a law prohibiting holders of large amount of shares of a company from borrowing shares of the same company from other firms so that he can make a killing by short selling. A Wall Street scammer may deliberately buy a lot of shares incrementally to facilitate the rising of the price of a particular share that he owns a lot of and then short sell it to make a killing when he sell his own shares to create a panic as the price falls and returns the borrowed shares at the lower price thus double-dipping on short sell. Warning sign: If the head of a hedge fund borrows a lot of shares he plans to short sell on his own hedge fund so there is a scam afoot.
3. This head of the hedge fund triple-dipped on his scam. He got bonuses for the NINJA mortgages sales, he made a profit selling his shares and also from short selling. This is what the Republicans are defending an inside bank robbery.
4. How did this happen? The ‘credit default swap’. This instrument is worded from the bank point of view. In Accounting Debit is incoming and Credit is outgoing. A loan is a credit as it is outgoing and monthly payment, or premium, is a debit. Credit Default means if the loan goes bad. Credit Default Swap means transferring the bad loan to an insurance company or passing the risk to the insurance company.
5. With the creation of Credit Default Swap passed thru Congress surreptitiously by the former Senator Phil Gram, the hedge fund in turn passed the NINJA mortgages to the insurance company. By classifying the NINJA mortgage as a certificate, the insurance company accepted it. Now an insurance company would not necessarily insure everything especially if it was too risky. The riskier the item the higher the premiums. Insurance companies make money by insuring against a bad event such as an accident or a loan going bad. If it has many clients it makes a lot of money. The chances of an accident occurring over a whole population are low. Say there are 50 accidents in a year for a population of 2 million. The premiums coming in as income far exceeds the pay out towards the accidents. But the NINJA mortgages they were all bad. As the NINJA mortgages were certified as safe by a bank, the insurance company was scammed thinking they were safe so the hedge fund paid very low premiums for insuring the NINJA mortgages. The insurance company, AIG, went broke and tax payers had to bail it out as it would have affected the whole economy by precipitating a Wall Street crash of the magnitude equaling that of the 1929 Crash. This is what the Republicans are defending.
6. A derivative is a highly leverage financial instrument. There are two or more ways it is financed. 1) The leverage could be other people’s money such as the bank loan, or depositors’ money in a bank that is used by the bank to make loans. 2) The leverage could also be time i.e. the loan or mortgage is spread out over forty years to pay back the principal loan as well as the interest. Forty years is a long time and anything can happen so it is very risky. 3) There can be swaps of assets or a barter trade of some kind. It is for these reasons why banks want to create hedge funds so if things go wrong they can be shut down as it goes bankrupt. They pass the risk on to insurance companies by certifying risky derivatives to mask their liability. The banks benefit from these transactions when the government bails out the insurance company from bankruptcy so tax payers end up paying for their failed decisions. If hedge funds are separated from banks then these derivatives could not be automatically certified as safe. An independent agency, or company, would rate a derivative according to the risk it carries and the proper premiums would have to be paid. Thus if the derivative fails the premiums paid would cover the loss. If the derivate is such then the insurance company may not cover it so the potential loss is avoided. Tax payers are saved from footing the failure.
7. High junk bonds. Hedge funds outside of banks finance their operations by offering high interest bonds. When they reach a certain amount of capital the originator sometimes close the hedge fund and abscond with the money. This is quite common and need to be addressed. Then there are corporate raiders who look for undervalued companies that are performing poorly. They see the assets are more valuable the total capital value i.e. sum of the common share value of the company. They may buy up enough shares to take control of the company and sell off the assets separately or change the management and then sell their shares when the company performs better with resulting rise in the company share price. In the case of the NINJA hedge funds they too lured investors with high yield bonds i.e. with high interest. The increase in mortgage sales spurred the cash inflow. The executives in the hedge funds also stoked the value of the shares by incrementally buying up the stocks in the market so the stock prices would rise. Then once a few mortgage holders began to default on their payments the executives dumped their stocks to create a downfall on the value of the stocks, or shares and once the value reached their short sell value they returned the borrowed shares and made a killing.
8. Then there are boiler-plate stock market activities. They get registered in less than sterling stock exchanges such as those based in Vancouver. Originators of shell companies issues a lot of shares to themselves and go on a marketing campaign to get naïve investors into buying penny shares of a ‘hot’ upcoming starter company with fake money-making operation or commodity. They stoke the price by incrementally buying up shares in the stock market. As the price rise they dump their shares in the market and create a panic. The company share price takes a dive and they dissolve the company with investors’ money in their pockets. They start all over again with another company with a different fake product, commodity or operation or ‘invention’. Proper legislations are needed to prevent these criminal stock market transactions which are criminal activities using guile to steal people of their hard earned savings. These people should be charged and identified as criminals and prevented from starting companies. A criminal background check should be done for those registering in all stock exchanges to prevent them from carrying out white-collar criminal activities. A system of certification and licensing of all participants in the stock market should be required and a code of ethics followed to uphold trust and honor of the stock exchange as a business center and not a den of thieves. A criminal background should bar the applicant from registering.
9. The executives of Goldman Sachs in their defense before Congress, pleaded innocent and they had no knowledge of the hedge fund’s activities. If they had no knowledge then there is a need to separate the bank from its subsidiary hedge funds as it has grown so big that it is no longer manageable. If they are lying which is more likely then separation is even more necessary as they are more likely to carry on the scams.
10. Why is Wall Street resisting? Maybe they have all participated in all these kinds of nefarious activities for there is ‘honor even among thieves’ i.e. ‘don’t rat on me or else’. They have all breached this trust that bankers are supposed to uphold. How did Casanova succeed in his conquest? He posed as a priest. How did Hitler succeed in conquering Europe? He breached this code of honor expected of a gentleman of high position of respect and responsibility.
Leverage = loan/principal
Loan is also liability, depositors’ money in the bank, debt, mortgage
Principal is cash, down payment, up front money
House price: $200,000
Income: $40,000 per annum
Interest rate: 4%
Down payment: $10,000
Loan: $200,000 - $10,000 = $190,000
Mortgage interest rate: 5%
Total payment: $190,000 x 1.05 = $199, 500
Time span: 20 years
Yearly payment: $9,975
Monthly payment: $831.25
Monthly payment @ 0% = $791.67
Leverage = 190000/10000 = 19:1. This is quite high as the bank net capital ratio is 15:1
If down payment was reduced to $5,000 then the ratio would be $195,000/$5,000 = 39:1
Yearly payment: $10,237.5
Monthly payment: $853.13
Ratio above 15:1 are dangerous as you increase the number of mortgages handled the bank has lent out 39 times the money it holds in case the mortgages default or the mortgage holder loses his/her job or cannot make the payments. Bank depositors may take out money to pay for things so the bank has to have money on hand for depositors withdrawals. If the bank end up having all the money in loans it would have file for bankruptcy or force mortgage holders to pay up or foreclose the property and recoup the money.
This is what risk is all about. Unforeseen events, accidents, disruptions occur all the time. You need to cushion against these events and a bank with high leverage reduced the cushion.
What must be discussed are speculators. The speculators affect the real estate market greatly. Another set of players are the ‘How to become a millionaire’ hotel seminar promoters who lure people in with free seminars on tidbits of real estate financing but offer for $500 - $1,500 for the enriched courses. Basically they advise people how to speculate on the real estate market. Either these promoters are creatures of the developers in the housing industry or the financial sector for this industry. The freelance promoters make money on the courses they sell but they could also get a small commission if house sales go up. If they are part of the housing industry then the courses are extras as they make their money on commissions on the house sales.
As can be seen commission sales can be good for a business but not necessarily for the buyer as the salesman may withhold damning information such as a used car or toxic asset certificate. There should be a law prohibiting 100% commission sales i.e. the salesman income is completely based on his commission. He will be desperate to withhold damning information in order to make a living. Many of the Wall Street abuses arose from 100% commission sales of Wall Street products. There should be a law to have commission salesmen disclose damning information i.e. risks involved in a financial certificate and history of damages to the car and the repairs done. Businesses should be required by law to supply this information or their license withdrawn. Of course, the solution is to have used cars certified as well as the financial products. But if these businesses depend on commissions as well then the certificate is of no value as was the case of the mortgage based certificates. These certifying businesses should be charged with a crime or their licenses withdrawn. Businesses that try to influence the certification should also be charged with a crime.
The promoters advise speculators-to-be to put little or next to nothing down to minimize their losses. They buy a residential unit comprising a condominium, apartment or a house, basically any residential unit. Buy during construction and just before completion advertise the unit for sale or for rent. Use the mortgage interest payment as a tax deduction. With a rising market the speculator makes a tidy profit.
Let us get into the numbers:
Down payment (cash): $5,000
Principal (residential unit price): $355,000
Period: 10 years
Interest rate: 5%
If the buyer changes his/her mind s/he loses the $5,000.
For the speculator to minimize losses get the maximum time period such as 10, 15 or 20 years or more. The monthly payments are reduced.
$(355,000-5,000) = $350,000 x 1.05 = $367,500
Monthly payment = $367,500/(10 x 12) = $3,062.50 for 10 years
Monthly payment = $367,500/(20 x 12) = $1,531.25 for 20 years
The project takes a year to complete so total outlay would be $5,000.
In a rising housing market housing prices could rise 10% in a year so the unit on completion after a year would have a market value of $390,500 a difference of $(390,500-355,000) = $35,000. Other speculators or those seeing the need for new lodging would now be in the market. Fear of a rising market would encourage the buyers to get the sale and not wait for the higher price. He would take over the mortgage from the original speculator and pay him/her $35,000. The speculator made $30,000 and if he included the $5,000 outlay for the down payment then s/he pocketed $35,000. Not bad for signing some papers. If s/he bought several units then s/he made that many times more money: N times $35,000.
The real estate promoters have always claimed that real estate prices only appreciate and never depreciate so speculators have no fear of a downturn. Every year they go around the cities lecturing on this kind of activity so every year more and more speculators enter the arena. The number of speculators could be in the thousands and even movie stars could be involved with high priced mansions.
The debt to liquidity ratio: 355,000/5,000 = 71:1 far above the ‘net capital ratio’ for banks.
The debt load for 10,000 speculators: $355,000 x 10,000 = $3,550,000,000 or $3.55 billion and cash or down payment of $5,000 x 10,000 = $50,000,000 or $50 million.
The speculators spur on the housing market. But in a sinking or saturated housing market they can precipitate a crash. If no one buys the finished house one speculator walks away and he loses $5,000 but if 10,000 speculators walk away they collectively lose $50 million. But what happens to the mortgage lender. For each speculator the lender (the bank or hedge fund) has $350,000 property on their hands and for 10,000 speculators who walked away the banks or hedge funds collectively hold $(350,000 x 10,000) = $3,500,000,000 or $3.5 billion. With mostly NINJA homebuyers they can’t sell 10,000 homes as the banks seek to foreclose these properties. The housing market begins to crash. The NINJA homebuyers also begin to walk away as the economy worsen and lose their jobs that are tied to the housing industry. The spiraling job losses and affect the banks and hedge funds. The hedge funds just go bankrupt but the banks tied to the economy create an alarming situation as they go bankrupt.
With a population of 300,000,000 and only 0.5% in the market for new houses that would mean there would be 1,500,000 buyers. $(1,500,000 x 355,000) = $532,500,000,000 or $532.5 billion or $0.5325 trillion was pumped into the economy. If the housing market cannot construct 1.5 million houses there would be increases in house prices as buyers rush to get their homes before they can afford the new prices. The speculators give a false demand as their activities create a false demand and induce panic buying. A growing population helps buoy the market and demand outstrips supply. Every year the number of speculators increase spurred on by the profits made by earlier speculators. But land is limited so construction moves upward and outward i.e. taller buildings are built and more suburbs are created.
The Clinton years, saw a period of great prosperity with government surpluses. With GWB the Gulf War cost maybe $500 billion as he unilaterally went after Saddam Hussein with mainly British and Australian allies. Each month cost $3 to 4 billion and the war carried on for seven years or more. The US military is probably the most expensive in the world as each Abram tank costs more than $1 million, an Apache helicopter ~ $20 million, a stealth bomber ~$500 million, a blackbird ~$2 billion, each cruise missile ~$1 million.
As a result of the Gulf War many nations chose Japanese or European products over American especially private corporations and citizens. Who wants to buy from an American bully? Republicans represent the rich and deliberately create a class system by nullifying the progressive tax system with tax cuts for the rich. So government revenues fall. Republicans want a business climate with no regulations so Wall Street criminals have a field day with shareholders’ money and social security is put into the stock market where Wall Street sharks operate. The upper class composed of CEOs in order to make more money outsource jobs. The national debt is rising and the annual deficit gets worse as American workers are downsized and must buy cheaper imported goods to make ends meet. A vicious cycle has been created. More Americans lose their jobs and more imported goods are bought by Americans. Defense spending does not create enough jobs. The economy is a mess. A program to pump up the economy is attempted so the housing industry is spurred on by promoting home ownership. As there are many who want homes but cannot afford them leniency is practiced with little or no down payment and the period of payment stretched to 40 years. This is just perfect for speculators. The Bush Administration encourages home ownership regardless of the risks with NINJA homebuyers.
The demographics show an alarming picture. The baby boomers are aging and dying off. There aren’t enough young people to replace them as the baby boomers create a bulge in the nation as it passed thru the serpentine python like national economic body. This means that population could shrink and could no longer support the housing market expansion. High fuel costs for heating and travel also hurt homeowners in suburban areas brought on by speculative activities in the crude oil and natural gas commodities market. The pent up desire for new homes is still there but loss of jobs from outsourcing and down sizing changed the status of homebuyers to that of NINJA. With government leniency more NINJA buyers came into being and Wall Street sharks wanted part of the largesse. Whether the Bush Administration encouraged Wall Street to provide the loans or mortgages cannot be determined. With the government turning a blind eye to NINJA homebuyers, it may have been a tacit signal for them to pass the risky mortgages. Since GWB was their guy they did it to facilitate the transactions and certified those mortgages. However, they knew there was a risk so they took steps to protect themselves. Besides, it was the Whitehouse’s baby so let them handle it if it blows apart. The Wall Street smart ones decided to insulate themselves so they bundled them out to hedge funds.
The economy was helped by the Fed setting low interest rates that encouraged corporations and individuals to start risky projects and banks to make equally risky loans. There were corporate takeovers and mergers. All these activities created a huge demand for loans and a mountain of debt in the private sector. All the takeovers and mergers were financed by debt i.e. loans from banks. All the financing hinged on mortgage payments from mortgage holders who had lost their jobs or were downsized. When the mortgages defaulted i.e. mortgage payments ceased, the capital base of the loans disappeared. The 10,000 speculators who walked away also got the banks holding $3.5 billion of real estate that are losing their value as the market crashes and stand to lose that capital base or money. Corporate takeovers and mergers were stopped banks that failed to meet capital requirements went bankrupt and Wall Street was in trouble. As to what initially caused crash it is hard to determine whether it was the mortgages defaulting first or the speculators walking away from a stalled housing market. The interesting question is why the Republicans are hindering the passing of regulations. Probably they are trying to protect the Wall Street sharks from squealing as they cooperated with GWB in this scheme to pump up the economy with the Homeownership Program. The Bush Administration proposed a sweetheart deal in bailout programs for banks in trouble and then the general elections were held. The rest is history.