Credit Crisis to Explode

Several “once in 100,000 years” events “cost billions and point to flaws in the design of quantitative trading strategies” was how one learned analysis explained the subprime mortgage fiasco this summer. This was highbrow talk for lowbrow greed that piled one sleight-of-hand scam upon another in an international Ponzi scheme that began unraveling in June.

Prominent international bankers, speaking not for attribution in Paris, said prestigious credit rating companies kept kicking the can down the road that said “subprime mortgage meltdown.” They arbitrarily decreed that borrowers who take out a second loan for the down payment on the first weren’t more of a risk than a standard mortgage. This defied common sense but still triggered a boom in subprime mortgages.

These universally trusted outfits eventually revised their opinions — but by then there was a $1.1 trillion subprime mortgage market. West Europeans owned 57 percent of subprime loans. Throughout 2006, those who knew and were in a position to blow an authoritative whistle didn’t. Ignored were precursory warnings about subprime delinquencies, homes repossessed, or refinanced to avoid foreclosures.

A symbiotic relationship between banks and mortgage companies erected beautiful monetary sand castles on the world’s financial beaches, just out of range of high tide. They hadn’t reckoned on a subprime mortgage rip tide that flattened them. Investment banks and bond rating agencies failed at the same time.

Banks sold leaky mortgage vessels to hedge funds hungry for high interest payments. Securities markets and their high-rollers took over from bank managers. Those who took on risk on the verge of default always expected to find someone willing to take on a bigger risk ad infinitum. Risks were even carved up, sliced and diced, repackaged, and passed on to make then look less risky.

All this was gerrymandered on millions of individual borrowers who were led to believe the value of their homes would keep appreciating and therefore could afford to go into deeper debt. Thus millions took mortgages to buy homes beyond their means.

Now millions stand to lose the homes they could not afford. Irresponsible, reckless driving has played into the hands of those who advocate more regulation in underregulated financial markets, along with a new right to sue everyone, from brokers that sold the repackaged loans to banks that originated them, to investors who picked them in secondary markets. Those gulled by the American dream of a modest dwelling can no longer get a mortgage because of earlier default. For many, it’s back to trailer parks.

The insiders called these subprime mortgages neutron (bomb) loans after the Cold War WMD that killed people but left buildings intact. Get-rich-quick schemes spawned the unacceptable face of democratic capitalism. From 350 billionaires at the turn of the 21st century seven years ago, the club has just gone over 1,000 members, many of them in tax free shelters with exotic names of countries the size of a dot on a map of the world that seldom make the news.

Even Bill Gates was upstaged last month by Mexico’s Carlos Slim Helu (of Lebanese descent), the world’s richest man at $59 billion (Gates gave over $30 billion to his foundation that is focused on the world’s most critical health problems). Slim got Mexico’s nationwide cell phone license after backing then President Carlos Salinas (1988-94). Privatization of state-owned companies was the vehicle for rewarding political supporters.

Hedge funds and derivatives, instruments usually reserved for the wealthy to move up the ladder to mega-rich status, were heavily leveraged by shaky subprime mortgage-backed bonds. The few who bet these bonds would tank made a fortune. But several secretive hedge funds went out of business as the stock market fell 7 percent. For the past ten years, good hedge funds had been averaging plus 20 percent to 30 percent a year. And rare was the hedge fund that would take on a new client for less than $5 million.

Renaissance Technologies’ flagship Medallion Fund averaged an annual return of 30 percent since 1988.

From Goldman Sachs’ year-end bonus pool of $16.9 billion for the brokerage giant’s best performers, Mark McGoldrick, 48, was awarded $70 million. He thought he was entidled to more, or a cool $100 million. So he quit. To start another hedge fund.

McGoldrick co-founded GS’s “Special Situations Group,” the heart of the Wall Street giant’s money-making machine. Since McGoldrick’s departure, GS’s shares dropped 23 percent. Three of GS’s hedge funds lost several billion dollars in 2007.

One hedge fund manager in Connecticut made $1 billion for himself last year. Several others had each averaged about $300 billion a year for the last three years through the end of 2006. $100 million a year was considered normal take home before taxes for the better hedge fund managers.

Hedge funds seem to be a law unto themselves. Germany’s suggestion for an international code of conduct for hedge funds was turned down by Washington and London. In the U.S., both political parties regard them as potential cash cows come election fund-raising time.

Leading European bankers are warning privately of the worst crisis in the money markets in 20 years that is yet to come. Huge amounts of commercial paper — market IOUs — come up for refinancing, mainly through London. According to the London Sunday Times, the amounts due this week exceed the $100 billion that came due in mid-August, an offshoot of the subprime debacle. Many of the off-balance-sheet structured investment vehicles (SIVs) that were set up by the banks were “borrowed in the form of asset-backed commercial paper,” explained one bank executive.

“It is both a liquidity and a capital crisis,” said Paul Mortimer-Lee, a global head of market economics at BNP Paribas. “Banks are taking more and more of this paper into their balance sheets, which uses up capital.” This week the Bank of England dropped its resistance to following the U.S. Fed and the European Central Bank in pumping hundreds of billions of Euros and dollars into the system. But it only committed to $10 billion a week for three weeks.

The U.K.’s foreclosures are suddenly at an 8-year high with 14,000 properties repossessed and 125,000 in default. At the other end of the scale, big private boat owners in the Med, were keeping their 200-to-500 footers in harbor — to save on 300-gallons-an-hour fuel bills.