What's caused the financial meltdown

Bad accounting laws, naked short selling, trading against bonds of companies shorted against, and I will add - the hyperavailibility and marketing of ARM financing on mortgages.


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How to Save the Financial System
By WILLIAM M. ISAAC

I am astounded and deeply saddened to witness the senseless destruction in the U.S. financial system, which has been the envy of the world. We have always gone through periods of correction, but today's problems are so much worse than they needed to be.

David KleinThe Securities and Exchange Commission and bank regulators must act immediately to suspend the Fair Value Accounting rules, clamp down on abuses by short sellers, and withdraw the Basel II capital rules. These three actions will go a long way toward arresting the carnage in our financial system.
During the 1980s, our underlying economic problems were far more serious than the economic problems we're facing this time around. The prime rate exceeded 21%. The savings bank industry was more than $100 billion insolvent (if we had valued it on a market basis), the S&L industry was in even worse shape, the economy plunged into a deep recession, and the agricultural sector was in a depression.
These economic problems led to massive credit problems in the banking and thrift industries. Some 3,000 banks and thrifts ultimately failed, and many others were merged out of existence. Continental Illinois failed, many of the regional banks tanked, hundreds of farm banks went down, and thousands of thrifts failed or were taken over.
It could have been much worse. The country's 10-largest banks were loaded up with Third World debt that was valued in the markets at cents on the dollar. If we had marked those loans to market prices, virtually every one of them would have been insolvent. Indeed, we developed contingency plans to nationalize them.
At the outset of the current crisis in the credit markets, we had no serious economic problems. Inflation was under control, GDP growth was good, unemployment was low, and there were no major credit problems in the banking system.
The dark cloud on the horizon was about $1.2 trillion of subprime mortgage-backed securities, about $200 billion to $300 billion of which was estimated to be held by FDIC-insured banks and thrifts. The rest were spread among investors throughout the world.
The likely losses on these assets were estimated by regulators to be roughly 20%. Losses of this magnitude would have caused pain for institutions that held these assets, but would have been quite manageable.
How did we let this serious but manageable situation get so far out of hand -- to the point where several of our most respected American financial companies are being put out of business, sometimes involving massive government bailouts?
Lots of folks are assigning blame for the underlying problems -- management greed, inept regulation, rating-agency incompetency, unregulated mortgage brokers and too much government emphasis on creating more housing stock. My interest is not in assigning blame for the problems but in trying to identify what is causing a situation, that should have been resolved easily, to develop into a crisis that is spreading like a cancer throughout the financial system.
The biggest culprit is a change in our accounting rules that the Financial Accounting Standards Board and the SEC put into place over the past 15 years: Fair Value Accounting. Fair Value Accounting dictates that financial institutions holding financial instruments available for sale (such as mortgage-backed securities) must mark those assets to market. That sounds reasonable. But what do we do when the already thin market for those assets freezes up and only a handful of transactions occur at extremely depressed prices?
The answer to date from the SEC, FASB, bank regulators and the Treasury has been (more or less) "mark the assets to market even though there is no meaningful market." The accounting profession, scarred by decades of costly litigation, just keeps marking down the assets as fast as it can.
This is contrary to everything we know about bank regulation. When there are temporary impairments of asset values due to economic and marketplace events, regulators must give institutions an opportunity to survive the temporary impairment. Assets should not be marked to unrealistic fire-sale prices. Regulators must evaluate the assets on the basis of their true economic value (a discounted cash-flow analysis).
If we had followed today's approach during the 1980s, we would have nationalized all of the major banks in the country and thousands of additional banks and thrifts would have failed. I have little doubt that the country would have gone from a serious recession into a depression.
If we do not halt the insanity of forcing financial firms to mark assets to a nonexistent market rather than their realistic economic value, the cancer will keep spreading and will plunge the world into very difficult economic times for years to come.
I argued against adopting Fair Value Accounting as it was being considered two decades ago. I believed we would come to regret its implementation when we hit the next big financial crisis, as it would deny regulators the ability to exercise judgment when circumstances called for restraint. That day has clearly arrived.
Equally egregious are the actions by the SEC in recent years lifting the restraints on short sellers of stocks to allow "naked selling" (shorting a stock without actually possessing it) and to eliminate the requirement that short sellers could sell only on an uptick in the market.
On top of this, it is my understanding that short sellers are engaged in abuses such as purchasing credit default swaps on corporate bonds (essentially bets on whether a borrower will default), which lowers the price of the bonds, which in turn causes the price of the company's stock to decline further. Then the ratings agencies pile on and reduce the ratings of a company because its reduced stock price will prevent it from raising new capital. The SEC must act immediately to eliminate these and other potential abuses by short sellers.
The Basel II capital rules adopted by the FDIC, Federal Reserve, Office of Thrift Supervision and the Comptroller of the Currency last year are too new to have caused big problems, but they must be eliminated before they do. Basel II requires the use of very complex mathematical models to set capital levels in banks. The models use historical data to project future losses. If banks have a period of low losses (such as in the mid-1990s to the mid-2000s), the models require relatively little capital and encourage even more heated growth. When we go into a period like today where losses are enormous (on paper, at least), the models require more capital when none is available, forcing banks to cut back lending.
As I write this article, I am seeing proposals by some to create a new Resolution Trust Corp., as we did in the 1990s to clean up the S&L problems. The RTC managed and sold assets from S&Ls that had already failed. It was run by the FDIC, just like the FDIC. We needed to create the RTC in the 1990s only because we could not comingle the assets from failed banks with those of failed thrifts, because we had two separate deposit insurance funds absorbing the respective losses from bank and thrift failures.
I can't imagine why we would want to create another government bureaucracy to handle the assets from bank failures. What we need to do urgently is stop the failures, and an RTC won't do that.
Again, we must take three immediate steps to prevent a further rash of financial failures and taxpayer bailouts. First, the SEC must suspend Fair Value Accounting and require that assets be marked to their true economic value. Second, the SEC needs to immediately clamp down on abusive practices by short sellers. It has taken a first step in reinstituting the prohibition against "naked selling." Finally, the bank regulators need to acknowledge that the Basel II capital rules represent a serious policy mistake and repeal the rules before they do real damage.
We are almost out of time if we hope to eradicate the cancer in our financial system.
Mr. Isaac, chairman of the Federal Deposit Insurance Corp. from 1981-1985, is chairman of the Washington financial services consulting firm The Secura Group, an LECG company.

A disaster of Phil Gramm's making.... too much deregulation for wall street is terrible for taxpayers

Buffett's "time bomb" goes off on Wall Street
Thu Sep 18, 2008 1:42pm EDT

By James B. Kelleher - Analysis

CHICAGO (Reuters) - On Main Street, insurance protects people from the effects of catastrophes.

But on Wall Street, specialized insurance known as a credit default swaps are turning a bad situation into a catastrophe.

When historians write about the current crisis, much of the blame will go to the slump in the housing and mortgage markets, which triggered the losses, layoffs and liquidations sweeping the financial industry.

But credit default swaps -- complex derivatives originally designed to protect banks from deadbeat borrowers -- are adding to the turmoil.

"This was supposedly a way to hedge risk," says Ellen Brown, the author of the book "Web of Debt."

"I'm sure their predictive models were right as far as the risk of the things they were insuring against. But what they didn't factor in was the risk that the sellers of this protection wouldn't pay ... That's what we're seeing now."

Brown is hardly alone in her criticism of the derivatives. Five years ago, billionaire investor Warren Buffett called them a "time bomb" and "financial weapons of mass destruction" and directed the insurance arm of his Berkshire Hathaway Inc (BRKa.N: Quote, Profile, Research, Stock Buzz) to exit the business.

LINKED TO MORTGAGES

Recent events suggest Buffett was right. The collapse of Bear Stearns. The fire sale of Merrill Lynch & Co Inc (MER.N: Quote, Profile, Research, Stock Buzz). The meltdown at American International Group Inc (AIG.N: Quote, Profile, Research, Stock Buzz). In each case, credit default swaps played a role in the fall of these financial giants.

The latest victim is insurer AIG, which received an emergency $85 billion loan from the U.S. Federal Reserve late on Tuesday to stave off a bankruptcy.

Over the last three quarters, AIG suffered $18 billion of losses tied to guarantees it wrote on mortgage-linked derivatives.

Its struggles intensified in recent weeks as losses in its own investments led to cuts in its credit ratings. Those cuts triggered clauses in the policies AIG had written that forced it to put up billions of dollars in extra collateral -- billions it did not have and could not raise.

EASY MONEY

When the credit default market began back in the mid-1990s, the transactions were simpler, more transparent affairs. Not all the sellers were insurance companies like AIG -- most were not. But the protection buyer usually knew the protection seller.

As it grew -- according to the industry's trade group, the credit default market grew to $46 trillion by the first half of 2007 from $631 billion in 2000 -- all that changed.

An over-the-counter market grew up and some of the most active players became asset managers, including hedge fund managers, who bought and sold the policies like any other investment.

And in those deals, they sold protection as often as they bought it -- although they rarely set aside the reserves they would need if the obligation ever had to be paid.

In one notorious case, a small hedge fund agreed to insure UBS AG (UBSN.VX: Quote, Profile, Research, Stock Buzz), the Swiss banking giant, from losses related to defaults on $1.3 billion of subprime mortgages for an annual premium of about $2 million.

The trouble was, the hedge fund set up a subsidiary to stand behind the guarantee -- and capitalized it with just $4.6 million. As long as the loans performed, the fund made a killing, raking in an annualized return of nearly 44 percent.

But in the summer of 2007, as home owners began to default, things got ugly. UBS demanded the hedge fund put up additional collateral. The fund balked. UBS sued.

The dispute is hardly unique. Both Wachovia Corp (WB.N: Quote, Profile, Research, Stock Buzz) and Citigroup Inc (C.N: Quote, Profile, Research, Stock Buzz) are involved in similar litigation with firms that promised to step up and act like insurers -- but were not actually insurers.

"Insurance companies have armies of actuaries and deep pools of policyholders and the financial wherewithal to pay claims," says Mike Barry, a spokesman at the Insurance Information Institute.

"SLOPPY"

Another problem: As hedge funds and others bought and sold these protection policies, they did not always get prior written consent from the people they were supposed to be insuring. Patrick Parkinson, the deputy director of the Fed's research and statistic arm, calls the practice "sloppy."

As a result, some protection buyers had trouble figuring out who was standing behind the insurance they bought. And it put investors into webs of relationships they did not understand.

"This is the derivative nightmare that everyone has been warning about," says Peter Schiff, the president of Euro Pacific Capital at the author of "Crash Proof: How to Profit From the Coming Economic Collapse."

"They booked all these derivatives assuming bad things would never happen. It was like writing fire insurance, assuming no one is ever going to have a fire, only now they're turning around and watching as the whole town burns down."

(Editing by Andre Grenon)

Quote Max Planck "There is no matter as such"

As a man who has devoted his whole life to the most clear headed science, to the study of matter, I can tell you as a result of my research about atoms this much: There is no matter as such. All matter originates and exists only by virtue of a force which brings the particle of an atom to vibration and holds this most minute solar system of the atom together. We must assume behind this force the existence of a conscious and intelligent mind. This mind is the matrix of all matter. ---"QUOTE BY MAX PLANCK"---


Upon accepting his nobel prize