WHAT REALLY CAUSED THE FINANCIAL CRISIS? Part 2

Part 2 of 3:

THE FINANCIAL CRISIS: A LOOK BEHIND THE WIZARD’S CURTAIN

March, 2009, written by Bruce Wiseman
(Before reading this, please make sure you have read Part 1 of this series which was presented in the previous Blog). Feel free to comment on what you have read at our Discussion Forum on the Silkin Facebook Page.

Larry Silver
President, Silkin

BASEL II

Greenspan, the Community Reinvestment Act, the repeal of Glass Stegall and Paulson getting the SEC to waive the capital rule for investment banks have all set the stage: the economy is screaming along, real estate is in a decade long boom and the stock market is reaching new highs. Paychecks are fat.

But by the first quarter of 2007, the first nigglings that all was not well in the land of the mortgage back securities began to filter into the press. And like a chilled whisper rustling through the forest, mentions of rising delinquencies and foreclosures began to be heard.

Still, the stock market continued to rise with the Dow Jones reaching a high of 14,164 on October 9th 2007. It stayed in the 13,000 range through the month, but in November, a major stock market crash commenced from which we have yet to recover.

It’s not just the U.S. stock market that has crashed, however. Stock exchanges around the world have fallen like a rock off a tall building. Most have lost half their value, wiping out countless trillions.

If it was just stock markets, that would be bad enough, but, let’s be frank, the entire financial structure of the planet has gone into a tail spin and it has yet to hit ground zero. While there surely would have been losses, truth be told, the U.S. banking system would likely have gotten through this, as would have the rest of the world, had it not been for an accounting rule called Basel II promulgated by the Bank of International Settlements.

Who? What?

That’s right, I said an accounting rule.

The final nail in the coffin, and this was really the wooden spike through the heart of the financial markets, was delivered in Basel, Switzerland at the Bank of International Settlements (BIS).

Never heard of it? Neither of have most people so, let me pull back the wizard’s curtain.

Central banks are privately owned financial institutions that govern a country’s monetary policy and create the country’s money.

The Bank of International Settlements (BIS), located in Basel, Switzerland is the central banker’s bank. There are 55 central banks around the planet which are members, but the bank is controlled by a Board of Directors, which is comprised of the elite central bankers of 11 different countries (U.S., UK, Belgium, Canada, France, Germany, Italy, Japan, Switzerland, the Netherlands, and Sweden).

Created in 1930, the BIS is owned by its member central banks, which, again, are private entities. The buildings and surroundings, which are used for the purpose of the bank, are inviolable. No agent of the Swiss public authorities may enter the premises without the express consent of the Bank. The Bank exercises supervision and police power over its premises. The Bank enjoys immunity from criminal and administrative jurisdiction. In short, they are above the law.

This is the ultra secret world of the planet’s central bankers and the top of the food chain in international finance. The Board members fly into Switzerland for once-a-month meetings, which they hold in secret.

In 1988 the BIS issued a set of recommendations on how much capital commercial banks should have. This standard, referred to as Basel I, was adopted worldwide.

In January of 2004 our boys got together again and issued new rules about the capitalization of banks (for those that are not fluent in bank-speak, this is essentially what the bank has in reserves to protect itself and its depositors). This was called Basel II.

Within Basel II was an accounting rule that required banks to adjust the value of their marketable securities (such as mortgage backed securities) to the “market price” of the security. This is called Mark to the Market. There can be some rationality to this in certain circumstances, but here’s what happened.

THE MEDIA AND MARK TO THE MARKET

As news and rumors began to circulate about some of the sub-prime, CRA loans in the packages of mortgage backed securities, the press, always at the ready to forward the most salacious and destructive information available, started promoting these problems. As a result, the value of these securities fell. And when one particular bank did seek to sell some of these securities, they got bargain basement prices.
Instantly, per Basel II, that meant that the hundreds of billions of dollars of these securities being held by banks around the world had to be marked down – Marked to the Market.

It didn’t matter that the vast majority of the loans (90% +) in these portfolios were paying on time. If, say Lehman Brothers had gotten fire sale prices for their mortgage backed securities, the other banks, which held these assets on their books, now had to mark to the market, driving their financial statements into the toilet.

Again, it didn’t matter that the banks were receiving payments (cash flow) from their loan portfolios, the value of the package of loans had to be written down.

A rough example would be if the houses on your street were all worth about $400,000. You owe $300,000 on your place and so have $100,000 in equity. Your neighbor, Bill, in selling his house, uncovered a massive invasion of termites. He had to sell the house in a hurry and wound up with $200,000, half the real value. Shortly thereafter, you get a demand letter from your bank for $100,000 because your house is only worth $200,000 according to “the market.” Your house doesn’t have termites, or perhaps just a few. Doesn’t matter.

Of course, if the value of your home goes below the loan value, banks can’t make you cough up the difference. But if you are a bank, Basel II says, you must adjust the value of your mortgage backed securities if another bank sold for less -- termites or no.

When the value of their assets were marked down, it dramatically reduced their capital (reserves) and this – their capital - determined the amount of loans they could make. The result? Banks couldn’t lend. The credit markets froze.

Someone recently said that credit was the life blood of the economy. This happens to be a lie. Hard work, production, and the creation of products that are needed and wanted by others; this is the true life blood of an economy. But, let’s be honest, credit does drive much of the current U.S. economy: home mortgages, auto loans and Visas in more flavors than a Baskin Robbins store.

That is, until the banks had to mark to the market and turn the IV off.

THE CRISIS

Mortgage lending slammed to a halt as if it had run head long into a cement wall, credit lines were cancelled and credit card limits were reduced and in some cases eliminated all together. In short, with their balance sheets butchered by Basel II, banks were themselves going under and those that weren’t simply stopped lending. The results were like something from a financial horror film – if there were such a thing.

Prof. Peter Spencer, one of Britain’s leading economists, makes it very clear that the Basel II regulations “…are at the root cause of the crunch…” and that “…if the authorities retain the strict Basel regulations, the full scale of the eventual credit crunch and economic slump could be disastrous.” “The consequences for the macro-economy,” he says “of not relaxing (the Basel regulations) are unthinkable.”
Spencer isn’t the only one who sees this. There have been calls in both the U.S. and abroad to, at least, relax Basel II until the crisis is over. But the Boys from Basel haven’t budged an inch. The U.S did modify these rules somewhat a year after the devastation had taken place here, but the rules are still fully in place in the rest of the world and the results are appalling.

The credit crisis that started in the U.S. has spread around the globe with the speed that only the digital universe could make possible. You’d think Mr. Freeze from the 2004 Batman movie was at work.

We have already noted that stock markets around the world have lost half of their value erasing trillions. Some selected planet-wide stats make it clear that it is not just stock values that have crashed:

China’s industrial production fell 12% last year, while Japan’s exports to China fell 45% and Taiwan’s were off 55%.

South Korea’s overseas shipments decreased 17%, while their economy shrank 5.6%.

Singapore’s exports were off the most in 33 years and Hong Kong’s exports plunged the most in 50 years.

Germany had a 7.3% decline in exports in the 4th quarter of last year while Great Britain’s real estate market declined 18% in the last quarter compared to a year earlier.

Australia’s manufacturing contracted at a record pace last month bringing the index to the lowest level on record.

There’s much more, but I think it is obvious that credit pipe can no longer be smoked. Welcome to planetary cold turkey.

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