It's About the Fulcrum, Stupid

Bill Clinton won the presidency in 1992 with the slogan "It's About the Economy, Stupid". He left office in 2000 (actually 2001) with the slogan, "It's about the Fulcrum, Stupid". Unfortunately, he was on the wrong side of the fulcrum on the way out. It's just a matter of elementary physics. A large part of the financial meltdown which began in late summer of 2008 resulted from the "Commodity Futures Securities Modernization Act of 2000" (CFMA-2000) which legalized unregulated leveraging of esoteric and often occult Wall Street gambling. Phil Gramm and Alan Greenspan (and Larry Summers, then Treasury Secretary, now President Obama's Director of the National Economic Council!) convinced Bill Clinton to sign this legislation that would work wonderful Midas-like magic for everyone.

As you learn in Mechanics for Beginners, a lever allows you to lift more weight than you could lift without the lever. The secret is the fulcrum, which is where the lever rotates. Think about a playground seesaw. The support in the middle is the fulcrum. When the fulcrum is in the middle of a 10-foot long lever, 100 pounds on one end will balance 100 pounds on the other end. However, place the fulcrum one foot from one end and then 100 pounds on the other end will balance 900 pounds on the short end, a leverage of 9. This is how Wall Street gave the taxpayer the short end of the stick.

Financial leverage is everywhere. When depositors put $10 million in a bank, the bank may be allowed to lend $50 million through Federal Reserve manipulations, creating more money through leverage. Stock market puts and calls are a form of leverage where the investor pays a small fee to buy or sell a particular stock at some time in the future at a given price. If the holder of a put option paid $10 to sell 100 shares of Google at $500 in three months and the price of Google dropped to $490 a share at the end of the three months, then the put holder could buy Google for $49,000 and sell it for $50,000 netting $990. This would be a leverage of 99, which is a lot better than the seesaw.

The CFMA-2000 went well beyond normal financial leverage. It legalized totally unregulated, heavily leveraged, side bets on credit default swaps (mortgage default insurance policies) with no requirement for any collateral what so ever. As side bets, these wagers put into play much more monopoly money than the value of the underlying mortgage securities. They were all drinking the Kool-Aid. The bill passed the Senate unanimously. Of course, when the fulcrum hit the fan in 2008, the Dems blamed it all on George Bush and John McCain. The truth is that the real Genesis started with the Reagan Heresy that "Government is not the solution, government is the problem" that led most neocapitalists to oppose all government regulations, especially where the Wall Street Casino was concerned.

The government solution to the crisis, benefitting from the advice of the same Wall Street croupiers, was to pay off the bets for the casinos using money borrowed from the Chinese Communists. I have a better solution. Have Congress pass the "We were stupid in 2000" law which would make Credit Default side bets illegal and ban payment for any existing bets. Who would get hurt? Wall Street gamblers – irresponsible hedge funds and greasy traders. Who wins? The rest of us. The bail out funds could then be used to shore up the mortgage markets, curtailing foreclosures, and restoring the housing market to normalcy. Anyone want to make a wager that they'll do it? I'll give you 100,000 to 1 odds that it won't happen.

Genesis of the Economic Meltdown

I'm astonished to hear that the sub prime mortgages/credit default swaps were so complicated that the even the CEOs didn't understand them. The truth is that if they didn't understand them, they were totally unqualified to be a doorman (my apologies to doormen, you probably earn more than I do) for their business, much less CEO.

The chain of events is incredibly simple. Here it is -

• To promote the "ownership society", lending institutions were encouraged to provide mortgages to everyone who took the initiative to walk in the banks' doors.
• Since banks no longer hold and service mortgages, they had no reason to deny anyone credit. They received their fees only if they processed the paperwork so that's what they did.
• Banks passed the hot potato (bad credit risks) up the line to Fannie Mae, Freddie Mac, or anyone else who would take them.
• Many mortgages were bundled into "Mortgage-backed Securities" (MBS) and offered to the investing marketplace.
• These securities were given high financial safety ratings by the ratings agencies although they contained many troubled assets.
• Investors trusted investment banks and ratings agencies and bought the MBSs.
• Investment banks then created an insurance policy called a "Credit Default Swap" (CDS) which allowed a purchaser of the MBS to insure his return in case of default by paying a monthly premium.
• Since they did not call the "Swaps" insurance policies, they did not have to comply with insurance regulations for reserve requirements (money held to pay up in case of defaults).
• The investment banks who sold the MBSs also sold the CDSs, so they doubled-dipped into the investors pockets.
• The investment bankers established no reserves trusting that the MBSs would never default - at least they hoped they would not before they took their outrageous salaries and bonuses.
• On top of this, the massive deregulation of the financial industry (Commodity Futures Modernization Act of 2000) led by Republicans, such as Phil Gram, but also supported by many Democrats with their hands also in the lobbyists' pockets, allowed extensive gambling games to be placed on the whole mess. The plan was also blessed by Alan Greenspan and Larry Summers (a Fox who really loves the Henhouse).
• The gamble was this: two parties who had nothing to do with the basic MBS were able to select an MBS and place a side bet. Player A would sell Player B a CDS based on the Dallas Action MBS (DAMBS). This CDS has a time limit, perhaps a year. B pays a monthly premium to A for the year term. If DAMBS does not default in that year, B loses all his premiums and A wins. If DAMBS does default, A loses and B collects the value of DAMBS.
• With this scheme, the amount of bets placed on the underlying MBSs greatly exceeded the value of the MBSs themselves.
• Furthermore, the investment banks had absolutely insufficient funds to pay for any but a minimal number of defaults. [To a layman, that looks criminal.]
• When the bad credit risk homeowners began defaulting, often due to ARM loan interest rate increases, the dominoes began to fall, resulting in the investment bank meltdown we all witnessed.

Next I will blog on a simple way the bleeding could have been stopped - it could be to late now, but it's instructive to ponder why it wasn't done.