Who is to blame for this mess? I’ve accused the Credit Insurance Fraud Industry (CIFI) of causing the financial crisis that started in the US subprime mortgage market during 2007 and has now spread to the European sovereign debt market. This industry expanded dramatically during the previous two decades by selling credit insurance derivative products that magically transformed subprime mortgages, junk bonds, liars’ loans, and other trashy debts into AAA-rated credits. This financial engineering was a great business while it lasted. But it was all mostly a huge fraud.
In the June 9, 2009 Morning Briefing, I wrote: “Before the crisis started in 2007, the fastest growing business was the Credit Insurance Fraud Industry. This industry emerged following the Basel Accords of 1988. The banking regulators of the major industrial nations agreed to impose uniform capital requirements on banks. Risky assets required more capital. The credit insurance fraud industry employed an army of financial engineers whose innovations magically transformed the most dodgy loans and bonds into AAA securities. Many of these products were defective. Fraud was rampant in the industry. The worst offenders were the credit rating agencies that had awarded triple-A ratings to thousands of CDOs.”
Lloyd Blankfein, the chief executive of Goldman Sachs, wrote an article in the February 8, 2009 FT titled, "Do not destroy the essential catalyst of risk." He observed that it should have been obvious that there was something not right about CDOs: “In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A. It is easy and appropriate to blame the rating agencies for lapses in their credit judgments. But the blame for the result is not theirs alone. Every financial institution that participated in the process has to accept its share of the responsibility.” Mr. Blankfein, who is still the CIFI’s capo di tutti capi, should be asked the following three questions under oath: “When did you know this? Why didn’t you alert us sooner? How much money did your firm make selling these bogus instruments to your customers while shorting them at the same time?”
The CIFI’s financial alchemy can create the illusion that trash has been turned into gold, but it’s all hocus pocus; it’s not real. We all know how the CIFI messed up the US mortgage market. Let’s consider its major contributions to the Euro Mess:
(1) The euro transformed Greek debt into German debt. Prior to the introduction of the euro on January 1, 1999, bond buyers required higher yields on European bonds issued by “weak” credits such as the government bonds of Greece, Italy, and Spain versus the much lower yields on German bonds. Indeed, during 1992-1994, the Greek yield was over 20%. It plunged below 4% in June 2003, matching the German yield. The government bond yields of all the other members of the euro zone also converged to equal the German yield.
The euro had converted the junk debt of some of the members into AAA credits. But not for long, given that now the Greek yield is 25%. That yield soared after a new Greek government revealed in late 2009 that the previous one had fraudulently understated the size of its fiscal deficit. In other words, governments can be involved in the CIFI.
The Bond Vigilantes became much less vigilant and stopped doing their due diligence on the credit quality of what are now called the “peripheral” countries of the euro zone. So, the buyers of the bonds willingly bought into the fraud and enabled the CIFI to expand like mad. Besides, is it really necessary to do any credit research at all on any bond if you can protect against its default by purchasing the CIFI’s insurance policies against such “credit events?” The answer to this question should have been, “Yes, it is!”--especially after AIG blew up. Instead, European banks loaded up on euro-denominated sovereign debt as though it was all issued by Germany.
(2) The Euro Mess may be morphing into AIG-2.0. The October 16, 2008 issue of BusinessWeek had a very good analysis of how AIG brought down the European banks: "How AIG'S Credit Loophole Squeezed Europe's Banks." Before the financial crisis hit, AIG did a booming business in credit default swaps. The biggest buyers were European banks, whose deals during 2007 with AIG totaled a staggering $426 billion. “But the banks didn’t always buy the swaps as insurance against defaults--they often used them to skirt capital requirements… By owning credit default swaps, banks could make it appear as if they had off-loaded most of the risk of a loan to AIG or another firm, thereby reducing their capital needs. The perfectly legal ploy allowed banks across the Continent to free up money to make more loans. It was part of the game taking place across the global financial system. During the boom, firms seemingly created money out of nothing, propelling the markets to unsustainable heights. Such excessive risk-taking has brought down several European lenders.” The European banks had set aside only 1.6% of a loan's value, rather than 8%. When AIG imploded on September 15, 2008, European banks suddenly found themselves up the creek without a paddle. That’s where they are again now.
European leaders have fashioned three Grand Plans (GP) so far. All three seem to have turned their sovereign debt problem into a full-blown banking crisis. The first Greek rescue plan (GP-1.0) was approved on May 9, 2010 and established the EFSF. By July 21 of this year, a second rescue plan (GP-2.0) was needed. It included voluntary haircuts of 20% and increased the size of the EFSF. In the third plan (GP-3.0) on October 27, lenders were forced to accept a voluntary 50% haircut on their Greek debt. The latest plan is shaping up to be AIG-2.0 because banks holding European sovereign debt can no longer be sure that the CDS contracts they purchased to insure against defaults will be honored. So, they’ve been selling their bonds. In principle, the EFSF was expanded again under GP-3.0 to buy these bonds, but the details remain in limbo.
(3) The EFSF is a CDO-Squared. On Friday, ECB President Mario Draghi hit back at the European leaders who have recently called on the ECB to clean up the Euro Mess for them. Instead, he insisted that they implement their bailout fund: “We are more than one and a half years after the summit that launched the EFSF as part of a financial support package amounting to 750 billion euros or one trillion dollars; we are four months after the summit that decided to make the full EFSF guarantee volume available; and we are four weeks after the summit that agreed on leveraging of the resources by a factor of up to four or five and that declared the EFSF would be fully operational and that all its tools will be used in an effective way to ensure financial stability in the euro area. Where is the implementation of these long-standing decisions?,” he demanded to know in a speech at the European Banking Congress, "Continuity, consistency and credibility," European Central Bank (November 18, 2011).
The EFSF has slammed into a brick wall because it is based on the faulty premise that Europe’s non-AAA debtors can join together with the AAA-rated ones to form a triple-A-rated rescue fund that can borrow on behalf of the debtors who need to be rescued. That sure sounds like the super-senior tranche of a CDO. The assumption is that the fund will remain AAA-rated even if it is expanded. That assumption held up after the EFSF was increased to €440 billion on July 21, but the non-AAA guarantors of the fund (i.e., Italy and Spain) were downgraded because they thus became exposed to more liability. When the EFSF was expanded in principle again on October 27 to over €1 trillion--in effect, a CDO-Squared--the details of how this would be done were omitted to avoid a downgrade of France’s AAA rating, which would have forced the rating agencies to lower the credit rating of the EFSF.
Note: This is an excerpt from today’s Morning Briefing for our subscribers.