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higher interest rates are less attractive to them. In the last “normal”
correction of the housing market, between 1989 and 1991, median
home prices dropped by 17 percent, and 3.6 million mortgages went
into default. Analysts estimated, however, that the same decline in
2005 would have produced 20 million defaults, because the average
equity-to-debt ratio (the percentage of a home that is actually “owned”
by the homeowner) had dropped dramatically. The ratio went from
37 percent in 1990 to a mere 14 percent in 2005, a record low, because
$3 trillion had been taken out of property equities in the previous four
years to sustain consumer spending.3
What would 20 million defaults do to the money supply? Al Martin
cites a Federal Reserve study reported by Alan Greenspan before the
Joint Economic Committee in June 2005, estimating that two trillion
dollars would simply evaporate along with these uncollectible loans. That
means two trillion dollars less to spend on government programs, wages
and salaries. In 2005, two trillion dollars was about one-fifth the total
M3 money supply. Accompanying that radical contraction, analysts
predicted that stocks and home values would plummet, income taxes
would triple, Social Security and Medicare benefits would be slashed
in half, and pensions and comfortable retirements would become
things of the past. And that was assuming housing prices dropped by
only 17 percent. A substantially higher drop was feared, with even
more dire consequences.4

Fannie and Freddie: Compounding the Housing Crisis with
Derivatives and Mortgage-Backed Securities

In a June 2002 article titled “Fannie and Freddie Were Lenders,”
Richard Freeman warned that the housing bubble was the largest
bubble in history, dwarfing anything that had gone before; and that it
has been pumped up to its gargantuan size by Fannie Mae (the Federal
National Mortgage Association) and Freddie Mac (the Federal Home
Mortgage Corporation), twin volcanoes that were about to blow.
Fannie and Freddie have dramatically expanded the ways money can
be created by mortgage lending, allowing the banks to issue many
more loans than would otherwise have been possible; but it all adds
up to another Ponzi scheme, and it has reached its mathematical limits.
Focusing on the larger of these two institutional cousins, Fannie
Mae, Freeman noted that if it were a bank, it would be the third larg-
est bank in the world; and that it makes enormous amounts of money

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in the real estate market for its private owners. Contrary to popular
belief, Fannie Mae is not actually a government agency. It began that
way under Roosevelt™s New Deal, but it was later transformed into a
totally private corporation. It issued stock that was bought by private
investors, and eventually it was listed on the stock exchange. Like the
Federal Reserve, it is now “federal” only in name.
Before the late 1970s, there were two principal forms of mortgage
lending. The lender could issue a mortgage loan and keep it; or the
lender could sell the loan to Fannie Mae and use the cash to make a
second loan, which could also be sold to Fannie Mae, allowing the
bank to make a third loan, and so on. Freeman gives the example of a
mortgage-lending financial institution that makes five successive loans
in this way for $150,000 each, all from an initial investment of
$150,000. It sells the first four loans to Fannie Mae, which buys them
with money made from the issuance of its own bonds. The lender
keeps the fifth loan. At the end of the process, the mortgage-lending
institution still has only one loan for $150,000 on its books, and Fannie
Mae has loans totaling $600,000 on its books.
In 1979-81, however, policy changes were made that would flood
the housing market with even more new money. Fannie Mae gathered
its purchased mortgages from different mortgage-lending institutions
and pooled them together, producing a type of lending vehicle called
a Mortgage-Backed Security (MBS). Fannie might, for example, bundle
one thousand 30-year fixed-interest mortgages, each worth roughly
$100,000, and pool them into a $100 million MBS. It would put a loan
guarantee on the MBS, for which it would earn a fee, guaranteeing
that in the event of default it would pay the interest and principal due
on the loans “fully and in a timely fashion.” The MBS would then be
sold as securities in denominations of $1,000 or more to outside
investors, including mutual funds, pension funds, and insurance
companies. The investors would become the owners of the MBS and
would have a claim on the underlying principal and interest stream of
the mortgage; but if anything went wrong, Fannie Mae was still
responsible. The MBS succeeded in extending the sources of funds
that could be tapped into for mortgage lending far into U.S. and
international financial markets. It also substantially increased Fannie
Mae™s risk.
Then Fannie devised a fourth way of extracting money from the
markets. It took the securities and pooled them again, this time into
an instrument called a Real Estate Mortgage Investment Conduit or


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REMIC (also known as a “restructured MBS” or collateralized mort-
gage obligation). REMICs are very complex derivatives. Freeman
wrote, “They are pure bets, sold to institutional investors, and indi-
viduals, to draw money into the housing bubble.” Roughly half of
Fannie Mae™s Mortgage Backed Securities have been transformed into
these highly speculative REMIC derivative instruments. “Thus,” said
Freeman, “what started out as a simple home mortgage has been
transmogrified into something one would expect to find at a Las Ve-
gas gambling casino. Yet the housing bubble now depends on pre-
cisely these instruments as sources of funds.”
Only the first of these devices is an “asset,” something on which
Fannie Mae can collect a steady stream of principal and interest. The
others represent very risky obligations. These investment vehicles have
fed the housing bubble and have fed off it, but at some point, said
Freeman, a wave of mortgage defaults is inevitable; and when that
happens, the riskier mortgage-related obligations will amplify the crisis.
They are particularly risky because they involve leveraging (making
multiple investments with borrowed money). That means that when
the bet goes wrong, many losses have to be paid instead of one.
In 2002, Fannie Mae™s bonds made up over $700 billion of its
outstanding debt total of $764 billion. Only one source of income was
available to pay the interest and principal on these bonds, the money
Fannie collected on the mortgages it owned. If a substantial number
of mortgages were to go into default, Fannie would not have the cash
to pay its bondholders. Freeman observed that no company in America
has ever defaulted on as much as $50 billion in bonds, and Fannie Mae has
over $700 billion “ at least ten times more than any other corporation in
America. A default on a bonded debt of that size, he said, could end
the U.S. financial system virtually overnight.
Like those banking institutions considered “too big to fail,” Fannie
Mae has tentacles reaching into so much of the financial system that if
it goes, it could take the economy down with it. A wave of home
mortgage defaults would not alone have been enough to bring down
the whole housing market, said Freeman; but adding the possibility of
default on Fannie™s riskier obligations, totaling over $2 trillion in 2002,
the chance of a system-wide default has been raised to “radioactive”
levels. If a crisis in the housing mortgage market were to produce a
wave of loan defaults, Fannie would not be able to meet the terms of
the guarantees it put on $859 billion in Mortgage-Backed Securities,
and the pension funds and other investors buying the MBS would

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suffer tens of billions of dollars in losses. Fannie™s derivative obligations,
which totaled $533 billion in 2002, could also go into default. These
hedges are supposed to protect investors from risks, but the hedges
themselves are very risky ventures. Fannie Mae has taken
extraordinary measures to roll over shaky mortgages in order to obscure
the level of default currently threatening the system; but as households
with declining real standards of living are increasingly unable to pay
rising home prices and the demands of ever larger mortgages and
higher interest payments, mortgage defaults will rise. The leverage
that has been built into the housing market could then unwind like a
rubber band, rapidly de-leveraging the entire market.5
In 2003, Freddie Mac was embroiled in a $5 billion accounting
scandal, in which it was caught “cooking” the books to make things
look rosier than they were. In 2004, Fannie Mae was caught in a
similar scandal. In 2006, Fannie agreed to pay $400 million for its
misbehavior ($50 million to the U.S. government and $350 million to
defrauded shareholders), and to try to straighten out its books. But
investigators said the accounting could be beyond repair, since some
$16 billion had simply disappeared from the books.
Meanwhile, after blowing the housing bubble to perilous heights
with a 1 percent prime rate, the Fed proceeded to let the air back out
with a succession of interest rate hikes. By 2006, the housing boom
was losing steam. Nervous investors wondered who would be
shouldering the risk when the mortgages bundled into MBS slid into
default. As one colorful blogger put it:
So let me get this straight . . . . Is the following scenario below
actually playing out?
For starters ma n™ pa computer programmer buy a 500K
house in Ballard using a neg-am/i-o [negative amortization
interest-only mortgage] sold to them by a dodgy local fly-by night
lender. That lender immediately sells it off to some middle-man
for a period of time. The middlemen take their cut and then sell
that loan upstream to Fannie Mae/Freddie Mac before it becomes
totally toxic and reaches critical mass. At which point FM/FM
bundle that loan into a mortgage backed security and sell it to
pension funds, foreign banks, etc. etc.
What happens when those loans go into their inevitable
default? Who owns the property at that point and is left holding
the bag?6


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Web of Debt

Nobody on the blog seemed to know; but according to Freeman,
Fannie Mae will be holding the bag, since it guaranteed payment of
interest and principal in the event of default. When Fannie Mae can™t
pay, the pension funds and other institutions investing in its MBS will
be left holding the bag; and it is these pension funds that manage the
investments on which the retirements of American workers depend. When
that happens, comfortable retirements could indeed be things of the
past.

What Happens When No One Has Standing to Foreclose?

In October 2007, a U.S. District Court judge in Ohio threw an-
other wrench in the works, when he held that Deutsche Bank did not
have standing to foreclose on 14 mortgage loans it held in trust for a
pool of MBS holders. Judge Christopher Boyko said that a security
backed by a mortgage is not the same thing as a mortgage. Securitized
mortgage debt has become so complex that it™s nearly impossible to
know who owns the underlying properties in a typical mortgage pool;
and without a legal owner, there is no one to foreclose and therefore
no actual “security.”7 That could be good news for distressed bor-
rowers but a major blow to MBS holders. Outstanding securitized
mortgage debt now comes to $6.5 trillion -- or it did before its value
was put in doubt. What these securities would fetch on the market
today is hard to say. If large numbers of defaulting homeowners
were to contest their foreclosures on the ground that the plaintiffs
lacked standing to sue, $6.5 trillion in MBS could be in jeopardy. The
MBS holders, in turn, might have a very large class action against the
banks that designed these misbranded investment vehicles.8
The discovery that securities rated “triple-A” may be infected with
toxic subprime debt has made investors leery of investing and lenders
leery of lending, and that includes the money market funds relied on
by banks to balance their books from day to day. The entire credit
market is at risk of seizing up.
It is at risk of seizing up for another, more perilous reason . . . .




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Chapter 32
IN THE EYE OF THE CYCLONE:
HOW THE DERIVATIVES CRISIS HAS
GRIDLOCKED THE BANKING SYSTEM


In the middle of a cyclone the air is generally still, but the great
pressure of the wind on every side of the house raised it up higher and
higher, until it was at the very top of the cyclone; and there it remained
and was carried miles and miles away.
“ The Wonderful Wizard of Oz,
“The Cyclone”




T he looming derivatives crisis is another phenomenon
often described with weather imagery. “The grey clouds are
getting darker,” wrote financial consultant Colt Bagley in 2004; “the
winds only need to kick up and we™ll have one heck of a financial
cyclone in the making.”1 A decade earlier, Christopher White told
Congress:
Taken as a whole, the financial derivatives market, orchestrated
by financiers, operates with the vortical properties of a powerful
hurricane. It is so huge and packs such a large momentum, that
it sucks up the overwhelming majority of the capital and cash
that enters or already exists in the economy. It makes a mockery
of the idea that a nation exercises sovereign control over its credit
policy. 2
Martin Weiss, writing in a November 2006 investment newsletter,
called the derivatives crisis “a global Vesuvius that could erupt at
almost any time, instantly throwing the world™s financial markets into
turmoil . . . bankrupting major banks . . . sinking big-name insurance
companies . . . scrambling the investments of hedge funds . . .
overturning the portfolios of millions of average investors.”3
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Chapter 32 - In the Eye of the Cyclone

John Hoefle™s arresting image was of fleas on a dog. “The fleas
have killed the dog,” he said, “and thus they have killed themselves.”4
Colt Bagley also sees in the derivatives crisis the seeds of the banks™
own destruction. He wrote in 2004:
Once upon a time, the American banking system extended loans
to productive agriculture and industry. Now, it is a vast betting
machine, gaming on market distortions of interest rates, stocks,
currencies, etc. . . . JP Morgan Chase Bank (JPMC) dominates the

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