Financial Plumbing Problems

It may feel the same with this financial crisis as it did 14 years ago, but this is much different. Yes, both initiated by politicians and governments. The 2008 “Great Financial Crisis” was started several years previous when the US government felt that Everyone should be a homeowner regardless of their credit worthiness.

You had a number of shady mortgage operations seize the day and the sub-prime mortgage business was under way. These mortgages (backed by the likes of Freddie Mac and Fannie Mae) were packaged into investment buckets and slapped with a fancy Triple AAA credit sticker. With this high-grade sticker, large investment banks would market them as income investments (the buyers would be pension funds, endowments, and John Q Public).

To juice returns, the investment banks traded Credit Default Swaps (CDS). In this instance CDS’s were designed as a form of insurance on bad mortgages in the pool. The banks traded them and used CDSs as a profit center. Credit Default Swaps were often backed by some of the largest insurance companies believing they were backing a Risk-Free investment. After all they were Triple AAA quality and backed by Fannie and Freddie. It was all a house of cards!

We all know how this story ended:

• Lehman Brothers, founded in 1847, filed for bankruptcy on Sept 15, 2008.
• Bear Stearns, founded in 1923, was forced to sell to JP Morgan in March 2008.
• Merrill Lynch, founded in 1914, walked into a shotgun wedding with Bank of America.
• Wachovia was insolvent and sold to Wells Fargo on Oct 3, 2008.
• AIG, the largest insurer in North America, is bailed out by the US Government.
• TARP (Troubled Asset Relief Program) - Many banks and insurance companies took TARP funds to sure up the book.

This is the result of the unintended consequence of government bureaucrats, with little to no banking experience encouraging poor risk decisions. As for the brokerage firms, they lacked discipline and risk controls as they sought investment profits.

The mess we find ourselves in today stems from our response to the last crisis. In 2008, it was a banking issue. Today, we are dealing with a sovereign credit issue (too much government debt globally). We often accuse politicians of overpromising and under delivering. Sometimes we may be better off if politicians didn’t bring home the bacon.

We live in a global world and the financial plumbing is as intertwined as a bowl of pasta. Just like in the law of physics, action will create a reaction of some kind. Central Bankers and governments have finally discovered the point of maximum government debt. Just think of what has happened this year.

The rising interest rates (albeit necessary) have created a situation where the interest we pay annually would fund the entire defense department. How crazy is that?