FEUDALISM

During the decline of the Roman Empire (around the 3d Century AD), increased
tax demands by Rome crippled the peasant class by reducing tenant farmer to serfs.
And this leads us into an economic model known as Feudalism. Feudalism was
prominent between the 9th and 15th Centuries. While it has no broadly accepted
definition, feudalism was common in Japan and Europe. There were three basic
components or attributes of Feudalism. First, you had a Lord, a nobleman, who
held huge tracts of land. The Lord granted possession of lands to a Vassal to
exploit, and in return the Vassal would pledge armies for the protection of the
Lord. The actual pieces of land granted to the Vassals were called fiefdoms, or
fiefs. And those fiefs were farmed by peasants known as serfs. The serfs farmed
in exchange for their keep (this is known as subsistence farming). Lord, Vassal
and Serfs were all loyal to the King.

Serfs could not abandon land without permission from the Lord, nor could they
hold title to any lands. There were also peasants known as Freeman, who were
rent paying tenant farmers. They owed little or no service to Lords. In 11th
Century England, 10% of peasants were Freeman. However, Freeman frequently
wound up serfs if economic conditions became harsh– crop failures, for example.
Serfs paid taxes and fees usually by working the fields or in the Lord’s manner for
a certain number of days (the rest of the days they worked to sustain their
families). Fees were normally paid in the form of crops.
Up until the 12th Century, less than 5% of Europe’s population lived in towns.
Skilled workers lived in the town, but still earned their keep from Lords rather than
a real wage.

So, what were the economic implications of feudalism?
For one thing, there was a lack of technological innovation. Since serfs were
merely subsistence farmers working for a Lord, they had no incentive for
technological innovation, nor incentive to cooperate with other serfs. The Lords
had no innovation incentive either since they did not produce goods to sell on the
market. Feudal manners and workers were self-sufficient.

What changed this dynamic? One of the largest transformational events affecting
Feudalism, was the Black Plague, aka The Bubonic Plague. The plague began
around 1346, and quickly killed 1.5 of 4 million Europeans. By 1400, 75-100
million people died worldwide. There would be more outbreaks from time to time,
and, in effect, the plague lasted until the 19th Century. And what does this have to
do with Economics, you might ask?
The plague created a tremendous labor shortage. Family guilds had to train and
hire outside workers, who were now moving into towns for a wage. Even Lords
had to pay to get labor. Birth rates exploded, and child labor became a huge
engine of economic development, as did a more active slave trade. Serfs were now
earning a real wage for their labor instead of simply subsistence farming.

MERCANTILISM

Feudalism had laid some of the foundations necessary for the development of
Mercantilism, our next economic model. A precursor to Capitalism, Mercantilism
is basically trade for profit, but where the government institutes controls to assure
the prosperity and security of the state. Mercantilism began principally as trade
between towns, but it was non-competitive trade since the towns trading with each
other had different goods or services to offer. Then over time, as demand
increased within the respective towns for the same goods and services, the products
and services became homogenized between those towns, thus trade had to spread.
First, county to county, then province to province, and eventually between nations.
What happens when nations become competitive with each other for trade? Often,
it stokes feelings of nationalism and sparks wars.

Among the measures governments took to protect the State, and promote
prosperity within, were: High tariffs to discourage imports; banning gold and
silver exports; limiting wages to keep profits high; forbidding trade with foreign
ships and colonies; and subsidizing home production of manufactured goods. The
State also took the place of local guilds as regulators of the economy. Before the
State usurped that function, there had been a collection of merchants from different
towns, such as the Hanseatic League in Germany, which pooled resources and
instituted regulations for conducting and protecting business. And finally, a vitally
important governmental measure instituted to protect and promote the State, was
the granting of monopolies to merchants that engaged in oceanic voyages-- leading
to colonization.

COLONIZATION

Oceanic voyages, while potentially fantastically profitable, were extremely
dangerous and risky. They required huge investments, and the returns on those
investments could take years to see. Merchants needed to be induced to risk their
fortunes. Kingdoms wanted to not only increase trade, but to extend their nation’s
reach via settlements and colonies. Most importantly, they wanted to mine the
natural resources from those colonies to send back to the motherland-- especially
precious metals such as gold and silver.

So, how did the Crown induce wealthy merchants to invest in these conquests?
One way was to grant Company charters – a monopoly to a company or
association for a number of years on trade within a certain region. With that
Charter came broad legal powers to enforce order in distant lands. There were also
some restrictions that came with the Charter. Colonies couldn’t trade with other
nations. In the case of England’s America, the colonists had to buy back finished
products with a pseudo currency that couldn’t be used anywhere else.

Still, a large number of speculators were needed. Thus was born the Joint Stock
Company, in which risk could be spread among many investors. Investors could
buy into a company and own the right to share in the profits in proportion to their
amount of stock. Britain issued their first joint stock backed charter in 1555, The
Muscovy Company. Other well known charter’s issued were: The East India
Company in 1600; The Hudson’s Bay Company in 1670; and The South Sea
Company in 1711.

So how did all these investors come to invest in these joint stock ventures? How
did they learn of the opportunities? Was it from a “town crier” on a street corner
or notices posted on doors? Very often, it was from within the first “Starbucks.”
In 1652, the first coffee house opened in England called Jonathon’s Coffee House.
Merchants would gather to partake in this new fashionable rage of drinking coffee
and talking business– many joint stock deals were consummated there.
Meanwhile, at another popular coffee house, Edward Lloyd’s, ship captains and
ship owners would also congregate to discuss business. Here, some investors
began gambling on the success of a voyage by ensuring the voyage against loss in
exchange for a premium. The “insurance” business grew in popularity at this
coffee house which later became known as Lloyd’s of London.

The joint stock structure was next adopted by unincorporated companies (those
trading without a royal charter). Previously, investors were buying stock in
companies with which they had a personal link, such as merchants seeking to sell
goods, etc. Now, investors could buy into a company in which they had no link.
Share prices were simply set by whatever price the buyer and seller agreed upon.

So, if you were an investor with no personal link to a company’s core business,
how did you find out about that opportunity? You needed someone with access to
those opportunities that would present them to you. This led to the advent of stock
brokers, who would arrange deals between buyers and sellers of shares, in
exchange for a cut of each transaction. By 1773, these popular brokers at
Jonathon’s coffee house labeled themselves – the stock exchange.
Along with colonization fever came an explosion in the growth of slavery.
Imperial powers such as France, Britain, Spain, Netherlands, Portugal and others
amassed worldwide empires primarily from agricultural plantations using African
slaves.
By 1552, African slaves comprised 10% of the population of Lisbon. Slavery was
a vital part of the Brazilian colonial economy, especially with regards to sugar cane
and mining production. Brazil had obtained 38% of all African slaves traded.

British colonies in the West Indies were unable to match the low cost of Brazilian
sugar in the marketplace. Moreover, Brits had become huge consumers of
product-- averaging 16 pounds per person per year by the 19th Century. This
eventually led, along with pressure from Evangelical reformers back in the U.K., to
intense lobbying by the British government for the Brazilians to end slavery.
However, those lobbying efforts came long after the British themselves had
become the principal purveyors of slaves. In fact, by the time of the Industrial
Revolution, profits from the slave trade and the West Indian plantations
represented 5% of the British economy.

ASSET INFLATED BUBBLES

Now, let’s jump back to the 1600s and a time of increased speculation,
specifically, the Netherlands in 1633. It is here where we witnessed the world’s
first “asset inflated bubble” from 1633-1637. First, what do we mean by an “asset
bubble”? Basically, it’s a sharp increase in the value of an asset which has no
relation to any fundamental economic reason, such as an increase in a product’s
quality or that it fills a needed demand for its use. So what was the first bubble?
Apparently, tulip bulbs. Tulips had become a huge status symbol in Europe, and
especially in the Netherlands. In fact, a single tulip bulb could be a bride’s dowry.
Houses and estates were mortgaged to buy rare bulbs so they could be resold, sight
unseen, to buyers. At its peak, a single bulb could sell for 10 times the annual
income of a skilled craftsman.

The belief was that the high prices would last forever and wealthy Europeans
would flock to buy them. There are, however, some modern scholars that
challenge the notion that there was a wide scale bubble burst in which many people
lost fortunes. Those scholars maintain that it was a relatively small number of
people who traded and lost. But the fact remains, there was an incredible increase
in the price of tulips, and then 4 years later it was gone. Does the psyche behind
that bubble sound familiar? Tulip prices will stay high forever, or “better get in
now while you still can.” As of the date of this publication, think about gold,
internet stocks, and contemporary art. It seems highly likely, that those assets are
experiencing a bubble. Take gold for instance, in October of 2007 gold sold at
$740 an ounce. A year later it was $1000 an ounce. In August of 2011, it sold for
$1800 an ounce. Recently, it has dipped down to roughly $1,720 an ounce, but
still significantly higher than 4 years ago. As for contemporary art, 2011 saw $5.5
billion of art sales in auctions alone, as compared to slightly over $1 billion in
2005.

Back to tulips and how this relates to Kabbalah. Perhaps it is no accident that the
first recorded bubble is literally due to seeds. This brings us to the Kabbalistic
concept of the planting of seeds, and the disconnect caused by time, space, and
motion. Every action we take, and even every thought we have, is a seed planted.
It has a consequence. Something will grow, either positive or negative. It is not a
question of “if,” it is a question of “when”. According to Kabbalah, there is no
such thing as "suddenly," such as: “He had a sudden heart attack”; “She suddenly
fell out of love”; “We suddenly ran out of cash”; or “The bottom suddenly fell out
of the market.” However, because of the existence of time, space and motion
(examples of physical laws of nature), there is often a distance or disconnect
between the planting of a seed and experiencing the fruit or effect of the planting.
And because of this disconnect, we often believe we have “gotten away with
something,” when there is a delay between the planting of a negative seed (a lie, a
crime, gossip, acting for the self alone) and the consequence of that planting.
Kabbalah tells us that we never get away without a reaction from an action. It may
take days, weeks, months, years, or even lifetimes, but there will always be a
consequence. And chaos may seem sudden because time has separated cause from
effect. Similarly, we may not see the benefits for a long time or even in our
lifetime of positive seeds being planted because of the disconnect of time, space
and motion. And just like believing “we got away with something,” in the case of
negative seeds, here we sometimes believe “it doesn’t pay to live by ‘the rules’ or
do the ‘right’ thing,” so we get discouraged and may alter our behavior and
choices. The important Kabbalistic lesson to take away here is that at the time we plant a seed, whether it be in our thoughts or actions, if we plant it without “an
agenda” or without the intention of acting for the self alone or to purposely hurt
another, the effect is irrelevant; we have already taken a step towards lasting
fulfillment.
As we pass through the numerous cycles of economic boom and bust, consider the
planting of a seed (the start of a bubble) and how long it takes before that bubble
bursts. But before we examine some of those other cycles, I want to point out
another significant historical event which fueled the world’s economic engine.
In 1651, the Great Assembly of the Netherlands adopted a Calvinist version of the
Reformation as the State’s religion. Why is that important? Predominantly,
because it removed the Catholic stigma associated with money lending, and
culturally internalized the doctrine of predestination-- namely, if virtuous people
are predestined to be saved in the hereafter, then it’s only logical that success in
this life is an advanced indication of God’s favor.

PAPER MONEY

We skip now to 1716 France, where the crown has incurred massive deficits due to
wars waged by Louis the 14th, as well as the building of extravagant palaces.
Compounding the difficulties, a shortage of precious metals leads to a shortage of
coins minted and, to top it off, creditors want their money back without delay.
France turns to a Scotsman, named John Law, who implements his theory on how
to lower the national debt while stimulating the economy at the same time. With
the Crown’s permission, he forms a National Bank. The Banque Generale, issues
promissory notes as currency – paper money, backed by depositor’s land, gold and
silver. These notes could be traded for whichever precious metal requested upon
the immediate demand of the note holder. The Banque Generale was private, but
75% of The Banks’s capitalization consisted of Government issued notes, and
government accepted notes-- again, paper. France was not the first country to issue
paper money. China issued paper bank notes in 806 AD. Sweden issued paper
money in 1661 and England in 1694. But John Law was in an entirely different
league when it came to finance. If he were alive today, he’d likely be running one
of the investment houses on Wall Street.

Law believed that the more paper money in circulation, the more commerce would
be generated. He allowed people to pay taxes with paper money. He also
instituted many beneficial reforms such as helping peasants, building roads,

abolishing tolls, and offering low interest loans to start new industries. Within two
years, the number of French export ships went from 16 to over 300.

Now, here’s where it gets a bit tricky. After replacing gold with paper credit, Law
allowed holders of Royal debt to replace their notes with shares in speculative
economic ventures. One such popular venture was the Louisiana Company. In
1717, investors, eager to own shares in gold, diamonds, and gems to be harvested
in Louisiana flocked to invest. Shares sold out, and then investors bought shares
from other investors with paper money. By 1719, the value of shares in The
Company rose 36 times their original value with no real riches discovered in
Louisiana. The millions of paper notes traded, even among the working class,
gave rise to a new term-- “Millionaire.” Remember, a precipitous rise in value for
no sound economic reason translates to-- a bubble.

Eventually, John Law effectively controlled all of the trade between France and the
world outside of Europe. He was granted control of French charters for trading
companies to the East and West Indies, China, Africa and the U.S. territories. He
purchased the right to mint new French coins, and to collect most of France’s
taxes. Essentially, he ran Europe’s most successful conglomerate. Law paid for
these privileges by issuing more shares in his companies. The shares could be
bought with notes, either from his bank, or with government debt.

Even though Louisiana never produced real value for France, no precious metals or
gems, the main problem with the system of paper money, was only one fifth of that
paper money was backed by gold. When word spread that there wasn’t enough
gold to back the notes, panic ensued. Fifty people died in a stampede in Paris, to
exchange their notes. The crown tried to stem people from exchanging their notes
by devaluing the price of gold, but that didn’t stop investors from wanting to cash
in their notes. The Government next responded by prohibiting the printing of
paper money, but that didn’t work either. Next they prohibited selling gold.
Finally, they closed the Banque, and seized control of the trading companies. John
Law fled France, disguised as a woman, and died a pauper. This episode was
known as the Mississippi bubble. The experience was so distasteful to the French
that they didn’t issue paper money again until Napoleon needed to fund his war
efforts in 1800.

Meanwhile, over in England in 1720, before the Mississippi bubble burst, shares in
the South Sea Company were also skyrocketing. The South Sea Company, had a
monopoly on British trade from South America to the Pacific. Taking a page from
John Law, the government sought to reduce their national debt by offering to exchange government bondholders shares in The Company. Within 8 months, the
share value increased eight fold. By year’s end, shares were back to their original
value. At the same time, there was a proliferation of unincorporated joint stock
offerings (companies not authorized by royal charter). Many, if not most, of these
offerings were fraudulent.
Arguably, this proliferation of fraudulent offerings led England to pass the “Bubble
Act” in 1720, which restricted the formation of joint stock companies, not
authorized by Royal Charter. I say “arguably” because many scholars believe that
the passage was really not in response to fraud, but to stem competition with the
South Sea Company shares, since the bubble hadn’t burst on the South Sea
Company at the time of The Act's passage. An important consequence of the Act,
was that investors circumvented the law by forming joint stock companies but
calling them something else-- particularly insurance companies.

CAPITALISM

As we move along through history, technological innovation becomes the rage.
The first water powered cloth mill opens in England in 1771. James Watt delivers
the first steam engine to purchasers in 1776. The industrial revolution has begun.
Where land had been the traditional source of wealth and the natural investment for
the wealthy, capital is now placed into manufacturing ventures. Adam Smith
publishes his “Wealth of Nations,” denouncing mercantilism as an inhibitor of
growth, and monopolies as stifling competition. He promotes “laissez faire”
capitalism – the literal translation “let do,” later becomes known as “leave it
alone.” He touts the elimination of all tariffs, regulations, and state interference.
Smith basically decried that public good will follow naturally from the
untrammeled pursuit of private interest. This, by the way, is the exact opposite of
what Kabbalah teaches. In Kabbalah, the untrammeled pursuit of private interest is
known as acting for the self alone. Remember, Kabbalah teaches that that behavior
will inevitably lead to chaos. Well, maybe that’s just a theory. Let’s keep
examining history and you can draw your own conclusions.

With the dawn of the industrial revolution, economic boom is ushered into
England. Investors become eager to invest, and in 1825 the Bubble Act is repealed
in England. Once again, numerous fraudulent schemes evolve and that leads to the
first meaningful and effective regulatory law promulgated in the UK-- The Joint
Stock Companies Act of 1844.
11
What was the economic effect of the Industrial Revolution? The Industrialist
replaced the merchant as the dominant actor in the Capitalist system. Artisans and
guilds declined in prominence. Factories sprang up in cities since new technology
meant that production did not have to be near waterways, and labor was plentiful in
cities. Cash crop production rose to feed a new market rather than the subsistence
farming vital to Feudalism. The rise of commercial agriculture and textile
production encouraged increased mechanization, such as Eli Whitney’s cotton gin
in 1793.

As time passed, wages increased and eventually the standard of living increased
leading to the birth of a middle class. Back in the United States, the war of 1812
had left the U.S. in significant debt, but America still experienced an economic
boom, mostly because of the damage to Europe’s agricultural markets caused by
the Napoleonic wars. The Bank of The United States (there were 2 Federal Banks
in U.S. History, but we are going to skip most of the specifics of their existence)
aided this boom through its lending, which encouraged land speculation. Land was
doubling and tripling. Land sales in 1819 alone totaled 55 million acres. A sudden
and precipitous increase in prices for no reason, sound familiar? The banks
realized they were massively over extended and began to call in their loans. This
led to a panic in 1819, and a widespread distrust of banks as well as the Bank of
the U.S. The Bank of the U.S. had thrived because it had been a depository for
Federal tax revenue. Later, Andrew Jackson instructed the Secretary of the
Treasury to deposit tax revenues in selected State banks, effectively driving the
U.S. Bank into bankruptcy. This also led to the States borrowing large sums from
the London banks. Many States in the U.S. were borrowing to fund infrastructure
investments in canals and railroads, in order to more efficiently get their goods to
markets.

After the Napoleonic wars, the UK rebounded with increased banking, and
increased trade. Their gold and silver reserves rose from 4 million pounds in the
Bank of England in 1821, to 14 million by late 1824. The London banks were also
undergoing in interesting metamorphosis. At the beginning of the 19th Century,
British banks were essentially clubs of very wealthy families. Gradually, they
became joint stock organizations run by professional managers, and accepted
deposits from a large pool of small savers.

On a side note, a slew of the States in America that had borrowed money, would
not raise taxes to cover those debts after yet another panic in 1837. This led to a
wave of defaults of state banks, and even the default of the States of Maryland and Pennsylvania both of which had refused to implement property taxes before they
defaulted.
We’ll jump ahead now to 1861, where Civil War breaks out in the United States.
President Lincoln closes ports in “rebellion areas” to international commerce.
Britain and France have to shift their reliance on cotton to Africa and Asia. This
creates pressure for an Anglo-French controlled Suez Canal, which opens in 1869.
In 1862, The U.S. passes The Homestead Act, hoping to shape the western region
by populating it with farmers. The Northerners wanted not just to create an
Agrarian base, but also wanted to break the institution of slavery and promote the
Union. The U.S. sold 160 acres of public land for $1.25 per acre to anyone who:
didn’t fight against the Union and promised to work the land for 5 years. The offer
was open to immigrants and women. Loans for livestock, seeds, barb wire, etc,
became easy to get and plentiful. Towns borrowed money for roads and buildings.
Speculators, Railroad and Timber companies bribed the residents to get the best
land (many speculators submitted fraudulent claims as well). The lion’s share of
public land went to those Companies and Speculators. In 1869, The Union Pacific
railroad spanned the entire North American continent.

In January of 1887, a major blizzard hit the new west, and thousands of cattle
perished. The harsh winter was followed by a summer drought. International
wheat prices fell 30%. Most of the financing in the Country now comes from the
main financial center, Wall Street. Borrowers default, credit dries up and the focus
of politicians and economists switches to the solvency of U.S. currency.
Consensus arises that gold reserves need to be $100 million.

In 1893, Gold reserves dipped to $80 million. Panic erupted, and investors
frantically seek to exchange their assets for gold. Where have you heard this story
before? 1720 France! But now, 170 years later, over 600 banks, 74 railway
companies, and over 15,000 commercial enterprises fail. Luckily, in 1896 gold is
discovered in Klondike, Alaska, and confidence slowly recovers.

Another interesting economic development in the late 1880s was the extension of
the 14th Amendment of the U.S. Constitution to Corporations. The 14th
Amendment forbids States from denying any persons equal protection of its laws.
It was meant to insure that freed slaves were not denied “life, liberty, or property”
without due process of the law. As for corporations, they originally had very
limited functions within the U.S. They operated under the “privilege” of a state
charter, for a limited time and for limited purposes, with stated capital.

Shareholders were also liable for the corporation’s obligations. At the end of the
Civil War, the U.S. gave huge federal subsidies to the railroads, but lawyers
actively sought to remove the restrictions placed upon those corporations. In
1886, in Santa Clara County v. Southern Pacific Railroad, the Supreme Court
recognized corporations as having the same rights as natural persons to contract, to
buy and sell property, to borrow money, to sue and be sued—and thus to be subject
to the 14th Amendment. But think of this concept carefully for a moment, is a
corporation REALLY a person? A corporation is legally bound to place the
financial interests of its owners above all other interests, including the public good.
It was once allegedly stated by Baron Thurlow: “A corporation has no soul to
save, and no body to incarcerate.”

THE GREAT DEPRESSION

At the turn of the 20th Century, economies were still reliant on horses, wind and
steam power. But by 1929, automobiles, planes, the radio, skyscrapers, ocean
liners, and an array of electrical appliances emerge. Europe declines as the U.S.
soars with its technological industries and financial might. By way of example, in
1880, the U.K.’s share of world trade was over 23%. By 1913, it was down to only
14.1% - Technology, trade, and financial might ushered in the “Roaring Twenties,”
with its unprecedented wealth and excess.
Another significant event in U.S. economic history was the creation of the Federal
Reserve in 1913. It established a central banking system, meant to serve as a
formal “lender of last resort” to banks in the event of a liquidity crisis, like during
panics when depositors seek to withdraw their money faster than banks can pay it
out (commonly referred to as a “run on the banks”). The Federal Reserve was
created in partial response to a severe panic in late 1907, also known as The 1907
Banker’s Panic, in which the NYSE fell 50% from 1906 levels. The Reserve is
also a safe depository for federal monies, and a source of ready capital when the
Federal Government needs to borrow money. All Nationally charted banks had to
become members of the Federal Reserve, and post a set amount of non-interest
bearing reserves. There are 12 member banks, and they are responsible for
regulating the commercial banks within their districts. They are considered nonprofit
since, historically they didn’t pay interest, though they were allowed
dividends limited to 6% per year. But in 2008, Congress granted authority for the
Fed to pay interest on the funds deposited to the reserve. The Fed was also given
the power to "print" money. On a side note, printing money, now referred to as
"quantitative easing," is not done on presses with paper. Rather, creating money
supply is accomplished by the Fed buying short-term federal securities from banks,

and crediting the purchase price to each bank's account in a federal reserve bank.
The selling bank's reserves grow and thus they can lend whatever leverage multiple
allowed by law.
Back to 1917, when another major event in history transpired. In Russia, workers
revolt and overthrow the Tzar. Communism is born. In simplest terms,
communism is a social and economic system whereby the public, “the community”
owns the means of production and distribution of goods and services for the benefit
of the community. This is in direct contravention to capitalism, in which the
private individual owns the means of production and distribution of goods and
services with no obligation towards the public welfare.
If we are all wired with the desire to receive, as the Kabbalists say, then why
wouldn’t communism be the perfect philosophy? It is an entire economic platform
where all needs are met. Everything is provided for the individual. This brings us
to another Kabbalistic principle known as “bread of shame.” Basically, “bread of
shame” is the feeling of discomfort that accompanies unearned good fortune. If
you continually get something for nothing, not only won’t you appreciate it,
eventually you may even grow to resent it and/or the donor or provider.
The problem with communism is that the individual’s drive, their desire to earn, is
not fostered by communism. Pure communism, like pure capitalism will fail—
communism because it fosters bread of shame, and capitalism because it fosters the
desire to act for the self alone. We will discuss more examples of bread of shame
later on.

During the “Roaring Twenties, ” Wall Street went wild. Share prices kept rising
and no one believed they would ever fall. Debt increased to astonishing levels as
did margin trading. Margin trading is when you own shares of stock, let’s say it’s
worth $100K, and the brokerage house or investment bank holding your stock
loans you money against the stock you own to buy more stock. Nowadays,
investment houses will typically loan 50-60% of the value of your shares. If the
price of your stock portfolio declines below your threshold value, you get a
“margin call” requiring you to replenish your account with cash. If you can not
pay the “margin call,” the investment house will sell your stock on the open market
to make up the deficit. In the 1920’s you could routinely buy stocks with 10%
down and the bank would loan the rest. At the same time, Europe entered into a
recession and they could not pay their international creditors with the gold they
had. Also, not surprisingly, U.S. banks were over-extended; confidence weakened
and panic hit again. Depositors began selling stocks, taking money from banks,
and hoarding cash. Banks were toppled in the U.S and Europe.

On October 24, 1929, the stock market crashes. The day becomes infamously
known as “Black Tuesday.” It was the beginning of “The Great Depression,” an
economic calamity which affected basically all Western industrialized nations and
lasted over a decade-- essentially until the outbreak of WWII. Even before Pearl
Harbor, the European Allies looked to the U.S. to help with supplies. After Pearl
Harbor and America’s entrance into the war, the need for workers to make
ammunition, weapons and military air/sea/land crafts contributed to the end of the
Depression by 1941.
So what is a Depression? While there is no generally agreed upon definition, there
are some basic characteristics such as: an extreme form of recession lasting a
prolonged period of time; large increases in unemployment; lack of available
credit; a large number of bankruptcies and bank failures; and deflation. Deflation
is where the price of goods and services decline so your money (if you have any)
actually buys more. In opposition, inflation is a rise in the price of goods and
services so your money buys less.
During the Depression, unemployment in the U.S. hit 25%, and 33% in other
countries. International trade plunged by 50%. Crop prices plunged 60%.
Housing prices declined by almost 80%. As a result of the Depression, capitalism
came under great scrutiny. Fascism rose in several parts of the world. Likewise,
communist and socialist ideologies rose in influence as well.
In 1931 Britain abandoned its gold standard to combat speculators demanding gold
for currency, and thereby threatening the solvency of England’s monetary system.
Obviously, it becomes prohibitively difficult to continuously acquire gold to
exchange for paper when there is too much demand for the exchange. The U.S.
followed suit in 1933.

In 1932-1933 – The Glass-Steagall Acts (GSA) were enacted which imposed
substantial regulations on the financial industry. Banking institutions were given
one year to choose if they wanted to be a commercial bank or an investment bank,
but they could no longer be both. This was to stop investment speculation by
commercial banks. The prior speculation of banks was considered a major cause
of the Great Depression. Banks had bought new issues of stock in companies,
extended unsound loans to those companies, and then encouraged their clients to
buy that stock. After the GSA, only 10% of commercial bank revenue could come
from securities; the one exception being underwriting government bonds. Another
part of the GSA was the formation of the Federal Deposit Insurance Corporation
(FDIC), which insured bank deposits (originally for commercial banks only)
against losses up to a certain amount. In 2010, to quell fears during the global
economic meltdown, the insurance limit on a depositor’s funds was raised from
$100,000 to $250,000. The Federal Reserve Board (the main regulator of U.S.
banks) was responsible for GSA implementation, which turned out to be fairly lax.

KEYENSIAN PHILOSOPHY

In 1938, The U.S. established the Federal National Mortgage Association, aka
Fannie Mae. Previously, the Veteran’s Administration and the Federal Housing
Administration had guaranteed home mortgages. The concept was that Fannie
Mae would buy those mortgages from the banks, which would free up capital for
banks to make more government insured loans. Local banks now had Federal
money to finance home mortgages. The intention was meant to be noble-- increase
home ownership and the availability of affordable housing. It is also important to
note that Fannie could only buy “conforming loans.” Conforming loans are loans
guaranteed or insured by the government, which were originally extended by banks
subject to strict criteria known as the 4 C’s: Credit, Capability, Collateral and
Character. For instance, if you had late payments on a previous mortgage, you
didn’t get a loan. If the principal, interest, property taxes and insurance exceeded
33% of your monthly income, no loan.
In 1944, at the Bretton Woods Conference in New Hampshire, 44 nations agreed to
a system for regulating international monetary relations, thus the International
Monetary Fund, or IMF was born. Countries currencies were pegged against the
U.S. dollar which could then be converted to Gold at a fixed exchange rate.
The fragile recovery from the Great Depression, then WWII, then post-war
reconstruction forced governments to have a close hand in capitalist economies.
Europe and the U.S. saw tough regulations implemented. For example, to prevent
financial conglomerates from amassing too much power the U.S. Congress, in
1956, extended the Glass-Steagall Acts to prevent bankers from underwriting
insurance policies. However, banks could still sell insurance and insurance
products. Protectionist trade tariffs were also introduced.

The 1950s and 60s ushered in a long economic boom in the U.S. and Europe.
Mass consumer goods markets were developed. Keynesian Economics became a
widely accepted method of government regulation. Keynesian philosophy
basically calls for private enterprise, but with an active government and public
sector role. The belief is that governments should stimulate the economy through
monetary policy such as reductions of interest rates and investments in
infrastructure. Keynesian economics certainly did not reign in 1929-- total U.S.
governmental expenditures (federal, state and local) were less than 10% of Gross
National Product (GNP). By the 1970s, they were 33%. GNP is the market value
of goods and services created by citizens in a year whether produced domestically
or nationally. As opposed to Gross Domestic Product (GDP), which is the market
value of only those goods and services which are produced domestically. The
1950s and 60s was also marked by major social safety nets put into place in most
advanced capitalist economies, such as social security, universal healthcare,
Medicaid, and Medicare. Advertising exploded as a way of promoting mass
consumption.

GOVERNMENT SPONSORED ENTERPRISES

In 1968, in order to further promote affordable housing, Congress split Fannie Mae
in two, creating one private corporation and one government owned corporation.
The government owned corporation was Ginnie Mae (Government National
Mortgage Association). GNMA would guarantee certain types of loans so lenders
could resell those loans in capital markets at a good price, and thereby allowing
those lenders to make new loans. Also, the power of the GNMA guarantee would
lower the cost of financing which could then be passed on to consumers (creating
affordable housing). GNMA only guaranteed loans, as well as guaranteed
repayment of securities that were backed by mortgages to government employees
or veterans (the underlying loans contained in the securities were also guaranteed
by other government organizations like the Veterans Association or Federal
Housing Administration). Fannie Mae continued, but in a new form. FNMA
could now buy conventional mortgages (not guaranteed or insured by the
government, but still meeting specified standards) and they were also permitted to
issue securities backed by FNMA guaranteed mortgages. FNMA would only
guarantee mortgages that were “conforming” loans, i.e. extended according to
strict criteria such as documentation requirements, acceptable debt-to-income
ratios, etc.; all part of the “4 Cs.” Fannie Mae is a GSE (government sponsored
enterprise) and has a federal charter, but is OWNED by private investors.
However, in September of 2008, it was taken over in Conservatorship by the U.S.
Government-- at least temporarily.

Another GSE chartered in 1970 is Freddie Mac (Federal Home Loan Mortgage
Corporation). Freddie was set up to provide competition for Fannie Mae and to
further increase funds for mortgage financing and home ownership. It has
essentially the same charter as Fannie Mae—to buy mortgages from S&Ls and
other institutions. Like Fannie Mae, they could also pool the mortgages they
bought from the secondary markets and sell mortgage backed security bonds
(MBS) to investors on open markets.
Freddie makes money mostly by charging a fee to guarantee the principal and
interest on the underlying loans they have purchased (which are then pooled into
MBSs). However, the U.S. Government does not back the loans.
In 1971, several foreign governments insisted on converting U.S. debt to gold. The
U.S. was unable to accommodate the demand. Then President, Richard Nixon,
responded by eliminating such an exchange. The Gold Standard was officially
abandoned in the U.S. (ending the Bretton Woods system).

REAGANOMICS

In 1973, the world experienced a major shortage of oil. OPEC (Organization of
Petroleum Exporting Countries), of which there are currently 12, quadrupled the
price of oil, triggering a worldwide recession and inflation, and eventually
“stagflation” (stagnant growth and high inflation). Interest rates hit 18%. This
contributed to the view that managed or regulated capitalism (Keynesian
Economics) didn’t work. It was time to go back to the philosophy of unfettered
capitalism in which “the market dictates because the market is always right-- it is
self-correcting.” This made conditions ripe for the Margret Thatcher and Ronald
Reagan brand of economics. They set out to remove the regulations enacted
during the previous 40 years. Unions were curbed, state-owned enterprises were
privatized, price and income polices (i.e., wage or price controls) were scrapped,
top tax rates were lowered and regulation of the financial system was progressively
dismantled. The rationale was that, since there were no crises, regulations were
unnecessary. Was that true? Or was that a disconnect due to time, space and
motion? Perhaps there were no crises BECAUSE of regulations. Case in point,
since 1790, the U.S. has experienced 16 significant banking crises. In contrast,
Canada, with its numerous financial regulations and abundant lending, has endured
ZERO banking crises including during the Great Depression!

This leads us into our next Kabbalistic concept, Tikkun, or correction. Have you
ever asked yourself why you are here on earth? Why you were born? What is
your purpose? According to Kabbalah, we are all here for one reason and one
reason only-- to transform ourselves by correcting that which we did not correct in
19
a previous lifetime. Now, you can choose to believe that or not, but one benefit of
that philosophy is how we view obstacles that we encounter. The Kabbalists
believe that what the rest of us call obstacles are not obstacles at all. They are
welcome opportunities sent our way to allow us to transform. So if you are a
person who has no patience, you may very well end up living in Los Angeles,
where you will battle traffic on the 405 Freeway everyday. To you that is an
obstacle, to the Kabbalist, that is an opportunity to correct your impatience. The
Hebrew word Tikkun literally translates to correction. Kabbalah teaches that we
all have our unigue tikkuns that we are born with in order to correct. Usually, they
are the patterns of negative or painful behavior that you keep repeating. If you fail
to correct, more "opportunities" will be sent your way, and they will likely increase
in their severity since you failed to correct previously. The greater the
obstacle/opportunity to overcome, the greater the transformation. Keep this is
mind as we proceed from economic crisis to economic crisis. For instance,
throughout history, do economic crises increase in severity? Do they increase in
frequency over time?

What does this concept of Tikkun have to do with regulations? The Kabbalistic
equivalent of regulation is known as restriction. We said earlier that we are all
born with the desire to receive. Another attribute that we are all born with,
according to Kabbalah, is a reactive nature. It is why we are ALL our own worst
enemy. Kabbalah actually teaches that we are our ONLY enemy, but we're not
going to explore that now. When we are reactive, that's not a choice, it comes
naturally to us. The choice is in resisting or restricting. It may be in letting go: of
anger, jealousy, of “being right,” or “acting for the self alone.” It may be resisting
the urge to do nothing, to be complacent, to be a victim or self-indulgent. The ear
needs an eardrum to resist in order to hear. A light bulb has a positive pole, a
negative pole and a filament. The filament acts as a resistor, pushing back the
positive current so it doesn't connect with the negative current and short circuit.
Without the resistance of the filament, there is no light. And without regulations,
the desire to receive meets the desire to act for the self alone and we have an
economic short circuit. We will talk a lot more about regulations throughout this
lecture.

THE S & L CRISIS

It’s time for a slight detour, which has some relation to the dismantling of
regulations, and that is the Savings and Loan crisis of the 1980s. First, a brief
history of S & Ls.
20
“Thrifts” (which officially had their name changed to Savings & Loans in the late
1930s) were originally non-profit coops managed by their membership and local
institutions. Most often, they only made home loans, primarily to working class
men and women (differing from banks which had a wide array of products and
served both individuals and businesses). S&Ls had their origin in late 18th Century
England, with the British building society movement (aka Buildings & Loans).
The panic of 1893 caused a decline in membership. By the end of the 19th
Century, nearly all B&Ls were out of business. In 1934, the FDIC was extended to
S&Ls. Of note, all S&Ls were charged the same insurance premium regardless of
the richness of each S&L’s particular portfolio. S&Ls were resurrected over time
with a prominent rise in the two decades following WWII, as millions of
servicemen returned from overseas and started families. This new generation was
known as the “baby boomers,” and a surge in home construction resulted, fueling
the development of suburbs. By the 1960s, S&Ls experienced a strong expansion,
largely due to this construction surge.

An important trend emerged which was the raising of interest rates on savings
accounts to attract depositors. This led to rate wars between S&Ls and commercial
banks. Since 1933, the Federal Reserve had limited the interest rates that
commercial banks could pay on deposits (Regulation Q). These rate wars
prompted Congress in 1966 to set limits on savings rates for S&Ls and commercial
banks. S&Ls were hit especially hard in the 1970s during the stagflation period.
The bread and butter of S&Ls were short term deposits, but they were routinely
extending long term loans (fixed mortgages for 15, 20, 30 years). Because
depositors’ savings rates were now capped, when the cost of money would rise,
depositors removed their money and invested in accounts that had higher rates of
return such as money market accounts, CDs, etc. (This removal and reinvestment
process is referred to as “disintermediation”). The S&Ls often wound up paying
more out to depositors than they took in. Also higher interest rates meant home
loan qualifying became much more difficult since less people could afford homes.
These factors all limited S&Ls from making money. S&L managers responded by
offering interest on checking accounts, and alternative mortgage instruments. It’s
worth noting here that, before 1981, adjustable rate mortgages (ARMs) were
barred. Adjustable rate mortgages, also called variable rate mortgages, have their
interest rates periodically adjusted – usually linked to the cost of borrowing money
that the lender experiences within their credit markets.

In October of 1979, then Federal Reserve Chairman Paul Volcker restricted the
money supply. Short term interest rates skyrocketed. In the ten months from June
1979 to March 1980 interest rates rose more than 6% from 9.06% to 15.2%. In
1981 and 1982 combined, the S&L industry reported $9 billion in losses.

DEREGULATION

During 1980 and 1982, Congress passed two laws deregulating S&Ls. The
Depository Institution Deregulation Monetary Act of 1980 (in which the FDIC
limits were raised from $40k to $100k), and the Garn-St. Germain Depository
Institutions Act of 1982. The Legislation authorized the use of more lenient
accounting rules for financial reporting, and eliminated restrictions on the
minimum number of S&L shareholders. It also eliminated the deposit interest rate
ceilings mentioned earlier. These maneuvers, coupled with a decline in regulatory
oversight, were factors that led to the S&L collapse. The laws were intended to
help the S&Ls get back on track, but they were also significant because, for the
first time, the government sought to increase S&L profits rather than promote
home ownership. The legislation also resulted in more lending then was prudent,
especially in commercial real estate for which S&Ls were not experienced in
assessing risks.
In November of 1980, The Federal Home Loan Bank Board (the now defunct
regulator of S&Ls) removed the limits on amounts of brokered deposits an S&L
could hold. Brokered deposits allow brokers to pool depositors money and create
$100,000 instruments (the new FDIC limit). These instruments were placed, for a
specified period of time, with the S&Ls offering the highest return. Although the
S&L had use of those funds, brokered deposits actually helped keep insolvent
S&Ls liquid, delaying regulators from closing them.
In August of 1981, the U.S. Congress passed the Tax Reform Act of 1981.
Powerful tax incentives were created for real estate investment by individuals, and
a huge boom in real estate ensued.
In January of 1982, The Bank Board reduced the requirement that an insured S&L
had to have a net worth equal to or greater than 4% of its total deposits down to
3%. It had already been reduced from 5% to 4% just 14 months earlier. Moreover,
now that accounting reporting rules had been relaxed, it was much easier to reach
the 3% threshold.

Deregulation had given the S&Ls many of the capabilities of commercial banks
without the regulations of commercial banks (i.e., to make consumer loans, and
issue credit cards). S&Ls could elect to be under federal charter and thereby
deposits were insured against loss by the government. This encouraged S&Ls to
be more speculative. In December of 1982, in response to massive defections of
state chartered S&Ls to federally chartered S&Ls, California allowed its S&Ls to
invest in any venture without limitation. Texas and Florida followed suit.
By the end of the S&L crisis, 5% of S&Ls had invested in junk bonds. A bond is
basically a contract in which a corporation or government borrows money (aka
bond issuer) from an investor (bond holder) and pays interest at fixed intervals
(coupons) and repays the principal at a later date (maturity). The higher the credit
rating (basically the likelihood the principal and interest will be paid on time)
given to a bond by a credit rating agency, the safer the bond. Junk bonds are rated
below investment grade, and have high yields because they have a higher risk of
default.
From 1982-1985, The Bank Board reduced its regulatory staff starting salaries for
regulators. In 1983 the starting salary for an examiner was $14k a year and the
average examiner had two years of experience. During this period of oversight
retraction, S&L assets increased by 56%.

In 1983, The FHLBB eliminated the limits on loan to value ratios for S&Ls. They
were now free to loan up to 100% of the appraised value of a home.
In March of 1984, Bank giant, Empire Savings of Texas, fails. A pattern of
criminal activities is revealed. The failure cost taxpayers $300 million. In
reaction, the FHLBB begins reversing deregulation, by placing limits on S&Ls.
For example, direct investments by an S&L are limited to the greater of 10% of the
S&L’s assets or two times the S&L’s net worth-- so long as the regulatory
definition of required net worth is met.
In March of 1985, The governor of Ohio closes all S&Ls. Eventually S&Ls that
can qualify for FDIC insurance are allowed to re-open.
In May of 1985, S&L failures in Maryland, cost its taxpayers $185 million.
In the midst of the S&L collapse, The U.S. Congress passes the Tax Reform Act of
1986. This Act was significant in many ways: it lowered the top tax rate on
individuals from 50% to 28%, while raising the bottom bracket from 11% to 15%;
it increased the home mortgage interest deduction; it eliminated the interest
deduction on credit cards; it encouraged everyone with equity in their homes to
refinance which led to an explosion of second mortgages and its less stigmatic
cousin, the HELOC (Home Equity Line of Credit). Second mortgages and
HELOC’s were tantamount to using one’s home as an ATM. Also of great import,
TRA 1986 limited tax deductions on investor’s passive activity (losses and gains)
essentially eliminating tax shelters, especially for real estate (passive activity is
explained in greater detail later on). Prior to 1986, it was commonplace for
investors to pool money in syndicates, buying/developing both commercial and
residential properties and hiring companies to manage those properties. TRA 1986
also limited deductions of losses from investor gross income on losing properties.
This led to large-scale dumping of those properties, which torpedoed real estate
values.
In May of 1987, S&L accounting reporting standards were tightened. By the end
of 1987, the combined losses from Texas S&Ls alone exceeded half of all S&L
losses in America, and 70% of the twenty largest losses in the U.S. were in Texas.
And in February 1988, the FHLBB unveiled a plan to consolidate and package
insolvent Texas S&Ls, and sell them to the highest bidder-- 205 S&Ls were
disposed of with assets of $100 billion.
In August of 1989, FIRREA is passed by The U.S. Congress (Financial Institution
Reform Recovery and Enforcement Act). It abolished the FHLBB & the FSLIC
(Federal S&L Insurance Corporation). It also promulgated meaningful S&L
regulations, including satisfactory net worth requirements, as well as funding for
criminal prosecutions of S&L crimes by The Justice Department. A bureau of The
U.S. Treasury Department replaced the FHLBB & the FDIC replaced The FSLIC.
From 1986 – 1995, federally insured S&Ls declined in the U.S. by 50%, from
3234 to 1645.
By 2004, S&L bailouts had cost the U.S. taxpayers over $124 billion. By the end
of 2004, 886 S&Ls remained with assets of $1.35 trillion.
There were two other significant events that took place in the 1980s which are
worthy of mention:
First, October 19, 1987 – Aka “Black Monday” – the Dow Jones Industrial
Average fell almost 22% in a single day-- 508 points (The DIJA is a stock market
index tracking 30 large "blue chip" public companies performance during a
standard trading session). The sell off began in Hong Kong, then Europe, then
followed by the U.S. To this day, no one knows what triggered the sell off-- panic
for no apparent reason. Remember, the Kabbalist does not subscribe to the notion
of "suddenly." Somewhere there was a seed planted, and because of the disconnect
caused by time, space and motion, we can not see that this was a consequence of a
seed planted.
Second, November 9, 1989, the collapse of The U.S.S.R. As The Berlin Wall
comes down, capitalists worldwide are emboldened. They conclude that
communism is a failed system. By the way, and not insignificant the eighties are
dubbed “the me generation.” A whole generation named for acting for the self
alone!

HOME OWNERSHIP PUSH RENEWED

The 1990s are ushered in with a new technological explosion-- the internet and
dot.com craze, as well as a continued push for home ownership. In 1992, George
Bush, Sr. signs the Housing & Community Development Act to facilitate the
financing of affordable housing for low and moderate-income families.
In July of 1997, The U.S. Congress passes the Taxpayer Relief Act. The Act
encourages people to buy more expensive homes and second homes. It lowers the
Federal long term capital gains tax rate from 28% - 20%. Capital gains are profits
that result from investments like stocks, bonds, real estate, goodwill, etc., as
opposed to ordinary income such as salary. Profits or income can be either
"active" (you were actively engaged in generating that profit/income, usually with
20+ hours per week devoted to that generation) or "passive" (you benefitted
chiefly through the efforts of others). Long term capital gains are assets that are
held for at least one year. So ask yourself this question. If you are able to buy an
asset and hold it for a year, then sell it for a profit, why should that profit be taxed
at a lower rate than anyone’s salary for a year? At the risk of stating the obvious,
capital gains sources of income represent a large chunk of income for the wealthy.
Also under The Act, the first $250K ($500K for couples) of gain on a personal
residence sold is exempted, so long as it has been lived in for two years. In
addition, The Act raised the estate tax exemption from $600K to $1 million,
phased in over 10 years.
In September of 1999, Fannie Mae eased the credit requirements for the underlying
loans it bought from banks and other lenders. The goal, again, was to increase
home ownership among minorities and low-income consumers. The credit easing,
encouraged banks to extend mortgages to below credit-worthy people, who simply
could not qualify for conventional loans.
In November 1999, on the eve of the new millennium, The U.S. Congress passed
The Gramm-Leach-Bliley Act, repealing The Glass-Steagall Acts. It is signed into
law by then President Bill Clinton. It was passed under the theory that banks
should be able to diversify to be able to reduce their risk. The Act effectively
removed any distinction between Wall Street investment banks and ordinary
depository banks. In other words, banks that were insured by the FDIC could now
speculate with depositor's money. Case in point, banks were allowed to engage in
underwriting-- raising capital from investors on behalf of an issuer of securities.
The new millennium begins with the bursting of the dot com bubble in March,
2000.
Now it’s time to explore subprime loans and mortgage-backed securities, collateral
debt obligations, credit default swaps and Armageddon.

SUBPRIME MORTGAGES

From 1998-1999, subprime mortgages accounted for 5% of all mortgages. Within
ten years that number would hit 30%. So what exactly are subprime mortgages?
Very simply, subprime mortgages are loans to borrowers that don’t meet credit
worthiness standards, and thus have a greater likelihood of default. One rule of
thumb is subprime mortgages are loans made to borrowers with a FICO credit
score of less than 620. FICO (Fair Isaac Corporation, named after its two
founders) is a fairly simplistic measurement of credit worthiness. Over 90% of
SPMs were adjustable rate mortgages (ARMs) in 2006. By 2008, it was clear to
anyone who bothered to look, that nearly 1/3 of all mortgages had a reasonable
likelihood of default.
Another fact to keep in the back of your mind: In 1997, the average U.S. household
had a debt to disposable income ratio of 77% (disposable income is all of your
personal income less your personal taxes). So, on average, after paying taxes,
people borrowed 77 cents for every dollar they earned. That’s a pretty high
number. But by the end of 2007, people borrowed $1.27 for every dollar of
disposable income earned (most of that debt was mortgage-related).
Why take on so much debt? One reason is that, similar to the tulips in 1600s
Netherlands, pretty much everyone thought that the value of houses would never
go down. Moreover, the values would only go up! So if one got into trouble, they
could refinance – again, use their homes as an ATM. Another explanation for the
debt explosion, is that home ownership, for generations, has been and continues to
be pushed by the government and American culture. In one speech, George Bush,
Jr. actually said that "part of being a secure America is to encourage home
ownership." The company slogan of Ameriquest, one of the most fraudulent and
worst abusers of ethical lending practices, was "Proud Sponsor of the American
Dream." Why is home ownership the “American Dream”? Think of the home
mortgage interest tax deduction. You can’t deduct the rental expense on an
apartment, but home interest you can – why? The 30-year fixed mortgage is
standard in only the U.S. and Denmark. Fannie, Freddie and Ginnie Mae all allow
for government-insured mortgages, which helps keep mortgage interest rates low
and encourages home ownership. The last reason to mention regarding our
proclivity for taking on debt ... because it was there – credit was plentiful. For
years before the crisis hit, the world was awash with capital. Asia and the oilproducing
countries poured money into the U.S.. Interest rates were low, and
temptation was high.
The denial rate for a conventional home loan in 1997 was roughly 28%. Five years
later it was roughly 14%. Another telling statistic, according to a U.S. treasury
report: between 1997 – 2005 there was a 1400% increase in mortgage fraud
(essentially where one intentionally materially misrepresents or omits information
on a mortgage loan application such as altering W2s and other income
submissions, as well inflating appraisals, etc.). Much, if not most, of this fraud
was conducted at the behest of unscrupulous loan officers. In fact, in October of
2004, the assistant director of the criminal investigative unit of the FBI, Chris
Swecker, told Congress that "mortgage fraud is pervasive and growing."

STRUCTURED FINANCE INSTRUMENTS

Before we turn our attention to the global economic meltdown, we need to
examine the world of finance and financial instruments, specifically MBSs, CDOs
and CDSs (mortgage-backed securities, Collateral Debt Obligations and Credit
Default Swaps). Before all of these “innovations” there was the good ole world of
government bonds and corporate bonds.
A government bond is basically a promise by that government to pay a certain
amount (face value) by a certain date (maturity date) along with periodic interest
payments (usually in that country’s own currency). If it’s issued in a foreign
currency, it’s called a sovereign bond. The first Government bond was issued by
England in 1693 to raise money for a war against France. These bonds are
considered “risk free” since defaults by countries are rare-- Russia in 1998 and
Greece in 2011.
Corporate bonds are issued by a corporation to raise money. The maturity date is
generally greater than one year. Maturity dates of less than one year are sometimes
27
referred to as “commercial paper.” The interest rate is often referred to as “The
Coupon.” Corporate bonds are frequently “listed” on stock exchanges. Corporate
bonds generally have a higher yield than government bonds because the risk of
default is higher.
So now comes the mortgage-backed security; MBS (aka, asset-backed securities –
ABS). These are bonds that are sold to investors who buy a portion of the stream
of income from a pool of thousands of home loans. A mortgage servicing
company collects the mortgage payments, subtracts their fee, and the remaining
principal and interest passes to investors.
By the way, Wall Street wasn’t the first to offer the MBS; it was the government.
As mentioned earlier, Fannie was split into two in 1968: Ginnie Mae was the
government arm and Fannie was half private, with shareholders and a board of
directors, and half G.S.E., while Freddie Mac was created to buy mortgages from
S&Ls and others.
Ginnie was the first to sell mortgage-backed securities in 1970-- bonds whereby an
investor could share in the income stream of hundreds of FHA and VA loans with
the principal and interest on the underlying mortgages guaranteed by the U.S.
government. In 1971, Freddie issued securities backed by conventional mortgages,
also guaranteeing the P&I. (Remember conventional loans were extended under
credit worthiness standards set by Fannie Mae). Attractive, risk-free securities.
Doesn’t sound bad, right? But they were fairly unpopular with investors. Why?
Because they weren’t truly risk-free to the investor-- the bondholder, because of
something known as “prepayment risk.” The mortgage owner (mortgagor) can
pre-pay the mortgage at any time. Why would a mortgagor pre-pay? The most
obvious reason, interest rates drop so the mortgagor wants to lower their payments
by refinancing. When that happens, the bondholders get cash, but they lose the
future interest payments. Now they are left with cash that is less valuable since
they have to invest that money garnering lower yields because interest rates in the
market are lower. The good fortune of the mortgagor is the bad fortune of the
bondholder. Because of prepayment risk, the investor doesn’t know how long an
investment will last; only that money will come back when it is least desirable.
This is where Wall Street came in to solve that issue and make MBSs more
attractive to investors.
Investment bankers, most notably, Lewis Ranieri, devised a product whereby the
pool of home loan payments were carved into pieces called “tranches,” which is
French for "slices." The buyer of the first tranch was like the owner of the ground
28
floor of a building in a flood – that investor is stuck with the first wave of
prepayments BUT now gets paid a higher interest rate. The second tranch gets the
second wave of prepayments, but less of an interest rate. If there is a default or
foreclosure, the home is sold and the proceeds are divied up by the tranches. The
AAA tranch may get 100% of its investment back, but the AA may not (if the sales
price is less than the mortgage balance). Incidentally, this is one reason why it is
so difficult to renegotiate a mortgage if you are a homeowner-- the AAA tranch
holder may be OK with it, buy lower tranches may not since they will lose income.
By 1981, MBSs for single family homes grew to $350 billion. By the end of 2001
it reached $3.3 trillion. By 1983, the mortgage financing arm of Salomon Bros.
accounted for almost half of Salomon’s $415 million in profits.
Tranching wasn’t the only factor in the success of MBSs. Another vital part were
the rating agencies. Before MBSs, rating agencies such as Moody’s, Standard &
Poor’s and Fitch, built their business almost solely around corporate bonds. At
first, they resisted rating MBSs, but eventually came around. Soon after, this
“structured finance” became a key source of profit for them. A quick tutorial on
the ratings system: AAA, AAA-, AA, AA-, A, A-, BBB, and BBB- are all
"investment grade" ratings. The highest, AAA, is considered to be as safe as a
U.S. Treasury Bond, with almost no chance of default. Anything rated below
BBB- are considered "junk" and are deemed too risky to be purchased by pension
funds or other institutional investment investors that are legally bound to hold only
safe investments.
Remember the GSE guarantees on Fannie & Freddie mortgages meant that
investors were not bearing the risk of mortgage default– the government insured
those loans. For some investors, GSE-based paper was the only type of mortgages
investors were allowed to buy. For instance, many states had laws prohibiting
pension funds from buying “private” mortgage backed securities. States also had
“Blue Sky” laws designed to prevent fraud. They required Wall Street firms to
register with each of the fifty states to sell MBSs, and the firms had to repeat that
step with each new bond issued. However, MBSs issued by Fannie or Freddie
were exempt from blue sky laws because of the implicit government guarantee.
By mid-1983, the GSEs had issued $230 billion of MBSs while the private sector
had issued $10 billion.
Lewis Ranieri disapproved of the massive power of the GSEs. He wanted their
grip weakened, and being a strong “market” conservative – the market is always
right and self-correcting – he felt that the private sector should be able to issue
29
MBSs without Fannie and Freddie. He had strong ties to the Reagan
administration, and, with Ranieri’s help, the administration drafted The Secondary
Mortgage Market Enhancement Act (SMMEA). (Direct loans are loans made
directly to a borrower, so they are considered primary loans. In contrast, MBSs
constitute a secondary mortgage market.)
The SMMEA exempted MBSs from blue sky laws. It also removed restrictions on
pension funds and insurance companies from investing in MBSs issued by Wall
Street, even when they lacked GSE guarantees. The law further provided that
MBSs had to have a high rating by a credit agency. That provision enshrined the
role of rating agencies in MBSs. While some expressed concern that the rating
agencies were given too much responsibility, supporters of the legislation
reassured Congress that investors wouldn’t rely solely on ratings to buy an MBS.
In the end, the fear of “turning the mortgage market of America into a total
government franchise,” which was pounded into Congress by Ranieri, was too
much for Congress to ignore. The law was signed in October of 1984.
An interesting postscript to the notion that investors wouldn't rely solely on ratings,
comes in a statement by The Office of the Comptroller of the Currency 13 years
later: "Ratings are important because investors generally accept ratings ... in lieu of
conducting a due diligence investigation of the underlying assets ..." Moreover,
the rating agencies had charts and studies indicating that they were accurate a high
percentage of the time. On closer inspection, that doesn't appear to be the case.
Here are some well known failures the ratings agencies missed: the near default of
New York City; the bankruptcy of Orange County CA; the collapse of the Russian
and Asian economies; the implosions of: Penn Central Transportation Company,
Long-Term Capital Management, WorldCom and Tyco. Even back during the
depression in 1929, 78% of municipal bonds rated AAA and AA defaulted.
Enron's debt wasn't downgraded until four days before they filed for bankruptcy
despite the rampant fraudulent practices of Enron being exposed two months prior!
In the summer of 2007, Moody's released a statement saying that "there are no
negative rating implications ... as a result of [the banks'] involvement in the
subprime sector." Yet 93% of the AAA rated subprime residential mortgagebacked
securities issued in 2006 and 91% of them issued in 2007 were
subsequently downgraded to junk status.
The horrifying truth, at least when it came to mortgage backed securities was that
the agencies themselves never really conducted any due diligence regarding the
underlying mortgages. Basically, they assumed that if housing declined it would
be a relatively modest decline. Also, they believed that the housing market was
regional, so any decline in value in one part of the U.S. was irrelevant regarding
30
another part (this is known as correlation). Another ugly factor that effected the
ratings of MBSs was something known as "ratings shopping." Investors preferred
to have two agencies rate a deal, but didn't require all three to rate a deal. This
allowed bond issuers to play agencies off of each other. If an agency was rating a
bond lower than the issuer wanted, the issuer could threaten to switch to the other
agency which would supposedly be more favorable. So if issuers could "game the
system" through ratings shopping, then how could the market, unaware of the true
state of the underlying mortgages contained within an MBS, correct itself??? The
answer is ... it couldn't.
Before MBSs, historically less than 2% of people lost their homes to foreclosures.
Quite simply, before the advent of the MBS, lending institutions and the borrower
had the same interest—getting the mortgage paid. But once the lender sold the
mortgage to a third party investor (as became prevalent with the advent of the
MBS), they had no real interest in whether there was a default.
When it came to creating securities from traditional mortgages
("securitizing"),Wall Street bankers realized, by the late 1980s, that they could not
circumvent the GSEs and thereby keep all the profits for themselves. They would
have to find some other mortgage product to securitize, something that Fannie and
Freddie wouldn’t touch. Enter the subprime mortgage. The first subprime
mortgage backed security was sold in 1988, by Guardian S&L. By 1991, Guardian
had sold $2.7 billion worth of securities backed by questionable loans.
A quick recap of how we legally ushered in these crappy subprime mortgages:
Before 1980, the ability to charge high interest rates and fees to borrowers was not
possible. States had instituted "usury laws," capping the interest rates people could
legally charge. However, these usury laws were preempted by Federal law in
1980 with the passage of The Depository Institutions Deregulation and Monetary
Control Act (DIDMCA). Logically, usury laws discourage lenders from
extending risky loans since those lenders may not be able to charge a high enough
interest rate to justify that risk. In addition, the use of variable interest rates and
balloon payments became permissible in 1982 with the passage of The Alternative
Mortgage Transaction Parity Act (AMTPA). And, finally, the big dog-- The Tax
Reform Act of 1986, which eliminated the deduction of interest on consumer loans
(credit cards), but kept the interest deduction on mortgages for primary residences
and a second home. This made mortgage debt (even with high costs and fees)
cheaper than consumer debt for many homeowners.
31
Now back to the evolution of the subprime mortgage (SPM). If you recall, rising
interest rates had decimated the S&Ls in the early eighties. That factor, along with
Fannie Mae being granted the right to buy conventional mortgages, actually aided
non-bank mortgage originators like Ameriquest, Household Finance and
Countrywide to not only grow, but to dominate the home lending business. By
1989, non-bank mortgage companies funded 19% of home loans in America. By
1993, that figure reached 52%.
By 1992, Countrywide grew to become the largest mortgage lender in the U.S., and
its co-founder, Angelo Mozillo, was dubiously listed by Time Magazine in its
issue: 25 People to blame for the financial crisis. In the early 1990s, interest rates
began to fall, which helped more people afford homes. Countrywide began
advertising a new technique to allow people to use their homes as equity to borrow
more money than their current home loan, and take out the excess cash – it was
called "refinancing." In 1992, refinancing accounted for 58% of Countrywide’s
business. In 1994, it was 75%. Another significant practice instituted by Mozillo
was employing independent brokers to make loans so as to grow quickly. With the
S&Ls closing down by the hundreds, Mozillo had a large, cheap pool of loan
officers who, once they sold a loan and got their fee, had no “skin in the game.”
By 1997, delinquent payments and defaulted loans exceeded “projected levels.”
Compounding the cost of unanticipated losses was the use of “Gains on Sales
Accounting.” It has been called the financial equivalent of “crack cocaine.” A bit
complicated, but in a nutshell, this accounting method allows companies to book as
profit, in the present, the expected future value of loans. Moreover, it allows for
the assumption that a loan will always be repaid, and not prematurely. Obviously,
those projections were used to lure investors. In 1998, the rash of defaults and
delinquencies began to affect MBS prices since investors finally became concerned
about the underlying assets contained within the bonds. This, coupled with an
Asian financial crisis in 1998, made the cost of borrowing money higher. MBSs
backed with subprime loans dropped almost 18% from 1998 to 1999, but recovered
again from 2000-2003. Many subprime loan originators failed or were acquired
during this downturn, so that by 2003, 90% of all subprime lending was done by
just 25 firms. The collapse of the subprime companies didn't have much effect on
the banking system or the housing market, and within a few years the SPM
business would be stronger than ever. What should have been a warning to
regulators was left unheeded, or in Kabbalistic terms-- uncorrected.
Why was Wall Street so eager to market these SPMBS? Larry Fink, who is
credited with devising “tranching” for MBSs, was once asked by Congress whether
32
Wall Street would ever try to securitize risky mortgages. He responded, “I can’t
even fathom what kind of quality of mortgage that is, but if there is such an animal,
the marketplace may just price that security out.” Basically, investors would
require such a high return that the security would be unmarketable. Once again,
the mantras of the market conservative: “the market is always right,” and “markets
are self-correcting,” simply turned out to be plain wrong.
One of the stunning revelations of the global economic meltdown was the
admission of market purist, financial guru, and former Federal Reserve Chairman,
Alan Greenspan. Also on Time’s list of 25 people to blame for the financial crisis,
Greenspan, in October of 2008, testified before Congress saying: “I made a
mistake in presuming that the self-interest of organizations, specifically the banks,
is such that they were best capable of protecting shareholders and equity in the
firms. I discovered a flaw in the model that I perceived is the critical functioning
structure that defines how the world works.”
Ironically, it was the U.S. government that gave Wall Street a jump start to
securitize SPMs. In another of a string of unintended consequences, after the S&L
crisis, the government, through the Resolution Trust Corp., wound up with
hundreds of billions of dollars worth of assets from failed S&Ls that they wanted
to unload. The best way to get rid of them was to securitize them, then sell them to
investors. Since much of these assets were too risky for Fannie or Freddie
backing, all they needed was an AA or AAA rating and pension funds would buy
them. So Wall Street devised various techniques known as “credit enhancements”
to lessen the risk to investors: get insurance companies to insure some risk; put
extra mortgages in the pool to minimize risk; or have some investment banks issue
letters of credit to investors in the event cash flows from the MBS dipped below a
certain level. These enhancements convinced the rating agencies to issue AA and
AAA ratings. Wall Street was finally able to create a huge securitization business
that they could market without sharing a dime with Fannie and Freddie.
In the early 1990s, the number of Americans owning homes had dropped slightly
due to the S&L crisis– 1.5% from 1980 to 1991. This prompted Bill Clinton, in
1995, to announce his National Home Strategy. It’s stated goal; increase the
number of U.S. homeowners by 8 million by the year 2000. Similarly, George
Bush Jr. pushed for increased home ownership. An unintended consequence of
pushing this “American Dream” is that politicians and regulators don’t want to
crack down too hard on subprime lenders because that could interfere with their
ability to make loans to the very people the government is trying to “help.” In fact,
one reason why Fannie Mae reluctantly ventured into the subprime world (the
33
GSEs entered that market late in the game-- circa 2005) was to meet increased
affordable housing goals instituted by the Bush administration. Another reason,
more compelling, was higher profit margins-- the yield for guaranteeing subprime
loans was greater than 30 year fixed mortgages. By the end of 2007, the GSEs
owned 23% of all the outstanding subprime mortgage backed securities and 58%
of all Alt-A mortgages (Alt-A are riskier than prime, but not as risky as subprime).
The sheer size of the GSEs’ purchases definitely help inflate the housing bubble.
As the authors of "All the Devils are Here" put it: "Without the GSEs' buying
power, the private market would never have been as big as it got. And without
Wall Street, there never would have been all those bad mortgages for the GSEs to
binge on"
By the middle of the nineties, SPMs are booming. Moreover, they got another
steroid injection by the Federal Reserve who raised interest rates in 1994. This
caused refinancing to plummet – some “Prime” lenders, saw their loan volume
decline by 50%. How did they respond? They wrote subprime loans. Wall Street
also jumped into the act, not only by issuing bonds backed by SPMs now featuring
“credit enhancements,” but by extending lines of credit known as Warehouse Lines
of Credit to subprime lenders. These lines of credit allowed the Lenders to make
more subprime loans. Warehouse lines were the primary funding mechanism for
subprime mortgage originators. Then Wall Street got even more juice by taking
those subprime companies public such as: The Money Store (1-800-LOAN-YES);
First Alliance; Aames; Cityscape Financial; and New Century. Remember, Gains
on Sale Accounting made these companies look really profitable, and thus more
attractive to investors!
From 1994 to 1999, the number of SPMs went from 138,000 to 856,000, and from
$35 billion to $160 billion. Nearly 13% of all mortgage originations were SPMs.
In 1999, home ownership hit a record of 66.8%, but 82% of all SPMs didn’t go
towards buying a new home. They actually went to refinancing existing homes,
and 60% of those borrowers pulled out the excess cash.
By the way, I don’t want to paint the picture that all subprime lending was
intentionally predatory. Some lenders, Angelo Mozillo for instance, really
believed they were helping lower-income people and minorities. In the end
though, they were loaning to many people who couldn’t afford to borrow. Also,
we can't let borrowers off the hook either. Many borrowers used loans with teaser
rates that were fixed, usually for two years before the floating interest rates would
rise, to buy houses to flip at a higher price before the rate hike.
34
In 1998, a prominent hedge fund, Long-Term Capital Management went bankrupt.
LTCM was started 5 years earlier by ex-Salomon Brothers’ bond trader, John
Meriwether. Meriwether had resigned from Salomon Brothers in 1991 after being
embroiled in a Treasury securities trading scandal perpetrated by a subordinate.
The U.S. Government had to bail out LTCM, but many subprime lenders were
subsequently denied capital, and went bankrupt. By 2002 there were no public
subprime lending companies in the U.S.
Left standing, was a lending behemoth named Household Finance Corporation.
They were still loaning second mortgages at a good pace. They offered 15-year
fixed mortgages at 7%, but it basically had a fraudulent component that tied the
interest rate to a 30 year loan, so that the effective rate of interest was 12.5%, not
7%. By the end of 2002, HFC settled a class action suit paying a $484 million
settlement distributed between 12 states. The following year, HFC sold its
company along with their toxic subprime portfolio to HSBC, a British
conglomerate for $15.5 billion.
By 2005, SPMs were back in vogue. Why the resurgence? After the internet
bubble burst at the end of 1999, Alan Greenspan reacted by lowering interest rates
to near historic lows. Mortgage rates dropped substantially, fueling a demand for
home buying. At the same time, investors were seeking higher yielding
investments. Wall Street wanted the subprime mortgages to package into their
bonds, which were in demand because of the higher yield they offered investors in
that low yield market.
In the mid-nineties, $30 billion of SPM constituted a huge year. In 2000, there had
been $130 billion in subprime lending, of which $55 billion was repackaged into
mortgage backed securities (42.3%). By 2005, there were $625 billion in SPMs, of
which $507 billion became collateral for mortgage backed bonds (81%). The
underlying terms of SPMs had also changed over time. For instance, in 1996, 65%
of SPMs had been fixed rate loans. By 2007, 80% of SPMs were adjustable loans-
- usually fixed for the first two years. By 1999, more than 50% of all mortgages
had down payments of less than 10%. Countrywide even marketed a product
called an 80/20 loan, which were actually two loans meant to enable a buyer to
borrow 100% of the home's purchase price. In addition, Countrywide raised its
loan limit to $1 million in 2006, up from $400,000 in 2001. And again, most of
these subprime loans were for refinancing (2/3 in 2006), rather than for buying
actual homes. Moreover, roughly 60% of their adjustable loans were made to
35
people who could not afford the increased interest rate once the teaser period
would expire.
Instead of trying to make loans to people who could afford to pay them back, the
goal was to make as many loans as possible and sell those loans as soon as possible
to Wall Street firms who would repackage them into bonds. Long Beach Savings
was the pioneer of the “originate + sell” strategy. LBS was the predecessor to
Ameriquest, founded by Roland Arnall. They were also the Originator of the
"stated income loan," which allowed potential borrowers to state their income
without any process of verification. In 2004, LBS loaned $50 billion worth of
SPMs (out of $587 billion total SPMs that year).
The quality of mortgages became less and less desirable over time. To wit: the
interest only negative amortizing adjustable rate subprime mortgage. There was
even an option for the home buyer to roll the interest only portion onto the
principal of the loan so the buyer would pay nothing for a period of time. Who
would be interested in that? A buyer with no income. Other toxic loans
developed such as: NINA loans, No Income No Assets-- "No problem"; and
NINJA loans, No Income No Job No Assets. Again, "no problem." All you
needed to borrow money was a good credit score.
So the lender was selling their crappy loans to Wall Street who packaged pools of
these crappy loans into MBSs and sold them to willing buyers all over the world,
in large part, because they had the AAA seal of approval from the rating agencies
and investors believed that real estate values would never decline.
Along with the MBS, Wall Street developed another related “structured finance
product” known as the CDO—Collateral Debt Obligation. It was first unveiled in
1987 by junk bond kings—Drexel Burnham Lambert. Once again, these pools of
obligations could be loans, pools of asset backed securities, or MBSs. So now you
have pools of subprime mortgages packaged into MBSs, and pieces of these MBSs
can be further packaged into yet another pool—the CDO. An amazing fact about
CDOs, investors frequently had no idea what securities were contained in a CDO
because securities were often changed, nor did investors seem to care. Again, they
were buying the AAA rating.
But that’s not all. Wall Street creates another revenue center, in the early nineties,
The Credit Default Swap, which they marketed as an insurance policy on MBSs or
corporate bonds. A CDS is a type, the most common type, of credit derivative.
Derivatives have been around for hundreds of years, and are a way to bet on the
36
future value of something. Farmers routinely use them to safeguard against
fluctuations in crop prices. These derivatives sold on commodity exchanges along
with futures of fuels, precious metals, currencies, etc. A Credit derivative basically
transfers ("or swaps") the credit risk from the underlying loan to another party. By
way of example, let’s say a corporation offers, through an investment bank,
hundreds of millions of dollars in corporate bonds to buyers. A CDS buyer can go
out to a Swap Seller, and, in essence, make a bet that the corporation is going to
default within a specified time. The buyer makes periodic payments, say quarterly
or semi-annually, to the seller. For instance, $100,000 a year to buy a ten year
CDS against $50 million of that corporation’s bonds. The most the buyer can lose
is $1 million ($100,000 per year for ten years). If the corporation defaults, $50
million goes to the CDS buyer. The CDS actually originated at JP Morgan after
the Exxon Valdez oil spill in 1994. Exxon, JP Morgan's client, was faced with a $5
Billion fine and, to prepare, drew $4.8 Billion from its credit line with JP Morgan.
The investment return on the credit line was relatively minor for JP Morgan, and it
would have to tie up hundreds of millions of dollars of capital in reserve due to
their exposure. So they convinced the European Bank of Reconstruction and
Development in London to take a stream of payments in exchange for that bank
assuming the risk of Exxon's default on JP Morgan's credit line. The Euro Bank
felt relatively safe that Exxon, with $100 billion in 1994 revenues, would not
default and was happy to take JP's payments. Although the actual loan remained
on JP Morgan's books, they were happy to reduce their risk. The Exxon deal went
off without a hitch and ushered in the CDS era. Next, Wall Street would lobby for
"capital relief," meaning that if they bought credit protection through CDSs then
they should be able to hold less capital in reserve. In 1996, the Federal Reserve
agreed.
As I mentioned earlier, Wall Street "marketed" CDSs as a form of insurance.
However, a CDS is not true insurance and there are many distinctions between the
two. A CDS is more of a bet against the market. The buyer of a CDS does not
have to own the underlying security or debt obligation, in other words there may be
NO “insurable” interest. A “naked” CDS is when the buyer has no insurable
interest in the underlying asset. If the buyer has an interest in the underlying asset,
then the CDS is in essence a hedge or type of credit insurance. Moreover, the
seller of a CDS does not have to be regulated. And, of paramount importance, the
seller is not required to maintain any reserves to pay off buyers in the event of a
loss. Conversely, by law, insurance companies must hold a certain amount of cash
reserves to pay an insured in the event of a loss. Swap transactions can be done
entirely with borrowed money, and without any transparency or disclosure. In the
U.S., CDS contracts are generally subject to "mark-to-market" accounting which
37
became a generally accepted accounting principle (GAAP) in the early nineties.
Mark-to-market accounting basically tracks the value of an asset daily, so that in
boom times an asset may be overvalued and in crises times the asset may be
undervalued. In contrast, historical cost accounting, used in insurance contracts, is
a simpler, more stable, principle based on past transactions. Mark-to-market
accounting can introduce volatility that would not be present in insurance
contracts.
In the late 1990's, JP Morgan developed a variation on the CDS. Instead of
referencing a single corporation such as Exxon, they would bundle hundreds of
credit derivatives on hundreds of corporations. They created CDOs containing
nothing but credit default swaps. While investors of MBSs owned pieces of actual
mortgages, here investors owned pieces of CDS "premiums," which were income
streams paid by the party insuring the risk. Because these securities were not built
out of "real assets" and had no collateral they were referred to as synthetic CDOs.
These synthetic CDOs made it possible to bet on the same bad mortgages dozens
of times. The Wall Street Journal uncovered a case in which a $38 million SPM
bond created in June 2006, wound up in over 30 debt pools and caused roughly
$280 million in losses!