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Thread: Banks’ Self-Dealing Super-Charged Financial Crisis

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    Banks’ Self-Dealing Super-Charged Financial Crisis

    Banks’ Self-Dealing Super-Charged Financial Crisis




    Over the last two years of the housing bubble, Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history.

    Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses:

    They created fake demand.

    A ProPublica analysis shows for the first time the extent to which banks -- primarily Merrill Lynch, but also Citigroup, UBS and others -- bought their own products and cranked up an assembly line that otherwise should have flagged.

    The products they were buying and selling were at the heart of the 2008 meltdown -- collections of mortgage bonds known as collateralized debt obligations, or CDOs.

    As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created -- and ultimately provided most of the money for -- new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain [1] that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.

    Individual instances of these questionable trades have been reported before, but ProPublica's investigation, done in partnership with NPR's Planet Money [2], shows that by late 2006 they became a common industry practice.

    An analysis by research firm Thetica Systems, commissioned by ProPublica, shows that in the last years of the boom, CDOs had become the dominant purchaser of key, risky parts of other CDOs, largely replacing real investors like pension funds. By 2007, 67 percent of those slices were bought by other CDOs, up from 36 percent just three years earlier. The banks often orchestrated these purchases. In the last two years of the boom, nearly half of all CDOs sponsored by market leader Merrill Lynch bought significant portions of other Merrill CDOs [3].

    ProPublica also found 85 instances during 2006 and 2007 in which two CDOs bought pieces of each other's unsold inventory. These trades, which involved $107 billion worth of CDOs, underscore the extent to which the market lacked real buyers. Often the CDOs that swapped purchases closed within days of each other, the analysis shows.

    There were supposed to be protections against this sort of abuse. While banks provided the blueprint for the CDOs and marketed them, they typically selected independent managers who chose the specific bonds to go inside them. The managers had a legal obligation to do what was best for the CDO. They were paid by the CDO, not the bank, and were supposed to serve as a bulwark against self-dealing by the banks, which had the fullest understanding of the complex and lightly regulated mortgage bonds.

    It rarely worked out that way. The managers were beholden to the banks that sent them the business. On a billion-dollar deal, managers could earn a million dollars in fees, with little risk. Some small firms did several billion dollars of CDOs in a matter of months.

    "All these banks for years were spawning trading partners," says a former executive from Financial Guaranty Insurance Company, a major insurer of the CDO market. "You don't have a trading partner? Create one."

    The executive, like most of the dozens of people ProPublica spoke with about the inner workings of the market at the time, asked not to be named out of fear of being sucked into ongoing investigations or because they are involved in civil litigation.

    Keeping the assembly line going had a wealth of short-term advantages for the banks. Fees rolled in. A typical CDO could net the bank that created it between $5 million and $10 million -- about half of which usually ended up as employee bonuses. Indeed, Wall Street awarded record bonuses in 2006, a hefty chunk of which came from the CDO business.

    The self-dealing super-charged the market for CDOs, enticing some less-savvy investors to try their luck. Crucially, such deals maintained the value of mortgage bonds at a time when the lack of buyers should have driven their prices down.

    But the strategy of speeding up the assembly line had devastating consequences for homeowners, the banks themselves and, ultimately, the global economy. Because of Wall Street's machinations, more mortgages had been granted to ever-shakier borrowers. The results can now be seen in foreclosed houses across America.

    The incestuous trading also made the CDOs more intertwined and thus fragile, accelerating their decline in value that began in the fall of 2007 and deepened over the next year. Most are now worth pennies on the dollar. Nearly half of the nearly trillion dollars in losses to the global banking system came from CDOs, losses ultimately absorbed by taxpayers and investors around the world. The banks' troubles sent the world's economies into a tailspin from which they have yet to recover.

    It remains unclear whether any of this violated laws. The SEC has said [5] that it is actively looking at as many as 50 CDO managers as part of its broad examination of the CDO business' role in the financial crisis. In particular, the agency is focusing on the relationship between the banks and the managers. The SEC is exploring how deals were structured, if any quid pro quo arrangements existed, and whether banks pressured managers to take bad assets.

    The banks declined to directly address ProPublica's questions. Asked about its relationship with managers and the cross-ownership among its CDOs, Citibank responded with a one-sentence statement:

    "It has been widely reported that there are ongoing industry-wide investigations into CDO-related matters and we do not comment on pending investigations."

    None of ProPublica's questions had mentioned the SEC or pending investigations.

    Posed a similar list of questions, Bank of America, which now owns Merrill Lynch, said:

    "These are very specific questions regarding individuals who left Merrill Lynch several years ago and a CDO origination business that, due to market conditions, was discontinued by Merrill before Bank of America acquired the company."

    This is the second installment of a ProPublica series about the largely hidden history of the CDO boom and bust. Our first story [6] looked at how one hedge fund helped create at least $40 billion in CDOs as part of a strategy to bet against the market. This story turns the focus on the banks.

    Merrill Lynch Pioneers Pervert the Market

    By 2004, the housing market was in full swing, and Wall Street bankers flocked to the CDO frenzy. It seemed to be the perfect money machine, and for a time everyone was happy.

    Homeowners got easy mortgages. Banks and mortgage companies felt secure lending the money because they could sell the mortgages almost immediately to Wall Street and get back all their cash plus a little extra for their trouble. The investment banks charged massive fees for repackaging the mortgages into fancy financial products. Investors all around the world got to play in the then-phenomenal American housing market.


    Continued




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    They created fake demand.
    One of the inherent features of central banking in general is to create [fake] demand, and their partners will benefit from this. Inject new money into the economy, hold interest rates below market value, and prop up business that are "too big to fail" from failing so resources can't be reallocated to more useful sectors. Business get fake signals of savings and investing, take out loans to increase production, not knowing it was all an illusion, and the savings and investment were never really there, then you have people taking on measures who can't really afford it, they take a loss. A Keynesian scheme that our country won't let it's grip off of.

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