Welcome to Babylon: Our economic "S" storm --Part I

"'Come, let us go down and confuse their language, 

so they will not understand each other.'  

That is why it was called Babel--because there the Lord

confused the language of the whole world..."

Genesis 12:7,9 NIV

How gut-wrenchingly ironic it is that almost nine years ago, we witnessed the symbols of economic might implode after two commercial jetliners deliberately crashed into them, and now, more recently, we saw a repeat of what occurred on 9/11.  But this time, no buildings were collapsed and no airplanes were used as missiles.  Instead, new security instruments called derivatives were the projectiles that collapsed--and continues to collapse--the entire world economy and financial system.  If you're saying to yourself, "Yeah, I've heard of derivatives; I hear that word thrown around all the time but I don't know what they are," you're not alone.  A whole slew of strange and complex new security instruments appeared that the general public,  and even some very smart people in government and on Wall Street, didn't understand.  It seemed that only a relatively small circle in the banking and finance industry truly understood what they were.  Reason: they created these dubious, high-risk investment vehicles.  

But what are derivatives?  In the simpliest terms, they are very high-risk bets, contracts based on the value of underlying assets, and/or which direction those assets will go.  Will they increase in value or decline in value?  The underlying assets could be anything--but that was the problem.  These underlying assets were collateralized debts--bits and pieces of good debts and bad ones, mixed and matched, diced and sliced until they were indistinguishable one from another.  This mish-mash of rotten and good assets were packaged together, chopped up into particular slices, and sold to investors.  The various types of derivatives floating around were enough to make most people's heads swim.  Here are a few abbreviations for them: CDO, CMO, CMBS, RMBS (investopedia.com is a great resource for simple yet comprehensive definitions of these financial instruments).  Everyone wanted a piece of the action.  All this activity was driving up the value of these dodgy securities, creating a derivative bubble. Everyone was doing it and making these kinds of bets.  But what made things worse was that these investments were highly leveraged--that is, the bets were largely financed by other institutions and investors.   But wait, there's more.  To insure against credit default, investors bought credit default swaps (CDS) from insurance companies such as AIG.  These insurance companies received monthly premium payments, with the expectation that, should their contract holders default, they would be covered.  AIG did not have the money to cover the mountain of defaults that were coming down like an avalanche in the Alps.  The whole thing stunk from the top down.

Alan Greenspan, the former chairman of the Federal Reserve, had said that it was all good, and that these kinds of high-risk bets were actually good for the market.  Peter S. Goodman filed an excellent and comprehensive report in the October 8, 2008 edition of the International Herald Tribune that covered Greenspan's role in the current crisis.  Since Greenspan was considered the Moses of the American economy, his thumbs-up on this extremely high-risk activity in the market was a signal to Wall Street to party on.  Greenspan's monetary policy, by the way, encouraged an orgy of borrowing and spending, since he countinued to raise the credit discount  window, thereby lowering the rate (the cost of borrowing money) during his tenure.  This was like pouring gasoline on fire.  When you include the fact that regulation (Glass-Steagall Act) that was made to prevent this disaster--regulation that was created in the wake of the first Great Depression, by the way--had been systematically dismantled since the 1980s, along with the relaxation of lending standards, which lead to the proliferation of subprime lenders, one begins to see the making of a perfect storm.  As the subprime tsunami picked up speed as it was moving toward shore, the attorney generals from all 50 states were sounding the alarm.  They saw what was coming and attempted to protect their citizens by exercising their regulatory powers within their jurisdictions.  Their cries to the federal government fell on deaf ears.  As a matter of fact, they were actively opposed by an arm of the federal government called the Office of the Comptroller of the Currency (OCC).  See the video below:

Let me be clear. I don't believe that this is a partisan issue, because upon honest inspection, I think that we will see that both parties (or members thereof) were culpable in aiding and abetting the criminals who pulled off this epic fraud on the American people.

Side bar: Although this is no laughing matter, there has been a humorous cartoon stick figure slide show circulating the Web called The Subprime Primer that accurately depicts how the subprime and derivatives Ponzi scheme worked.

So, Bernie Madoff gets trotted off to jail--alone.  He pulled that multi billion dollar scam off all by his lonesome.  He scammed hundreds of millionaires and some billionaires with no help from anyone, and without raising any red flags to regulatory bodies that something foul was afoot.  Really?  The whole world was scammed to the tune of trillions of dollars, and while Congress gives the culprits a good tongue-lashing, our legislators are, at the same time, giving them trillions more of our money in order that the miscreants may recover their losses--rewarding criminally reckless behavior. It's like being robbed at gunpoint.  The robber flees and loses the money while making a get-away.  Realizing his loss, he files a report to the police.  The police then comes to you and demand that you compensate the robber for his loss of your money.  Welcome to Babylon.

UPDATE: April 1, 2009

Sean Brodick of Money and Markets takes the gloves off in his viscerally scathing analysis of the current global economic/financial crisis.  The anger is really building out there.