So the most irresponsible central banker in the history of the world created the biggest bubble in the history of the world, which had disastrous consequences for the stock market and the economy. In order to ameliorate that, he has created bubble-like conditions and absurd financing schemes in real estate. Meanwhile, we've seen an enormous concentration of risk develop inside the financial system: We are down to just a handful of big banks and government-sponsored entities that are using his other favorite toy, derivatives, to theoretically manage away all their risks.
So how has that favorite toy of Greenspan done? As Jon Markman writes this week, one of the most knowledgeable experts on credit/derivatives, Satyajit Das believes that they are the reason we are now on the brink of "an epic bear market." (h/t Sideshow) The entire housing market built up under Bush have relied on leveraged debt which is the reason there is such a dangerous financial situation right now. (emphasis mine)
So what caused this economic meltdown? Conservative ideology which always favors greed and wealth and disdains regulation as an unbearable crimp on the economy. This too is a legacy of Bush.Rather than joining the crowd that blames the mess on American slobs who took on more mortgage debt than they could afford and have endangered the world by stiffing lenders, he points a finger at three parties: regulators who stood by as U.S. banks developed ingenious but dangerous ways of shifting trillions of dollars of credit risk off their balance sheets and into the hands of unsophisticated foreign investors; hedge and pension fund managers who gorged on high-yield debt instruments they didn't understand; and financial engineers who built towers of "securitized" debt with math models that were fundamentally flawed.
"Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game," he says. "Those loans were invented so that hedge funds would have high-yield debt to buy."
...So if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing.
In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to identify.
...When you add it all up, according to Das' research, a single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion -- or eight times total global gross domestic product of $60 trillion.
...One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It's a vicious cycle. In this context, banks' objective was to prevent customers from selling their derivates at a discount because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers already thin on cash.
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