The Undead Heart – Part 3

by Golem XIV

Part Three

What I have argued so far tries to describe how the system was poisoned and why it ‘froze’ as suddenly as it did. What I want to argue now is far more important. I want to show how Securitization and the Shadow Banking System, will, by necessity of their design, always accelerate towards the point of their own poisoning, crash and wreak. The devastation this rains down on our lives and societies, is, I want to show, inevitable and built in. If I am in any way correct, then the conclusion is, that attempting to ‘fix’ the system with regulatory tinkerings, back to any semblance of how it was, will put us back on the same path again. We will start towards a next crash: one even bigger than the present one. I believe our leaders and their financial masters are already pushing us on to that path.

Addiction – the need of greed

Financial experts love to talk about managing risk. They will often say that is what finance and banking is all about. It is buying and selling risk. Handling it, taming it, mastering it. But while that may indeed be what bankers do they are all too often driven by greed. And greed often overwhelms them and their cleverness.
The desire to create more securities, to buy and sell and bet on them, grew. The drug took hold. Sub-prime became a legal high. So did Alt-A and Option ARM’s and exotic, synthetic combinations and derivatives of them all. All delivering a jolt of risk and a legal high.

But like most synthetic drugs the process of making them can be long and delicate. A recent Fed paper on the Securitization and the Shadow Banking System found that

“Typically, the poorer an underlying loan pool’s quality at the beginning of the chain (for example a pool of sub prime mortgages originated in California in 2006), the longer the credit intermediation chain that would be required to “polish” the quality of the underlying loans to the standards of money market mutual funds and similar funds.” (P. 14)

The authors found six or seven levels of “polishing” might be required to turn sub-prime to AAA rated security. And remember these are now securities with the extra zing of contained risk added in. Risk you could get very, very high on.

Now I want to take a step back. It all sounds so good, so plausible, so ‘manageable’ that you just know that something is too good to be true.

Let’s return to reality shall we. All of this, no matter how clever or polished, ultimately rests on and derives its worth from, a pool of mortgages, which, if all the borrowers pay up, can still only give the known and finite return. Money lent out, money paid back with interest. The interest is the profit. And NOTHING, but nothing, you do will increase this amount. Sure, you might make more money betting on them with CDS contracts, but you can’t bet on them unless someone buys them in the first place. And if you are the one buying the actual securities – and someone has to – then at every step in this ‘polishing’ process some one has to be paid to polish, and each time a little piece of the total possible profit is spent.

Normally when you buy something, if you then have to do something to it, you expect to be able to sell it for more. Like you spend money doing up the kitchen so you can sell the house for more. But here you are having to spend money from your profit just to make them pass as AAA rated.

The worse the mortgages the more you will have to spend. And at the end of it you have a security, which is insured up the wazonga and is still dodgy. Why go to such expense and such lengths to make things so mediocre, unless you had some other very good reason for doing so? Why do it? Why would anyone buy them?

It’s no good saying, because its risky you’ll get a better return. Remember that return can still only come out of the profit from the interest on the underlying loans and some of that has been spent already for “polishing”.

In short, these dodgy securities don’t make a great deal of sense if you are buying them as an investment in order to get profit from the regular payments. Too much has been eaten away, what’s left is still risky over the life of the mortgage and you are reliant on the insurers to pay up if it all goes pear shaped. But they do make sense if you think of them as money.

First, as money, no one intends to hold these risky things for long. Everyone intends to get them to spend them. In which case going for risky ones that offer a higher return seems quite attractive. Neither you nor the person who accepts them from you as payment intends holding them. This works fine in a bubble market where everything is very liquid and deals are being done every day. And in the bubble years we did all hear of the ‘appetite for risk’.

Those creating the sub-prime based securities could justifiably say people wanted them. There was an appetite.

The second point is more important. These may have always been poor earners as long term investments but as long as they were polished, rated and accepted by all as AAA then they were as good as any other as a piece of cash.

You use the debt-turned-to-money to take on more debt. You then put your new debt to work in some new money making venture.

Welcome into the warm, hydraulic embrace of leverage.


You pay to have some new cash printed and polished. You use it to take out a large loan. You invest the loan. And it is the profit from this new investment that pays for and makes sense of the costs of all that polishing. This new investment, far removed from the original mortgages is what it has all been building towards. What it has all been about.

It is the profit you will make from the investment, made with the loan, given to you on the basis of the securities, made from the underlying mortgages. This is the real logic of the whole system. NOT getting a feeble return from a few poxy mortgages.

Mortgages were merely the feed-stock for a system (called Securitization) whose purpose was to create new money in order to feed into, in turn, another machine called Leverage.

Securitization plus leverage, lubricated by an unlimited new source of money. That was the machine. It’s what they are trying so hard to kick start again.
The thing to note is that the Securitization of sub-par mortgages does NOT make sense unless you have leveraged loans to bring in the profit. Is it any wonder that Henry Paulson while at Goldman from around 2000 onwards lobbied relentlessly for limits on leverage to be relaxed or lifted. And is it coincidence that when leverage was lifted in 2004 when Mr Paulson was now US Secretary of the Treasury that sub-prime took off?

I am not saying leverage was the cause of sub-prime. I am saying it was the other necessary part which had to be married to securitization for the bubble to inflate as it did. Securitization required leverage. Leverage enabled it. Together they brought the debt-to-money machine to life.

You started with a debt/mortgage. Turned it into currency. Used that to get another loan, i.e. turned it back into debt which you then invested it in another enterprise hoping to bring in more cash. And along the way that new loan you took on, using ‘money’ made from the earlier debt – will probably be securitized and entered into the same process. Confused? Don’t worry. So were half the people in the market, but it didn’t matter to them. They were turning water into wine and getting drunk on it.

Because from that one loan/mortgage has sprung another debt. Both now need to perform. If they do, the bubble grows and you will get twice as rich, twice as fast.
The securitization machine provided an endless supply of new money. It made sense to acquire the stuff because with it you could expand your own loan book. This is why the German Landesbanks bought so much of it. It was, to them, capital, which allowed them to go on a borrowing and lending spree of their own.

Anyone who wanted to grow aggressively and lend massively became the purchasers of as much of this stuff as they could get hold of. RBS was one. Buy it. Sell it on, use it as collateral. It was all good, as long as the bubble grew and leverage allowed returns to cover the costs.

But for the bubble to keep growing and the profits continue to pay for the costs and risks of the sub-prime securities leverage had to get higher and higher. The rate of acceleration of growth of the whole market had to increase. The graph had not just to climb but steepen. The problem is a line can’t get steeper for ever. Eventually it goes vertical and then there is no more. Markets call this a parabolic blow-off. After which because there is no more acceleration, the whole thing collapses back under its own weight.

That was the moment when everyone suddenly recognized the risk in every account and when Lehman could not repo any of its ‘assets’. The promise was revealed as a lie and everything stopped – dead.

The point after all this, is that the securitization system requires this leveraged acceleration of greater and greater risk and return. It will always be drawn to it, as a function is drawn to its underlying attractor. It is written in.


The most common argument heard about the ‘crisis’, is that something simply broke down/went wrong/ran amok. The break down caused a systemic malfunction of an otherwise fine system. Thus what we need to do is ‘fix’ whatever caused the breakage in the first place and adjust things so the same thing can’t happen again.
Fixing it will require a few trillion of cash injections. And then a combination of better ‘regulation’ and a few technical adjustments such as a bit more capital here and a bit better ratings there.

The argument I have offered you is totally different. It says that we have NOT, will not, CANNOT and SHOULD NOT fix the present financial system back to its former state.

For the simple reason that the present catastrophic situation we find ourselves in, was not due to a break down in the system, but is an inevitable consequence of how that system works in the first place.

Financial crashes and systemic insolvencies are built-in to the securitization/leverage system. So if we restore it to how it was – ‘fix ‘ it – we will have keep having these deflationary crashes.

The Savings and Loan crisis cost about $350 Billion to bail out, or 6% of US GDP at the time. This crisis so far, has cost about $2.35 Trillion or 16% of US GDP. Anyone remember all the pious, mea culpa, ‘lessons have been learned’ after the S&L crisis? Yeah sure!

According to Fed itself, what the Securitization of the Shadow Banking System does is,

“…converting opaque, risky, long-term assets into money-like and seemingly risk less short-term liabilities.” (Introduction)

“seemingly risk less”.
Let’s not get fooled again.

Original article here