How $700 Billion in Bad Debts Destroyed the World Economy

Want to understand how $700 billion in bad loans could take down a $14 trillion US economy and a $70 trillion world economy?

In an infamous speech on May 17, 2007 Ben Bernanke assured the world that the size of "bad loans" was limited and any problem with defaults would be "contained" and not have a big effect on the world's economy:

All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well. Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable.

But as Matt Taibbi points out, the banks took that bad debt and effectively xeroxed it again and again makes copy after copy that it sold into the world's "derivatives" market ballooning the real losses up into trillions and trillions that were untraceable because the idiot US government under Greenspan, Bernanke, Summers, Rubin, and Geithner refused to regulate the derivatives markets despite the efforts by Brooksley Born to try and regulate it.

Here is the relevant bit from a post by Matt Taibbi on his Rolling Stone blog. Look at the bolded bit for the key fact:

Apparently people feel that by explaining how the banks profited from the explosion of subprime home loans, I’m somehow letting the ordinary homeowner who over-borrowed off the hook.

But the question was never, Do ordinary homeowners share any blame for the crisis? The question, as implicitly posed by Bloomberg, was, Is it true that the banks had NO blame for the crisis?

We can all argue about how big of a slice of the blame pie should be doled out to other actors – the irresponsible homeowner, the corrupted ratings agency analyst, the sleeping regulator, the do-gooder liberal congressman, etc. – later on. But what the mayor said, and Wall Street flaks have been saying for years, is that the banks shouldn’t eat any of that pie, and that they only made those loans because they were forced to, by Barney Frank and Franklin Raines and other such liberal meddling kids.

So let’s examine that for a minute.

For one thing, we know, because of investigations like Carl Levin’s inquiry into Washington Mutual and its subsidiary Long Beach, that these banks were often well aware that fly-by-night lenders like Countrywide and Long Beach were committing fraud on a massive scale – and bought their loans anyway, knowing they could still sell them off on the secondary market.

In 2005, for instance, Washington Mutual did an internal audit of two of Long Beach’s biggest offices, one in Downey, California, and one in Montebello, California. They found that 53 percent of the Downey loans involved some type of fraud, while the number in Montebello was 83 percent. The internal investigation drummed up the usual litany of unsafe financial sexual practices, using white-out to disguise low income levels, cutting and pasting info from good borrowers onto the loan applications of less worthy applicants, and so on.

So you know what WaMu did about all that fraud they found? Zip.

The company overrode its auditors and sold those phony loans off into the market anyway. And internally, they did nothing to change lending practices. WaMu did a follow-up investigation in 2007, and found the fraud rate at Montebello was still 62 percent.

So forget about the banks being dragged, kicking and screaming, to take on even legitimate loans for unworthy, overextended homeowners. Not only did the banks willingly take on every conceivable real home loan, government-backed or not – they even wanted the fraudulent loans, the loans that were not just likely to fail but virtually guaranteed to fail.

Why? Because they could. Because they were making huge profits hawking these bad loans to third-party customers who didn’t know what they were buying.

But here's the real kicker: when the banks milked the Countrywides and Long Beaches dry, and ran out of real people with pulses to lend homes to, they went out and made derivative copies of those "unworthy” lenders supposedly forced upon them by Barney Frank, and sold those copies off on the secondary market.

In other words, they were so “reluctant” to give that Oakland janitor a house that once they had his loan on their books, they promptly Xerox-copied him in the form of synthetic derivatives (essentially, bets on his home loan) and sold him off in five, ten, fifteen different directions. Janitor takes out home loan, bank tells two friends, and those friends tell two friends, and so on, and so on. The banks sold every one of those endlessly-replicating little squares and made cold hard cash each time.

You remember that notorious Abacus deal that Goldman Sachs was involved with, the one in which a pair of European banks, the Dutch bank ABN-Amro and the German Bank IKB, lost a billion dollars buying a portfolio of designed-to-fail mortgage-backed instruments hand-picked by a short selling billionaire named John Paulson?

Well, that portfolio that Goldman and Paulson dumped on those two banks was not, in fact, a portfolio of real subprime home loans. It was a synthetic CDO – a giant package of bets on subprime home loans.

Mike Bloomberg wants you to believe the banks didn’t want anything to do with those unworthy borrowers. Yet in reality, the banks not only went to every conceivable length to take on the home loans of those subprime borrowers, they actually invented new technology to make clones of those Barney Frank debtors.

And there were thousands upon thousands of those synthetic deals, meaning each and every of those deadbeat subprime borrowers have been Xeroxed by the banks fifty or a hundred times over, and are flying around the globe to this day as toxic assets.

Nomi Prins pointed out in her book It Takes a Pillage that we could have paid off every subprime loan in America at the start of the crisis for about $1.4 trillion dollars. But the bailouts ended up being four, five, perhaps as much as ten or twelve times that size.

Why? Because we weren’t paying off the underlying loans of those subprime, personal-responsibility-deficient homeowners. We were paying off the banks' bets on those loans. We were adopting all those clones they made.

Anyway, there's is a massive gap between making a bad decision with one’s personal finances and committing criminal fraud in billion-dollar amounts. Morally, the two acts are not even in the same universe.

The real crime is that Bush's administration refused to regulate the financial system and the Obama administration has refused to clean up Bush's mess and prosecute the trillion dollar fraud that destroyed the world's economy.