If you are an
ART client, or own a previous Edition, this is free for you,
This monographs targets layman and
journalists, to provide a clear down-to-earth explanation of the
workings of the derivatives markets. In addition to trading
and industry practices, the purpose and essence of IR Swaps,
Mortgage Backed Securities, Credit Default Swaps, Collateral Debt
Obligations, etc are explained in simple terms understandable by
anyone, and especially if you have ever had a loan or a mortgage.
There is not a single mathematical equation in sight, except for
some very simple ones in the Appendix.
The motivation for this document was the considerable nonsense in the main-stream media regarding bankers and
derivatives. In many cases, the rhetoric is not only
fallacious, but also manipulation in attempts to promote
political ideology, and to deceive the public of the true
The document provides an account of the financial
markets "melt-down" of 2008 with hard data that shows the primary
cause of the melt-down was the US Government and its agents (the GSE's
Fannie, Freddie, et al). While bankers have a share of the
blame, their contribution is seen as primarily that of "speed" of
collapse. The primary issues is the US Government's 5
Trillion dollar "shadow bail-out" of the GSE's and the effective
cover-up of the US Government's culpability in the melt-down due
their 9.4 Trillion dollar over-supply of the sub-prime mortgage
markets, and the repeal of the Glass-Steagall Act.
The politicians' trick of "Wall Street bashing", who by early
2010 had paid-back 100% of the value of TARP, cleverly diverts the
public's attention away from discovering the 5 Trillion
used to "bail-out the Government" by "quietly" printing money (and a
lot of it).
"market professional" level products, see also the
This Edition's Update
The essence of this Edition and updates from earlier Editions are
provided in the Preface, which is available as an independent
document as one of the
This monograph was produced
using easily available public domain data so that non-market
specialists would be able to verify easily and independently the
facts and conclusions herein. Unfortunately, the US Government
is rather uncooperative and "sneaky" regarding the financial data
for many of its operations/agents. Moreover, they "morph" the
various departments and agencies, thus creating much discontinuity,
and the opportunity to "hide" crucial information.
As such, the data in the earlier editions of this monograph was
restricted to the easily available free data, which implies a very
much lower US Government created mortgage market (public sector
portion of the mortgage market). For example, just the three
agencies Fannie, Freddie, and Ginnie together are reported by the
Federal Reserve to have on the order of 7 Trillion (with a T) of the
14.6 Trillion US retail mortgage market as of 2008. However,
it is well known that other agencies have also created or induced
huge mortgage pools, such as the Federal Home Loan Banks, the FHA etc.
Indeed, as noted in the document, activities by the FHA and other
GSE's are particularly misleading. For instance a mortgage
issued by a bank to somebody who would not receive a mortgage if it
was not for FHA insurance generally shows up in the Government data as a
private sector mortgage. Clearly, such Government induced
mortgages correctly belong in the realm of public sector mortgages.
The earlier editions of this document put this "hidden" portion of
the public sector mortgage pool at 1 - 2 Trillion, as the data that
is easily available to non-specialists was not freely available to
confirm these "hidden" numbers. Thus, the earlier editions
quoted "verified" portion at around 7 Trillion, but expect a total of about
9 Trillion. That is, of the 14.6 Trillion of the total market
at the end of 2008, the US Gov accounts for 9 Trillion, or
approximately twice the size as the entire rest of the
market put together.
DOMAIN INFORMATION: late 2010 (just after the release
of our 2nd Edition), the FHFA (who are the new Government
controllers of the GSE's, replacing OFHEO and other previous
government controlling entities), released freely available public
information that the 14 GSE's that they now control have a total
mortgage and debt obligation of 9.4 Trillion. Crucially,
the total retail mortgage market at the end of 2010 is quoted by the
Fed at 13.8 Trillion. Therefore, the government's mortgage and
related portfolio is 68% of the total market, leaving the entire private
sector with about 32%. Thus, the US Government's "creation" is
indeed more than twice as big as the entire rest of the mortgage market
As in the book, keep in mind that the reality is
much worse, since the public sector/government position is more than
60% "crap prime" (i.e. the "special sub prime" created by the
government for the so-called NINJA etc loans, and which have a
default rate of around 30-35%). By comparison, only about 18% of
private sector positions are "sub prime" and those are generally
composed of "normal sub prime" (which default at around 8-15%).
Put differently, the total write-off of government created
mortgages is around 5 Trillion, while the total write-off in
the private sector is around 0.6 - 1.1 Trillion ... i.e. the
Government's pool of lost money is about 5 - 8 times the size of the
entire private sector put together, and about 40% of US GDP.
Keep in mind that
the GSE's have already received as much as 400 Billion in direct
cash infusions/bail-outs, plus many Trillions in bail-outs by
direct purchase of their MBS's or Fed "trickery" to artificially
inflate Fannie et al's holdings and profits (see the book and also
As a matter of interest, reports state that 9 of
outstanding mortgages are now controlled by the Government.
A COUPLE OF CHARTS - and the Real Culprits
There are a number of charts detailing all aspects of the "Crash".
A couple are presented here with abridged explanations, to
illustrate, with data, a tiny portion of the real cause and
The image to the right
(click to enlarge) shows the
data in the current book, and is referred to as "unadjusted" Fed
data, since it is taken directly as published by the Fed.
Notice that this image implies that the Gov's share of the total
market is about 50 - 60% around 2009.
US housing prices are included to demonstrate the Gov's mortgage
funding expansions creating the "bubble" starting around
2002 - 2003.
However, the Fed uses a "special" kind of reporting in which
large portions of the Gov's involvement are buried in the private
market data. For example, the FHFA's annual reports show that
the FHLB contributed on the order of 1 Trillion, but in the Fed's
data this shows up as private market activity. Similarly, the
"insurance" and other "indirect" efforts by the Gov create
mortgages that otherwise would not have existed. These too show up as
private market mortgages and induce on the order of another Trillion or
so that needs to be moved from the private sector side in the data
to the public sector side, The image to the right shows this
"adjustment**", with US GDP overlaid to illustrate the scale
of the Gov's "insanity".
Notice that the Gov's hyper-inflation of
the mortgage market (which starts around 1998) continues to increase
for almost two years after the mortgage market started to collapse
in early 2007 (and also well after the private sector has actually
started reducing its mortgage exposure in early 2007). That represents on the order of 1.5 Trillion in
"insane" additional fuelling of the mortgage/sub-prime disaster by
just Fannie & Freddie. Crucially, Congress knew of this in
2007 as can be confirmed by creation of the HERA legislation (to
bail-out the GSE's) by Nancy Pelosi ... so why did the Gov allow the
GSE's to continue past 2007? Indeed, Congressional and related
documents illustrate that Congress should have closed-out the GSE's
already in 2005-2006, but certain Representatives (e.g. Barney
Frank) scuttled every effort to stop-out the GSE's.
So who is the "gorilla" in the room, who is trading in
massive uncontrolled risk, and who is the real culprit in
creating the sub-prime melt-down?
Incidentally, and as explained in the book, the real problem is/was
not the "crash" at the end of 2008, but rather the recession that
started in 2007 due the Gov using a colossal credit card to
underwrite the us economy at rate averaging around 5% of GDP each
year from 1998 - 2008, via the "backdoor" we call the mortgage
Any financial reform that only restricts Wall St is nonsense, since
the Gov's role is 5 - 8 times the size of the entire private sector.
"Goldman bashing" may be good sound bites, but utterly meaningless
when their entire operation is the proverbial "pee in the ocean".
Moreover, if we are to send Wall St types to jail for the collapse,
then surely you must give even bigger sentences to the politicians
** Some of the "adjustment" follows from various
interpolation/extrapolation of known data, since it is particularly
difficult to have the Gov release certain data (e.g. the "indirect"
effects in the period 2000-2007). The data for 2008-2011 is
more complete, or can be extracted from additional sources. To
be sure, the "uncertainty" or "sparseness" in the data only applies
to the "adjustment" or "difference" between the Fed's and actual
results. In the worse case scenario, the few estimated data
point would not be more than 15% off, and again, that is only for a
small number of inputs to the charts.