"Subprime loans carry high interest rates, sometimes as high as 12 percent, and were designed for people with weak credit records. Unlike traditional banks and thrifts, which traditionally financed their loans with deposits, most subprime lenders are financed by investors on Wall Street who buy packages of loans called mortgage-backed securities."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

On top of that, many Fed officials counted on the housing boom to prop up the economy after the stock market collapsed in 2000.

Mr. Greenspan, in an interview, vigorously defended his actions, saying the Fed was poorly equipped to investigate deceptive lending and that it was not to blame for the housing bubble and bust.

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person's income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

Before this year, officials here enthusiastically praised subprime lenders for helping millions of families buy homes for the

Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2007 - Final results

19 December 2007

The 2007 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity Report which the BIS is publishing today shows a substantial increase in turnover in foreign exchange and OTC derivatives markets. Turnover in traditional foreign exchange markets increased by 71% between April 2004 and April 2007 to reach $3.2 trillion. The largest contribution to the increase in aggregate turnover was made by growth in FX swaps. Activity in OTC derivatives markets was vibrant in April 2007. Average daily turnover in OTC foreign exchange and interest rate contracts went up by 74% relative to the previous survey in 2004, to reach $4.2 trillion in April. Notional amounts outstanding went up by 135% to $516 trillion at the end of June 2007 and gross market values of OTC derivatives, which refer to the cost of replacing all open contracts at the prevailing market prices, increased at a considerably lower rate (74%) than notional amounts during the reporting period, to $11 trillion at the end of June.

These days a lot of people are saying things like that about subprime loans - mortgages issued to buyers who don't meet the normal financial criteria for a home loan. But here's the thing: Mr. Gramlich said those words in May 2004.

And it wasn't his first warning. In his last book, Mr. Gramlich, who recently died of cancer, revealed that he tried to get Alan Greenspan to increase oversight of subprime lending as early as 2000, but got nowhere.

A new report from Congress's Joint Economic Committee predicts that there will be two million foreclosures on subprime mortgages by the end of next year. That's two million American families facing the humiliation and financial pain of losing their homes.

At the same time, investors who bought assets backed by subprime loans are continuing to suffer severe losses. Everything suggests that there will be many more stories like that of Merrill Lynch, which has just announced an $8.4 billion write-down because of bad loans - $3 billion more than it had announced just a few weeks earlier.

Second, much if not most of the subprime lending that is now going so catastrophically bad took place after it was clear to many of us that there was a serious housing bubble, and after people like Mr. Gramlich had issued public warnings about the subprime situation. As late as 2003, subprime loans accounted for only 8.5 percent of the value of mortgages issued in this country. In 2005 and 2006, the peak years of the housing bubble, subprime was 20 percent of the total - and the delinquency rates on recent subprime loans are much higher than those on older loans.

Fed Shrugged as Subprime Crisis Spread

"Why are the most risky loan products sold to the least sophisticated borrowers? The question answers itself - the least sophisticated borrowers are probably duped into taking these products."

Fed Governor Edward M. Gramlich

In June, Dr. Gramlich published "Subprime Mortgages: America's Latest Boom and Bust" on a topic that he had warned about for years. Much earlier, as chairman of the Neighborhood Reinvestment Corp., he had urged lawmakers to better protect consumers against predatory lending practices and toughen the regulation of mortgage lenders and banks, calling the mortgage process "confusing."

LONDON (Reuters) - The $45 trillion credit derivatives market, created as a way for banks to hedge their lending, is now also contributing to the risks that banks will fail.

The rise of the market over the past 15 years, however, also makes it crucial that a big bank not be allowed to go down.

"Because of derivatives, it gets more probable that a big bank is going to get into trouble, but then there would be intervention to make sure it doesn't fail," said Willem Sels, head of credit strategy for Dresdner Kleinwort.

About two dozen big banks are major broker-dealers in the CDS market, which means they take one side of nearly every contract. The failure of a dealer such as Bear Stearns would threaten the entire CDS market and other derivatives market

The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) - see inflation derivatives - or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the

Averrage daily turnover in OTC foreign exchange and interest rate contracts went up by 74% relative to the previous survey in 2004, to reach $4.2 trillion in April. Notional amounts outstanding went up by 135% to $516 trillion at the end of June 2007 and gross market values of OTC derivatives, which refer to the cost of replacing all open contracts at the prevailing market prices, increased at a considerably lower rate (74%) than notional amounts during the reporting period, to $11 trillion at the end of June.

Buffett characterized their risk when he called derivatives a "financial weapon of mass destruction

PAUL B. FARRELL
Derivatives the new 'ticking bomb'
Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen

"We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

Derivatives bubble explodes five times bigger in five years

Wall Street didn't listen to Buffett. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. The new derivatives bubble was fueled by five key economic and political trends:

Sarbanes-Oxley increased corporate disclosures and government oversight
Federal Reserve's cheap money policies created the subprime-housing boom
War budgets burdened the U.S. Treasury and future entitlements programs
Trade deficits with China and others destroyed the value of the U.S. dollar
Oil and commodity rich nations demanding equity payments rather than debt

To grasp how significant this five-fold bubble increase is, let's put that $516 trillion in the context of some other domestic and international monetary data:

U.S. annual gross domestic product is about $15 trillion
U.S. money supply is also about $15 trillion
Current proposed U.S. federal budget is $3 trillion
U.S. government's maximum legal debt is $9 trillion
U.S. mutual fund companies manage about $12 trillion

warnings of real risk in 1995,

Financial Institutions Center
The Wharton School
University of Pennsylvania

Risks in Derivatives Markets

Ludger Hentschel

Clifford W. Smith, Jr.

96-24

November 20, 1995

Abstract : The debate over risks and regulation in derivatives markets has failed to provide a clear analysis of what risks are and whether regulation is useful for their control. In this paper we provide a parametric model to analyze default risk in derivative contracts. A firms less likely to default on an obligation on derivatives than on its corporate bonds because bonds are always a liability, while derivatives can be assets. Using default rates for corporate bonds, we provide an upper bound for the default risk of derivatives - one substantially lower than the popular debate seems to imply. Systemic risk is the aggregation of default risks; since default risk has been exaggerated, so has systemic risk. Finally, this debate seems to have ignored what we call "agency risk." Features of widely used incentive contracts for derivatives traders can induce them to take very risky positions, unless they are carefully monitored.

bond expert Bill Gross

Nov. 26, 2007

Beware our shadow banking system

We have a secret banking system built on derivatives and untouched by regulation, says Pimco's Bill Gross. Here's how to protect your pocketbook.

By Bill Gross, founder and chief investment officer of Pimco

Bill Gross, founder and chief investment officer of Pimco

(Fortune Magazine) - The tangled web of subprimes has claimed more than its share of victims in recent months: homeowners by the hundreds of thousands, to be sure, but also those who created, packaged, insured, distributed, and ultimately bought what should have been labeled "junk mortgages" but which by a masterstroke of marketing genius received a more respectable imprimatur.

"Skim milk masquerades as cream," warned Gilbert and Sullivan over a century ago, and sure enough, today's subprimes, packaged into financial conduits with monikers such as SIVs and CDOs, pretended to be AAA-rated cubes of butter.

Financial institutions fell for the ruse, and now we all suffer the consequences. Defaults are rising, the dollar's sinking, and - good Lord! - even Google's (Charts, Fortune 500) stock price is going down. Something must really be wrong.

It is. What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.

PHILADELPHIA - Derivatives are popping up everywhere - even in plain-vanilla bond funds - and it is making financial advisers and regulators nervous.

"I think most investors don't have a clue about the risk," said Lou Stanasolovich, president and chief executive of Legend Financial Advisors Inc. in Pittsburgh. "A lot of mutual fund managers that use these things don't even understand what they're doing."

Despite such concerns, however, the use of derivatives in mutual funds, exchange traded funds, closed-end funds and other investments is expected to increase, according to industry experts.

The reason is that asset managers can use derivatives to increase yield, and that is particularly attractive to baby boomers looking for income in retirement.

This year alone already has seen the creation of products that use derivatives to achieve a higher yield, and they have been popular, industry observers say.

Snip

But some financial advisers said that derivatives of any kind make them nervous.

It's not that derivative strategies are bad, said Richard Schroeder, executive vice president of Schroeder Braxton & Vogt Inc., a financial advisory firm in Amherst, N.Y., but derivatives are complicated, and it is up to the fund industry to explain the additional risks of such investments. He said he fears that it isn't doing so.

The same fears were expressed last month by Andrew J. "Buddy" Donohue, director of the Securities and Exchange Commission's division of investment management.

"It has been reported that many investors at the retirement stage of their lives are investing in funds based principally on the yield those funds may provide," he said at a conference in Palm Desert, Calif., sponsored by the Investment Company Institute of Washington. "It is imperative that funds, and those who sell fund shares, are clear about how that yield is generated, whether that yield is from income, and the risks that may be associated with a fund and its yield generation techniques."

WASHINGTON - The cost of the wars in Iraq and Afghanistan could total $2.4 trillion through the next decade, or nearly $8,000 per man, woman and child in the country, according to a Congressional Budget Office estimate scheduled for release Wednesday.

A previous CBO estimate put the wars' costs at more than $1.6 trillion. This one adds $705 billion in interest, taking into account that the conflicts are being funded with borrowed money

WASHINGTON - The Bush administration is importing many of the
contracting practices blamed for spending abuses in Iraq as it begins
the largest and costliest rebuilding effort in U.S. history.

The first large-scale contracts related to Hurricane Katrina , as in
Iraq, were awarded without competitive bidding, and using so-called
cost-plus provisions that guarantee contractors a certain profit
regardless of how much they spend.

Contracts for temporary housing have been awarded to politically
connected companies like Fluor Corp. and Bechtel National Inc., a unit
of Bechtel Group Inc., leading congressional Democrats to renew charges
of cronyism they first leveled when the firms won lucrative work in Iraq.

In response, there have been bipartisan calls in Congress to establish a
new government agency to manage the Louisiana rebuilding, and possibly
have it run by a prominent figure such as former New York Mayor Rudolph
Giuliani or former Secretary of State Colin Powell.

Separately, House Minority Leader Nancy Pelosi (D., Calif.) yesterday
said she supported the creation of an "antifraud commission" to oversee
government contracts issued in response to the disaster.

Some are questioning as well whether the Federal Emergency Management
Agency - which has a small procurement staff responsible for spending a
relatively tiny amount of federal money each year - is capable of
effectively disbursing tens of billions of dollars.

In Iraq, several audits found that contracting problems were exacerbated
by overworked and inexperienced government procurement officers who
weren't up to the difficult work they were entrusted to carry out.

"You can easily compare FEMA's internal resources to what you saw in the
early days of the Coalition Provisional Authority in Iraq: a small,
underfunded organization taking on a Herculean task under tremendous
time pressure," said Steven Schooner, a contracting expert at George
Washington University law school in Washington. "That is almost by
definition a recipe for disaster."

FEMA already is under fire for its poor initial response to Katrina. Its
chief, Michael Brown, was removed on Friday as head of the direct relief
effort. (See related article.)

U.N. experts, HUD disagree on housing

by The Times-Picayune

Thursday February 28, 2008, 10:10 AM

Two experts from the United Nations said thousands of black families would continue to suffer displacement and homelessness if the demolition of 4,500 public housing units is not halted, but federal housing officials in New Orleans countered that they have units available immediately for former public housing residents displaced by Katrina.

U.N.-appointed experts Miloon Kothari, the U.N. Human Rights Council's investigator for housing, and Gay McDougall, an expert on minority issues, urged U.S. and local government leaders to further include current and former residents in discussions that would help them return home.

"I think this is vindication of what public housing advocates have been saying from day one," said Monique Harden, co-director of the public interest law firm Advocates for Environmental Human Rights, who testified before Geneva-based U.N. experts

CBS News Investigates

Suicide Epidemic Among Veterans

A CBS News Investigation Uncovers A Suicide Rate
For Veterans Twice That Of Other Americans

(CBS) They are the casualties of wars you don't often hear about - soldiers who die of self-inflicted wounds. Little is known about the true scope of suicides among those who have served in the military.

But a five-month CBS News investigation discovered data that shows a startling rate of suicide, what some call a hidden epidemic, Chief Investigative Reporter Armen Keteyian reports exclusively.

Why hasn't the VA done a national study seeking national data on how many veterans have committed suicide in this country?

"That research is ongoing," he said.

So CBS News did an investigation - asking all 50 states for their suicide data, based on death records, for veterans and non-veterans, dating back to 1995. Forty-five states sent what turned out to be a mountain of information.

And what it revealed was stunning.

In 2005, for example, in just those 45 states, there were at least 6,256 suicides among those who served in the armed forces. That's 120 each and every week, in just one year.

Dr. Steve Rathbun is the acting head of the Epidemiology and Biostatistics Department at the University of Georgia. CBS News asked him to run a detailed analysis of the raw numbers that we obtained from state authorities for 2004 and 2005.

It found that veterans were more than twice as likely to commit suicide in 2005 than non-vets. (Veterans committed suicide at the rate of between 18.7 to 20.8 per 100,000, compared to other Americans, who did so at the rate of 8.9 per 100,000.)

One age group stood out. Veterans aged 20 through 24, those who have served during the war on terror. They had the highest suicide rate among all veterans, estimated between two and four times higher than civilians the same age. (The suicide rate for non-veterans is 8.3 per 100,000, while the rate for veterans was found to be between 22.9 and 31.9 per 100,000.)

PTSD

On Tuesday, the second day of testimony before U.S. District Court Judge Samuel Conti, Dr. Gerald Cross, the undersecretary for health at the Veterans Health Administration, made a startling admission during cross-examination by the plaintiffs' attorneys that would appear to contradict the agency's position.

Cross admitted that veterans of Iraq and Afghanistan were not only entitled to free healthcare, "there is no co-pay," he said.

Perhaps most startling, however, was testimony by Cross stating that of the 300,000 veterans of the Iraq and Afghanistan wars treated at VA hospitals, more than half were diagnosed with a serious mental condition, 68,000 of which were cases of PTSD.

His testimony marks the first time a Bush administration official has provided detailed information about the psychological impact of the Iraq and Afghanistan wars on combat veterans. Cross testified that five years after the invasion of Iraq, the VA has still not completed a study on the link between suicides and PTSD among combat veterans. However, he said such a study is currently in the works and may be published soon.

Paul Sullivan, the executive director of Veterans for Common Sense, Paul Sullivan, said more than 5,000 veterans commit suicide per year.

Dr. Arthur Blank, a renowned expert on PTSD who has worked closely with the VA, testified that about 30 percent of Iraqi war veterans are likely suffering from PTSD due to multiple deployments and the VA is not doing enough to care for them.

September 2007 - More than 1,000,000 Iraqis murdered

In the week in which General Patraeus reports back to US Congress on the impact the recent 'surge' is having in Iraq, a new poll reveals that more than 1,000,000 Iraqi citizens have been murdered since the invasion took place in 2003.

Previous estimates, most noticeably the one published in the Lancet in October 2006, suggested almost half this number (654,965 deaths).

These findings come from a poll released today by ORB, the British polling agency that has been tracking public opinion in Iraq since 2005. In conjunction with their Iraqi fieldwork agency a representative sample of 1,499 adults aged 18+ answered the following question:-

QHow many members of your household, if any, have died as a result of the conflict in Iraq since 2003 (ie as a result of violence rather than a natural death such as old age)? Please note that I mean those who were actually living under your roof.

Roubini’s Nightmare Scenario: A Vicious Circle Ending In A Systemic Financial Meltdown

It's another round of the credit crisis. Some markets are getting worse than January this time. There is fear that something dramatic will happen and that fear is feeding itself.
- Jesper Fischer-Nielsen, interest rate strategist at Danske Bank, Copenhagen; Reuters

Yesterday's action by the Federal Reserve proves that the banking system is insolvent and the US economy is on the verge of collapse. It also shows that the Fed is willing to intervene directly in the stock market if it keeps equities propped up. This is clearly a violation of its mandate and runs contrary to the basic tenets of a free market. Investors who shorted the market yesterday, got clobbered by the not so invisible hand of the Fed chief.

In his prepared statement, Bernanke announced that the Fed would add $200 billion to the financial system to shore up banks that have been battered by mortgage-related losses. The news was greeted with jubilation on Wall Street where traders sent stocks skyrocketing by 416 points, their biggest one-day gain in five years.

"It's like they're putting jumper cables onto a battery to kick-start the credit market," said Nick Raich, a manager at National City Private Client Group in Cleveland. 'They're doing their best to try to restore confidence."

"Confidence"? Is that what it's called when the system is bailed out by Sugar-daddy Bernanke?

Snip

The point is, Bernanke's latest scheme is not a remedy for the trillion dollar unwinding of bad bets. It is merely a quick-fix to avoid a bloody stock market crash brought on by prevailing conditions in the credit markets.

Bernanke coordinated the action with the other members of the global banking cartel - The Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank - and cobbled together the new Term Securities Lending Facility (TSLF), which "will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally." (Fed statement)

The plan, of course, is wildly inflationary and will put additional downward pressure on the anemic dollar. No matter. All of the Fed's tools are implicitly inflationary anyway, but they'll all be put to use before the current crisis is over.

Snip

According to the Wall Street Journal, the Fed has other economy-busting scams up its sleeve:

With worsening strains in credit market threatening to deepen and prolong an incipient recession, analysts are speculating that the Federal Reserve may be forced to consider more innovative responses - perhaps buying mortgage-backed securities directly.
As credit stresses intensify, the possibility of unconventional policy options by the Fed has gained considerable interest, said Michael Feroli of J.P. Morgan Chase. He said two options are garnering particular attention on Wall Street: Direct Fed lending to financial institutions other than banks and direct Fed purchases of debt of Fannie Mae and Freddie Mac or mortgage-backed securities guaranteed by the two shareholder-owned, government-sponsored mortgage companies. ( "Rate Cuts may not be Enough", David Wessel, Wall Street Journal)

Wonderful. So now the Fed is planning to expand its mandate and bail out investment banks, hedge funds, brokerage houses and probably every other brandy-swilling Harvard grad who got caught-short in the subprime mousetrap. Ain't the "free market" great?

Snip

Economist Nouriel Roubini predicted the whole sequence of events six months before the credit markets seized and the Great Unwind began". Here's a sampling of his recent testimony before Congress:

Roubini's Testimony before Congress:

There is now a rising probability of a "catastrophic" financial and economic outcome; a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown ... Capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit.
To understand the risks that the financial system is facing today I present the "nightmare" or "catastrophic" scenario that the Fed and financial officials around the world are now worried about. Such a scenario - however extreme - has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible.

Roubini has been right from the very beginning, and he is right again now. Bernanke can place himself at the water's edge and lift his hands in defiance, but the tide will come in and wash him out to sea anyway. The market is correcting and nothing is going to stop it.

Mike Whitney lives in Washington state. Read other articles by Mike.

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