The Recent Financial Meltdown – Financial Crisis Devastates American Economy Further

The financial sector of the United States is collapsing – and it has been for years now. Defaulted home loans number in the millions and the Fed can no longer make positives out of the reckless behaviors demonstrated by greedy investment banking institutions. Here are some quick facts concerning the recent financial meltdown on Wall St.

o The Fed granted Bear Stearns a $29 Billion dollar bail-out;
o The US government has taken over both home mortgage monsters, Fannie May and Freddie Mac – at a total economic impact to taxpayers totaling over $200 Billion;
o The traditional standard of finance, Lehman Brothers, recently filed for bankruptcy;
o Insurance mogul, AIG received an $85 Billion loan from the Fed – before being taken over by the US government;
o The Bank of America acquired full ownership of Merrill Lynch – previously the world’s leading brokerage company;
o Morgan Stanley stands to be purchased from a similarly-savvy commercial banking institution;
o Goldman Sachs has been beat nearly to death by the failing stock market;
o Washington Mutual, the largest savings bank on the planet, is bordering on a complete collapse;
o and guess who’s going to pay for all of it?

YOU ARE!

You are not yet diluted enough to believe that the government is going to take the losses, are you? Maybe our elected officials will all jump in and voluntarily take some serious pay-cuts. Or better yet, maybe the CEOs of these companies will all give up a measly $20 or $30 million of their wages to help stabilize the economy. Yeah right.

The fact is, as usual, that we the taxpayers will be made to suffer in unseen and uncountable ways as we continue to attempt to remain positive and faithful to our all-compassionate leaders and employers.

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The True Cause of the Global Financial Meltdown

Recently, we witnessed firsthand the global financial markets undergo a total meltdown. What amazes me is that very few people know the actual, underlying cause of the meltdown. Sure, there are plenty of suspects: greedy, reckless financiers, lax regulators and irresponsible consumers top the list. But these targets of our mutual wrath are merely scapegoats. Now I am not saying that they are all completely innocent of any wrong-doing. Some clearly crossed lines they were not supposed to cross; and, in some cases, their motivation for doing so was pure greed. But the truth is that their greed and failings were not the root cause of the meltdown; their greed and failings were merely coincident. After all, bankers have always been greedy, regulators invariably become lax, and history is replete with examples of irresponsible consumers; why should we expect any of them to behave any differently today than they have behaved throughout time immemorial?

The fact is that, like the fall of Rome, the meltdown was inevitable. That is because the global financial system was and continues to be inherently astable. In fact, the origin of the meltdown has its roots in relatively simple mathematics.

Now some of you reading this will think that I am a complete lunatic to suggest that mathematics is the root of our financial chaos. But I can assure you that that was exactly what caused the collapse.

It all has to do with a number famously known (and quite appropriately, I might add) as the golden ratio. Over time, as total debt increased, the interest that had to be paid on the debt effectively drove the money multiplier lower and lower. Eventually the money multiplier reached the magic number known as the golden ratio, and that is precisely when all hell broke loose in the financial world.

So what exactly is so special, you might ask, about this “golden ratio” number and why should it have anything to do with the meltdown?

The answer is that the golden ratio (approximately 1.618034) is something akin to the speed of light. It is a limit that relates specifically to continuing fractions. And it just so happens that the money multiplier is itself a continuing fraction.

When the money multiplier is greater than the golden ratio, the net money supply (the money supply less interest owed) is greater than 1. And a net money multiplier greater than 1, such as 2 or 3, means there is excess money available within the system to support an increase in the total amount of interest income and, therefore, also an increase in the total amount of debt. In fact, the higher the money multiplier, the more excess money the system generates and the higher the interest rate the system can support.

But an odd thing happens on the way to the forum when the money multiplier hits 1.618034 (the golden ratio). At that magic number, the true, effective “reserve rate” is equal to 38.2% (or more precisely, 2 minus the golden ratio). And when that number (38.2%) is multiplied by 1.618034, the product turns out to be 0.618034 (or the golden ratio minus 1).

What all this mumbo jumbo mathematics means is that the interest/reserve portion of the money supply (38.2% of the total money supply) is equal to 61.8034 cents for every dollar of hard currency originally in the system. When the interest/reserve portion of the money supply is subtracted from the total money supply (represented by the money multiplier: 1.618034), the remainder is 1, meaning that there is one dollar left in the system for each dollar that was in the system from the start.

Unfortunately, it also means that there is no excess money left over that can be added as additional interest income. In other words, the effective interest rate is forced to 0. And at 0% (and below), banks and other lenders have absolutely no reason to lend out money. Banks are, after all, literally in the business of making money, not losing money.

So, as you see, the problem stems from simple math. Take the money supply and subtract out the interest/reserve portion. If what remains is more than what you started out with, you can afford to increase your total debt. But if the remainder is less than what you started out with, then adding additional debt will eventually grind you down to zero (and when I use the word grind, I do so with full awareness of its denotative and connotative meanings).

Now to see for yourself that I am right, you simply need to turn to the Federal Reserve’s own graphs.

The first chart shows the 10-year treasury constant maturity rate. Note that, after peaking at the end of 1981, the interest rate begins a somewhat “steady” decline.

Credit Default Swaps and How They Almost Brought Down the Financial System

With most people continuing to pay their mortgages, despite potentially being underwater, many have wondered how can what seems not so big of a problem require trillions of dollars of bail-outs worldwide. Where we have gotten of course has several moving parts to it, including easy credit. A few years ago, the homeless guy on the corner who couldn’t find a job, could theoretically state his income from pan handling as a self-employed individual, of course exaggerating his income, and, get a mortgage. But we all know the first answers that come to mind: easy credit, little to no lending standards and simple euphoria over real estate prices like the tech bubble, which also came to an end. However, ultimately we believe there is one part to this answer that many people don’t know about, yet, and it is one of the main reasons why governments globally cannot let any major financial institution fail, despite the thought many have, which is if they screwed up, let them fail.

It all started with leverage, we all know this, but has anyone really sat down and wondered “How were these banks leveraged 20 to 30-1?” Are other banks just blindly loaning money? Lehman ultimately failed because it was leveraged 30 to 1….as did Bear…as did Fannie and Freddie (not 30-1, but you get the point). Well, there are these financial instruments called Credit Default Swaps or CDS’s, which until recent times, no one really paid attention to or knew enough about to truly understand what is happening in the heads of Paulson and his global counterparts. So, what is a CDS? A CDS is kind of like insurance, however, the CDS market is not regulated, and therefore we cannot call it insurance. It is a “swap,” which essentially is a private contract between two counterparties. That being said, these contracts can also be traded between other parties than who they were originally issued, and you can even own a CDS without owning the corresponding debt. For example, let’s say last year I am a European bank and I bought $100 million in Lehman Brother’s bonds. I then went to AIG and said “I want to buy a CDS on this particular bond.” They would then come up with some amount or premium for this “insurance policy” where as for the amount of time agreed, AIG has guaranteed that $100 million of Lehman debt to me under a contract; so if Lehman does not pay, AIG is required to give me or the owner of this contract at the time of settlement, the $100 million. Now, since CDS’s are essentially private contracts and not regulated, how they are reported on a company’s books is completely irresponsible (a discussion for another time) but, when buying this insurance from AIG, the buyer ultimately has no idea how many CDS’s AIG has sold on Lehman. All the buyer has to go on is their level of confidence in the seller, in this example, AIG.

Of course, a year ago, AIG was a highly rated company with a huge market cap, and buyers would think, oh this $100 million is nothing for them to “insure” for me. Again, the fact that these things were not regulated by anyone is a conversation for another time, but, at this point, the European bank is then able to go to XYZ financial institution and borrow based on some calculation that factors in the fact that they have essentially bought what they believe is insurance on this investment. Without getting into details, let’s say they were able to borrow 80% of this investment, and go buy another $80 million of Lehman bonds, buy another CDS, and yup, you guessed it, do the whole exercise over again. In this example, the leverage is great for the buyer as long as things work. The CDS transaction is great for AIG because they took in a premium which they will pocket as long as there is no claim on this contract. Now, this market has exploded over the past several years, simply because we have been in strong economic times, and there had been virtually no payouts on these contracts. Companies were essentially pocketing billions of dollars of premiums each year, and not paying out a dime. Imagine, an insurance company who sells life insurance, but nobody dies! Now, to not complicate things further and move on, just start to imagine this: If you could sell life insurance and have nobody die, at some point, you would start selling a lot more insurance to take in the premiums than you could ever cover if all of a sudden everyone died at once. That being said, as mentioned above, the insurance industry is regulated, and contracts are issued based on actuarial data. Unless something catastrophic happens, this data is pretty reliable.

Now, in this world of unregulated CDS’s, there is no market where these trade, there is no pricing model, there is no standard. So when the European bank came to AIG, AIG supposedly used their internal risk model to come up with a price, which we can pretty much promise you was much cheaper then it should’ve been because they never thought they would pay out a claim. Further, they would continue to sell protection on Lehman to anyone who came to them. For example, instead of saying to the buyer “we cannot further protect Lehman because we have reached our limit with outstanding contracts” they just kept selling it. Of course, as the buyer, you are hoping (or not caring because you want your leverage) that AIG has taken all of this into account as they have come up with your price and agreed to offer you this protection. Now imagine in a world of no regulation, the type of trouble institutions could get themselves into. In the simple example of AIG, which is now starting to become public, they sold 100’s of billions of dollars of CDS’s on anything from Lehman debt, to a pool of subprime mortgages, to a pool of car loans, to a pool of unsecured credit card debt, to various government’s debt. From what we understand, you could come to them with any sort of debt, and they would use their internal pricing model to essentially come to you with an offer for a CDS. Now if it was only one company doing this, things would be ok. Unfortunately, the financial world loves risk, loves leverage, and well, who doesn’t love an opportunity to sell something that you believe you will never have to pay a claim on. That being said, here is a little summary of what has happened in recent times and how we have quickly gotten where we are. Oh, before we continue, by the way, CDS’s originally started in Europe, so it’s not just US institutions who have been selling these things; it is global, as are the buyers.

Essentially, Fannie and Freddie have been buying CDS’s for years to hedge their portfolio of mortgage holdings. As explained above, this is how they have been able to use leverage and buy mortgages on large scale. Did you wonder why the Treasury forced Fannie and Freddie into receivership when in fact they could access the capital markets, they had the proper capital ratios to move forward, and actually, as many argued, they were much less levered than Lehman for example and the government could’ve have just loosened up their leverage requirements (which they did do early on before receivership)? At some point, the US Treasury woke up and realized that the CDS market is a HUGE market. When we say huge, we are referring to the notional value. Notional value is the contract amounts of the CDS’s out there. In the above example, the CDS had a notional value of $100 million, even though when times were great maybe only $5 or $10 million in premiums would’ve exchanged hands for this protection. Well, the Treasury realized that the CDS market has a notional value of around $55 Trillion Dollars. At this point, in their infinite wisdom, they realized, as mortgages began to default, and Fannie and Freddie went to their counterparties on these CDS’s to get paid, it would not take much for a counter party to simply not have the equity to make good on this contract and file bankruptcy. Fannie and Freddie would then suffer huge losses that they were un-prepared for and this is what would eventually lead to their demise. So the treasury looked ahead a year, and realized Fannie and Freddie would get screwed on these transactions, and would quickly become insolvent. As the executives of the companies argued almost daily, “we are above our capital requirements”, the Treasury came in and took them over. They foresaw the problems ahead with the CDS’s.

Moving forward, did you wonder why AIG needed the government within days of Lehman collapsing? What we mean is, what was going on that all of a sudden they needed the government and had no option. Well, a few days before Lehman went under, AIG realized that their exposure to Lehman CDS’s alone would put them out of business. Without getting into detail of exactly how the moving parts of a company’s corporate structure work, this is why AIG has needed to quickly borrow $130 Billion+ from the Government within a month of being essentially taken over. The $130 billion is to keep them in business due to some collateral requirement they have agreed to once the Government came in and applied their formulas on AIG’s outstanding CDS’s. Even S&P came out and said they were “shocked” that AIG has had to borrow so much money so soon, and that this lowers their outlook of AIG surviving. When S&P made these comments, along with the subscriber emails asking questions, was when we decided to spend the time on this education. We couldn’t believe even S&P apparently did not understand what the sudden immediate global crisis was really about. So what would’ve happened if AIG was allowed to fail along with Lehman? Think about this; let’s say AIG is exposed to the tune of $100-150 billion with the Lehman BK. If AIG was not supported by the government, this would immediately lead to $150 billion lost globally by counterparties who did not expect to lose that money. When we say they did not expect to lose that money, what we mean is:

1. Since they had a CDS on their position that they felt was reliable, they were never proactive with selling their LEH debt prior to it going to zero. For example, if they did not have the CDS, many parties would have opted to “stop out” of the position when the debt went to.50 on the dollar, but why should they? They were “insured.”

2. Now, as explained above, they would use the CDS’s to lever up. So wherever the $150 billion of losses were going to occur, you can pretty much assume the other side of that transaction, whether it was a bank, a pension fund, a hedge fund, or maybe just another company, used some sort of leverage on that position since they had the “insurance,” and the losses they would have incurred would have immediately wiped many of them out, or at least put them in a position of being wiped out.

When Paulson realized the global fallout from a LEH and subsequent AIG bankruptcy, he realized financial institutions globally were on the verge of collapse, due to just, one company. LEH’s CDS’s are an interesting story in themselves, as some have estimated the full claims on the outstanding CDS’s will be somewhere between $400 and $600 Billion dollars. We say interesting because remember, there is no regulation. Ultimately NO ONE knows who is exposed, and further, when exposed, who might collapse because they can’t pay, and then, NO ONE knows who owns the CDS and will collapse when they can’t get paid. That being said, this is why just weeks after Paulson stepped in and saved AIG, he came to congress and said “I need $700 billion dollars immediately!” Many thought he was exaggerating when he said the financial system could collapse in weeks if he does not get this money. Well, he was not lying. Think about how it is playing out since. Paulson got his $700 billion, and has vowed to do all he can to not allow institutions to fail. Further, the EU nations, who can never agree on ANYTHING, all of a sudden quickly agreed to a $2.3 Trillion package, in which they are basically guaranteeing all bank deposits and all newly issued bank debt. Why such extremes? Because the Lehman bankruptcy alone could have caused the financial system to collapse depending on who is exposed. These governments, quite possibly led by Paulson’s intervention, quickly understood the potential repercussions and stepped up. They all want to be ready to back stop the CDS’s (whether it be through investing in a bank that was exposed or allowing one that is exposed to fail and then investing in the institutions who then unexpectedly lose on their Lehman investment.) Further, Europe at least has come close to guaranteeing they will not let any financial institution fail. Many have asked why this is truly necessary. Well, since CDS’s are unregulated, no one will know who is exposed until it is too late. That being said, it is easier to make sure no one of size fails, instead of letting their be serious repercussions and coming to the scene of the accident which would quickly become a chain reaction pile up. Also, Lehman is just the first and easy example. However, Lehman alone could have caused everything to unravel globally. Just think of the chain reaction:

Bank A and Pension fund B own debt on Bank C, D and E, and are invested in Hedge funds F and G. C,D,E,F and G all own Lehman Debt, are leveraged, and bought CDS’s on Lehman from XYZ. Further, A and B also have CDS’s on the debt they own in C,D and E, and a majority of those CDS’s were also purchased from XYZ. Remember, XYZ could get over-exposed to everything, because there is no regulation. Now remember, for the most part, when these guys owned the CDS’s they assumed they are insured, so they have went and either gotten leveraged, or maybe just got overexposed. Let’s do the math:

Lehman fails. XYZ becomes insolvent. All of a sudden banks C,D, and E experience huge losses they did not expect, and the way the markets work these days, we all know, they would all struggle to find a life line, and could quite possibly go under. Further, F and G go belly up. Now you have Bank A and Pension Fund B experiencing huge losses on all of their investments, which were leveraged, and thought to be insured. But wait, XYZ is gone. Now what? Now Bank A needs a lifeline and a Pension just became severely underfunded.

As complicated as the above exercise is, multiply it over and over and over again, simply because you can’t forget, Banks C, D, and E, may have sold CDS’s on Bank A. Now if Bank A doesn’t make it, all of the investors in Bank A lose unexpectedly. Long story short, the whole financial system could collapse.

Now, think about the above example, and just remember, CDS’s are out there on every sort of debt. That being said, have you asked yourself “Why are the credit markets locked up?” especially when it seems many institutions are just sitting on cash and not putting it to work. For example, why is an absolutely financially stable company’s short term commercial paper all of a sudden not attractive? We believe, for one, fears of the above example. Simply stated, if you are involved in hundreds if not thousands of counterparty transactions, yet, you have no idea who is involved with whom and who is exposed, you really have no clue where your liability is. Come tomorrow, you could all of a sudden be staring at huge losses on your holdings, institutions you do business with and have many arrangements with becoming insolvent overnight, etc. Because of this, most large institutions have chosen to keep their cash as cash so they may buffer any unexpected losses and not be forced into a potential quick demise. Further, let’s say you buy commercial paper on ABC, and tomorrow the bank that provides ABC with their main credit line becomes insolvent because of their exposure to Lehman CDS’s, all of sudden your short term low risk commercial paper investment is in danger. That being said, simply the risks involved compared to the returns on these investments just make them unattractive.

So where do we go from here?

If you abstractly think further and remember that the notional value of CDS’s is over $55 trillion, you realize all the global steps being taking are mainly to prevent the potential of the chain reaction explained above from occurring in the sense that they will make sure no large CDS claims ever need to be paid since they will essentially not allow anyone to fail! With that being said, we do believe that the recent steps taken by foreign governments, along with the additional steps being announced by Washington almost daily, including them forcing banks to take money, will slowly unlock the credit markets and will eventually work. How long will this take? We are in unprecedented times, and this remains unknown. However, trillions of dollars in global currencies will have to be printed, and economics 101 teaches us when you print money you have inflation, and inflation is just not good.

Greece, Cultural History and the Financial System

Greece has always had a thriving underground economy. The long history of human civilization there and even the geography of the island nation has created long-standing traditions and deep kin relationships that bypass official governmental channels, which leads to a significant percentage of the economic activity happening outside of the purview of the political powers. This is the way many Greeks have lived for hundreds of generations.

It is important to understand this point. The Greek people are no less hardworking than the French or the English, and if the underground economy is included, the per capita economic production of Greece is not that far off of France or Italy (at least until recently when the EU started choking their economy to death). The truth of the matter is Greece never really joined the rest of Europe in reforming and modernizing its economy in the post-war years.

The whys and wherefores of the situation are complex cultural questions, but it boils down to political will… they didn’t want to and they never had to (until now). The overall effect of a huge underground economy is, of course, that a lot of economic activity occurs (money changes hands) without the government taking its share (as no one involved pays any taxes, fee and so forth). The other overall effect is a general cultural belief that it is OK to cheat the system… I mean my neighbor and my brother are making a lot of money and not paying any taxes, so why should I pay mine and just barely get by… ? And, of course, this attitude about the system comes from the top and spreads from parent to child by cultural transmission… and on one level can even be justified by the fact that the politico-economic system is largely “rigged” with politicians and civil servants almost all making very comfortable salaries.

When you couple this socioeconomic situation with two or three generations of self-serving, inept and increasingly bureaucratic political leadership, and you throw in a major international financial crisis and hard-headed creditors with a different cultural perspective who demand you now play by their rules if you want to stay in the EU, then you have created the “Perfect Storm” that is Greece today.

In fairness to the Greeks, it should be mentioned that they are certainly not the only society in the world (or in Southern Europe for that matter) where underground economies have historically flourished and still exist today. Italy, Spain, Portugal, Albania and Serbia (non-exhaustive list) all have large black markets of various sorts, and therefore a great deal of economic activity occurs in the unofficial economy.

Ramifications of a Greek Debt Default

The issue can be reduced to whether the Greek government should accept the austere terms from the EU for yet another major bailout of their debt, or simply default and start over from scratch. But viewing the situation as a simple dichotomy ignores the elephant in the room… that is, what happens to Europe and even the world economy if Greece defaults on some or all of their $375 billion sovereign debt.

Most economists and financial analysts believe (although only a few have said so publicly) that this entire two-year-long dog and pony show with Greece and the EU negotiating bailouts has really been about buying time to build an economic “firewall” to protect the rest of Europe from the fallout of a Greek default. In other words, most reasonably realistic European political (and financial) leaders expect that Greece will default on their debt on some level at some time. The devil, of course, is the details.

The EU has had time to cobble together various mechanisms to constitute the “firewall” they hope to use to insulate the rest of Europe from the fallout of a Greek default, but the mainstay is the $1 trillion European Stability Fund (ESF). With that amount of money, the issue is not covering any losses from a Greek default, but rather what happens to the financial system at large given the systemic shock of a several hundred billion dollar sovereign default.

A few doomsayers predict a “Lehman-like” collapse of the financial system due to the shock of a Greek default, with Italian, Spanish and Irish debt costs spiraling out of control, but most economists now seem to believe the odds of complete default that could possibly produce that kind of systemic disruption are very low, and that a “controlled default” where the various creditors agree to take a haircut is the most likely outcome.

Future of the Greek Economy

The first point to be made is that this whole situation is only partly Greece’s fault. Sure, they racked up the debt, and worse, together with Goldman-Sachs and other Wall Street Crooks, fudged the accounting through out the mid 2000s so it didn’t look so bad, but the reality of Greece’s culture and economy is common knowledge to all and those who loaned them the money did so with this knowledge. Furthermore, as numerous economists and historians have pointed out, Greece and Spain, Portugal and even Italy were essentially forced into the EU before they were ready (in terms of financial and regulatory infrastructure), and other nations like Germany and France profited handsomely from the unequal economic relationship in the first decade or so of the union.

The second point is that the draconian austerity measures the EU is insisting on as part of the bail out guarantee that the Greek economy will be in a severe recession/depression for at least the next 5 to 7 years, and maybe even as long as decade. Given this now inescapable fact, there is absolutely no question that the Greek economy and the Greek people would have been better off defaulting a year or two ago, and yes, leaving the EU. Having control over your own currency is an invaluable tool in dealing with sovereign debt, and if the Greeks had been able to deflate their debt (like we are doing right now) then they would have been able to right their economy much more quickly and the many years of suffering that the Greeks now face would have been significantly reduced.

Debt Settlement – A Loophole in the Financial System That Allows You to Eliminate Unsecured Debts

There is no doubt that these days thousands of Americans have been gripped in the fierce clutches of unsecured credit card liabilities and see no way to get rid of them or come out from this vicious circle of debt. By each passing day their difficulties are increasing as they are being approached by collection agencies and they are threatening and harassing them for the repayments of their liabilities. The credit card debtors are having intense difficulties these days because on the one hand they have lost all their financial resources over which they were depended for the repayment of their loan and on the other hand they are not finding any regular income streams or other opportunities so they could repay or even service their massive liabilities. Now they have no need to worry anymore because you can take advantages of the current situation and the loopholes of the financial systems which can easily eliminate your debt by even more then half.

It is a viable fact that the increased number of consumer default may result in the collapse of the entire financial system because hundreds of national and international investors will certainly pull out their billions of dollars in investment immediately when they find that consumers are defaulting over their financial commitments. The same situation is being witnessed in the US economy these days because of the recent financial turmoil. It has wiped out financial assets of debtors and compelled them to become bankrupt on a large scale, if they started to show their default over their financial commitments then there are higher chances that the economic instability may turn into recession with the collapse of the whole US financial system.

This loophole of financial systems is very beneficial for credit card debtors because the Government is offering several debt relief programs in order to protect them from possible default and the debt settlement program is one of them through which you can eliminate legally more than 50 percent of your debt and the remaining balance you can pay in a lump sum, trough this loophole of the financial system, you can easily get rid of your massive debts.