HELGA ZEPP-LAROUCHE: Greed Turns to Angst: The House of Cards Is Collapsing
August 4, 2007 • 9:49AM

by: Helga Zepp-LaRouche

The core meltdown of the world financial system, which has been in preparation for a long time, has now openly occurred, with the collapse of the subprime mortgage market in the United States. Beginning with two hedge funds belonging to Bear Stearns, a series of such funds have gone to ground due to speculative failures, and the turbulence has finally spilled over into the international markets and implicated financial institutions in Germany, France, Great Britain, and Australia. And that is only the beginning.

While most of the press internationally is in full cover-up mode, the near collapse of the German "industrial credit bank" IKB has shocked some in Germany into recognizing the situation (see accompanying article). Jochen Sanio, head of the German banking regulatory agency Bafin, admitted, minutes before the IKB crisis was declared to be out of control, that this amounted to the "worst banking crisis in Germany since 1931." According to the Sueddeutsche Zeitung, the "whole German banking system" was in danger, which was obviously the reason for a temporary rescue action for the IKB by the German government and the State Credit Bank for Reconstruction, at the tune of 8.1 billion euro (over $11 billion).

But this is only the tip of the iceberg; more U.S. mortgage bankers, such as American Home Mortgage, are in serious distress. One reason for that lies in the practice of so-called "adjustable mortgages," a procedure whereby the buyers can acquire real estate, which is more expensive than their ability to pay, and in which, for a certain period of time rather low interest rates on the mortgages fall due, but then, after a prescribed period, at most two years, are automatically raised. If the higher rate goes into effect, the payments rise in the range of hundred of dollars (per month). This subprime mortgage market went into full swing in the spring of 2005, therefore an avalanche of increases in the rates has been unleashed precisely at the present time.

All in all, increases in the interest rates on adjustable rate mortgages affect 12 percent of all mortgages in the United States, raising mortgage payments by a trillion dollars, on at least 12 percent of all mortgages in the United States. In October alone mortgages will be jacked up by over 50 billion, at which point the bloodbath, which has already occurred in the subprime mortgage market, will be a proverbial picnic, and eventually all categories of mortgages will be threatened to be affected. According to Moody's Economy.com, between 1995 and 2005 about 3.2 million householders bought houses on the basis of the secondary mortgages or similar credit-terms, and thus it is expected that about two million of these houses will be lost in the next months—as long as you consider only the situation in the housing market itself. The flood of housing sales has led to a dramatic collapse in real estate prices; because of the exposed position of the financial institutions, it will become considerably harder to get new mortgages, and the effect on the real economy, including jobs in the construction sector, will be catastrophic.

Much more dramatic than this situation itself is the fact that this collapse has been accelerated by another process with very much more far-reaching consequences, namely the drying-up of the paradise of cheap credit as a result of the end of the Japanese yen-carry-trade. With it dried up the wonderful source of liquidity, which permitted investors for years to borrow advantageously in yen at a zero interest rate, in order to invest in higher interest rate sectors around the world. The flood of liquidity from this source amounted to 500 billion dollars, which has been as good as cut off. In the face of rising interest rates, now speculators who have contracted cheap yen-credit and were met with losses in the American mortgage market and in the hedge funds, have sought desperately to turn their investments into cash in order to pay back their yen-loans, which has led to an up-valuation of the yen. Again this raises the losses of the speculators. The reverse leverage leading to the collapse of the speculative pyramid is in full swing.

Actually the banks and financial institutions are currently suffering from a kind of withdrawal shock. Because, while the takeover mania by the hedge funds and private equity funds has recently reached dimensions never known before, —worldwide the hedge funds in the first half year of 2007 have taken over companies worth 2.3 trillion dollars—they are sitting on a debt mountain of 1.5 trillion, of which a portion, in light of the situation of the always growing reach of the capital markets, threatens to become bad debt. The credit institutions, in a panic, are trying to get these debts off their books by year's end, because they could otherwise not undertake any new financial operations. For the market of mergers and takeovers, the honeymoon is definitely over.

Analysts from Credit Suisse are warning that the banks are having great difficulties in selling new bonds—if they can't do this, the credit lines to the hedge funds and other market participants must be cut off, which must lead again to a cascade of liquidations, in other words, a crash.

In reality we are now experiencing how the greatest liquidity bubble in the history of the financial markets is beginning to burst. Lyndon LaRouche incisively recognized the beginning of this development when he identified Nixon's intervention on August 15, 1971, namely the loosening of the fixed exchange rate system, the separation of the dollar from the gold standard and the creation of the Eurodollar market, and with it, of private credit creation, as the beginning of a process which would lead to a new depression.

Alan Greenspan, who can take dubious credit for his part in this development, going down in history as "Mr. Bubble," is responsible for the recent explosion of the casino economy. After the crash of 1987, which showed parallels with Black Friday of 1929, he had the glorious idea of inventing "creative financial instruments." To that category belonged, among other things, credit derivatives. By 1998 the volume of credit derivatives amounted to 180 billion dollars. When in September of 1998 the hedge LTCM, in the context of the Russian state bankruptcy and the GKO crisis, threatened to go bankrupt, the G-8 nations decided to set a huge liquidity-pumping machine into motion. In 2006 the volume of the "wonder-weapons" of financial transactions, the so-called collateralized debt obligations (CDOs), reached a fabulous 3 trillion.

Through these "structural products," the bankers package credit-risks of totally different kinds of debtors into bundles, divide them into different classes of risk, and sell them in tranches to investors. The defenders of this practice argue that the hedge funds thereby play a positive role, because they spread the risk onto many shoulders. This theory has only one totally cogent flaw: as long as all asset prices are rising, everything functions wonderfully, only—because there is also no risk. But at the moment a reverse leverage collapse sets in, the linkage between the different market segments through the hedge funds drags the whole system into collapse: the famous cluster-risk.

A further problem arises from the fact that, through the instrument of the credit derivatives, a house of cards has arisen, which is susceptible to the domino-effect of the crash. The difference between creditors and debtors is wiped out, the debtor appears at the next moment as a creditor to another debtor, who again gives out credits from his side, etc. etc.—this is at the same time the mechanism for the wonderful multiplication of money. Because when the market participant gets such a loan, this loan becomes the reserve capital for loaning a new credit to someone else. And thus a further spiral goes into effect. Greater credit issuance provides more room for greater securitization, the creation of more liquidity again allows for greater credit issuance.

As they say, as long as the speculative bubble can inflate further, as long as the credit issuance increases, everything is fine (at least in the monetary realm, but not in the real economy, which has been sacrificed in this process). But if, as now, in the event of poor quality mortgage markets, there comes a break, and, as a result of the drying up of the liquidity pump which follows from the end of the yen-carry-trade, there occurs a reverse leverage process in this pyramid, then the illusion bursts. What we experience today, is the psychologically highly interesting process of how limitless greed, in the nature of physical lust, turns almost overnight into limitless Angst. If no one believes any more that the emperor has new clothes, everyone sees that he is naked.

At the moment that the subprime mortgages, which were bundled into interest-bearing securities as CDOs, fell in value, the bankers and other financial institutions could no longer loan or borrow on the basis of these CDOs, as reserve capital or collateral. As a result, the global wave of liquidity dried up. A further aspect of the selloff began when the banks had difficulties in financing the takeover of Chrysler through the private equity firm Cerberus (the locust fund which significantly bears the name of the hound of hell). A similar thing happened with the attempt by Kohlberg Kravis Roberts to take over the British drugstore chain alliance Boots.

Then where do we stand? Are those right who say that there need only be a "straightening out" of the markets, and a little bloodletting, and then let the central bankers and established powers again take control?

It is interesting that an unorthodox newsletter in France, "La Chronique Agora," asked July 31 under the headline "Stock market crash: Can you still escape?": I don't think so. This time the crisis is too deep and the worry well installed... This time the alert on the credit markets is of unprecedented magnitude. Long minimized, its gravity is becoming more obvious each day... the ongoing phenomenon marks the end of an epoch. That of the illusion of unending world liquidity."

The next weeks will leave no doubt that Lyndon LaRouche is right, and all his critics will appear pale. There is nothing to expect from the Bush Administration, as long as it contains Vice-President Dick Cheney. Therefore, everything depends upon whether the world listens to what former Mexican President Jose Lopez Portillo recommended in 1998: listen to the wise words of Lyndon LaRouche.