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Commentary :: Globalization
Billions Dissolve in Thin Air
04 Sep 2007
While the political class practices faith healing, all the participants know the end is coming when more speculative bubbles burst. The popular dogma that financial markets and the world economy are more efficient when deregulated and liberalized is over.

Anatomy of a world financial crisis. Stock brokers reacted in a logical panic mode since rotten credits are everywhere

By Michael R. Kratke

[This article published in: Freitag 34. 8/24/2007 is translated from the German on the World Wide Web,]

Four weeks ago the world still seemed in order. The world economy and financial markets boomed. Now we have a stock market crash on installment that flows into a money market crisis. The central banks are incessantly pumping capital into the financial markets.

In Germany, the Saxony regional bank fell into disarray and had to be cushioned with a survival dose of 17.3 billion euro through savings accounts and other regional banks. The state of Saxony guarantees this mammoth sum that exceeds its annual budget.

While the political class practices faith healing, all the participants know the end is coming – when more speculative bubbles burst. At the moment the brave new world order of the “liberalized” international financial markets are severely tested. The popular dogma that financial markets and the world economy are “more efficient” and “more stable” when they are more deregulated and liberalized, this faith of Helmut Kohl, is over. Calls for rules and restraints from actors on the financial markets are heard everywhere.


What has happened? In the US, a gigantic real estate bubble has burst. Low interests, constantly rising home prices (up to 20 percent a year in better areas) and an exploding mortgage market kept the US economy on the go. The boom supported private consumption on credit. The indebtedness of US households quickly soared: 120 percent of a yearly income on average, three quarters in mortgage debts. Mortgage banks and real estate funds forced credits on people who could never have afforded their own home. The ruin of countless small homeowners is no problem as long as the boom continues. The banks, financing companies and hosts of real estate brokers earned fabulous sums.

For months, the payment arrears grew. Forced sales explode. More than five million homes in the US are for sale. For the first time in ten years, real estate prices are dropping and interests soar. The crises – hardly anything else seemed possible – broke out in the “sub prime” segment of the market with poorer families with trifling (and falling) incomes. More than two million Americans are losing their homes. Nearly $500 billion in mortgages are rotten. A tsunami of exploding mortgages rolls through the land.

With the spectacular bankruptcy of two hedge funds worth millions of the fifth largest US investment bank Bear Streams, $1.6 billion was lost in June. As a result, the shares of Bear Streams collapsed along with many other investment funds, banks and insurance companies. More than $200 billion dissolved in thin air. Wall Street fell into a state of turmoil; the world stock exchanges reacted immediately. The collapse of the two hedge funds was an alarm signal for all insiders. Stock brokers reacted in a logical panic mode. The rotten credits are everywhere; they are time bombs laid worldwide, not only in the financial sector of the US. The real estate bubble could only grow because the financiers believed they could always sell the worst and most risky mortgage credits. Like all other kinds of debts together with future interest payments and repayments, these credits were transformed into commodities. Thus discount acceptance credits served as a basis for a rapidly expanding superstructure of credit derivatives in the hands of speculators. Masses of mortgages and other credits were bundled and used as securities for new securities. Mortgage banks sold these securities (mortgage backed securities). Their credit risk was passed on to a third party: banks, investment funds and insurance companies. They weren’t worried about the credit-worthiness of the original mortgage debtor since they also only wanted to resell these securities.

As long as a real estate boom continues, such securities are lucrative investments. The hedge funds break. The securitization of all kinds of debts and the erosion of such securities (asset backed securities) become a boom branch for special funds. Worldwide trade with such derivatives occurs outside the stock exchanges. The competition of large hedge funds forces up their prices so that a cloud of more derivative bubbles forms on the real estate bubble.

But what happens when the underlying credits are cancelled? Then the participants immediately realize they ride on a homemade wave of fictional assets. Because the securities are no good, their value melts away. The banks want their money back that was lent in the short term. The hedge funds cannot sell their securities and go bankrupt. Those banks, insurance companies and investment funds are in a bit of a mess since they financed the speculation with these derivatives. Since these derivatives are traded worldwide, banks that never financed a mortgage in the US are suddenly mired in problems. The German middle class IKB bank, the West German, the Saxony regional bank and many others participated in hedge funds that speculated with such credit derivatives. Their losses are reflected in their stock prices. Worldwide financial assets are on a downward slide. Expecting a wave of bankruptcies, huge numbers of investors flee. Divisions of banks that had nothing to do with mortgage speculation are now in distress.


After the first banks fall as in the US or were rescued from tight emergencies as in Germany, the next act of the drama begins, the money market crisis. Because the banks know everyone else is stuck in a quagmire, they strongly restrict their credits with each other. In other words, the most stable sector of financial markets, the credit transactions of banks with each other, will suddenly be jammed. Only the central banks can help out as lenders of last resort. They did this massively for days and days.

The European central bank pumped more than 200 billion euro as short-term credits in the money market. Less generously, the US Federal Reserve opened the credit-valve, lowered its discount rate and extended the repayment period for short-term credits. Central banks worldwide followed. Even if the money market crisis seems overcome for the moment, the worldwide financial crisis has only begun.

To cover their losses, hedge funds and banks sold securities that were still worth something – their paper-oil and their paper-metals. Oil prices and metal prices quickly fell worldwide. Many conservative investors worldwide are fleeing into safe securities or government bonds. Simultaneously the wave of mergers and takeovers – already amounting to more than $3 trillion worldwide in 2007 – comes to a standstill since the banks are drastically tightening their credit conditions. Since it is now risky and very expensive to operate with a long credit lever, many planned or already implemented mega-deals are delayed or cancelled. Banks have enormous problems in extending the billions of completed credits as in the past. Deals on the exchange are postponed; the market for new issues collapses. The second motor of the worldwide market rally stutters. The bullish stock market is over.

The end of the flagpole is still not visible. At the moment the stock exchanges record the greatest markups in years. Banks and hedge funds break off risky worldwide credit derivatives that they financed with cheap Japanese money. The credits must be paid back in yen. The yen price quickly soars upwards and the stock prices in Tokyo pancake. The next dollar crisis and the world trade crisis will occur when the Chinese and German export economies break away from the US sales market.
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