Servias Ministries Blog

What is fraud? It is "the intentional deception resulting in injury to another person."  The Scripture has several stories containing fraud.  Jacob defrauded is brother.  Laban defrauded Jacob.  The list goes on.  Typically, fraud has scarcity connected to it.  Jacob thought that Isaac’s blessing was going to Esau and there would be nothing left for him.  Fear caused him to deceive his father and injure his brother.  Where was the revelation of Love?  Love sacrifices "self" for the benefit of others.  Love knows that THE FATHER will come through no matter what the circumstances appear to be.  The perception of scarcity breeds deception.  The Scripture is full of assurances of abundance.

The sub-prime mortgage crisis may be the unraveling of the current credit system.  When a system is built on credit and perception, the tipping point of failure is akin to the "domino effect".  If a thousand dominoes are lined up together, only one critical domino will bring the thousand down.  As mentioned in an earlier writing, a financial institution’s capital structure determines its ability to loan and invest.  If the capital structure is 10% of the total balance sheet, a 10% loss or devaluation of assets wipes out its capital structure.  The result is bankruptcy.  In recent weeks, the larger investment bankers have found it necessary to search for investors to inject serious amounts of cash into their institution.  China’s Wealth Fund recently injected over $5,000,000,000 into Morgan Stanley (http://www.nytimes.com/2007/12/19/business/19cnd-morgan.html).  Morgan Stanley claimed losses of $5.7 Billion and received a cash injection of$5 Billion.

Another more subtle issue to the average person is the "insurance" or derivatives behind the credit instruments.  THE DERIVATIVE INSTRUMENT IS ONLY AS GOOD AS THE BALANCE SHEET OF THE LOSING PARTY OF THE TRANSACTION.  Derivatives are so complex that the CEO’S of most companies participating in these financial instruments do not have a clue to the risks involved.  They are simply assured by a subordinate that they are "covered".  What happens if the losing party goes bankrupt?  You may want to do an internet search on "Long-Term Capital Management".  MBIA (who in the world is this?) recently disclosed its exposure to the CDO derivatives.   The impact to their stock was historic.  As an investor, how would you like to lose 70% of your investment in 90 days?

See http://www.bloomberg.com/apps/news?pid=20601087&sid=aHPogLA7dWPs&refer=home

Of course the average investor is the last to know about the company’s exposure.  The product of this company was "insurance" of a bet made by another company.  It looks like these companies ought to move their corporate headquarters to Las Vegas.

How did all this sub-prime mortgage crisis begin?  Some financial industry guru initiated adjustable rate mortgages (ARM’S) so that the home buyer could buy a bigger house than his balance sheet and income statement could afford.  This in itself defies the lending principles taught by the Dunn & Bradstreet Credit Course taught to all loan officers in the 1970’s.  (While in banking, I took the course.)  From the onset of making this type of loan, every lender in essence committed fraud as defined by the definition above.  The regulators looked the other way.  The CEO’S looked the other way.  The Ratings agencies looked the other way.  Alan Greenspan and the Federal Reserve promoted ARM’S.  The consumer was the neophyte in the transaction yet he will be the one to lose in the end.  The experts assured him that the loan was solid and it was justified.

Expect to hear the word "FRAUD" more often in upcoming financial news reporting.  The lawyers are going to make a lot of money in the world of "high finance".  We are at the beginning of this bubble popping event.  Litigation will keep the Federal Courts busy.  MBIA’S disclosure caused the ratings agencies to downgrade the securities they guarantee from "investment grade" to "junk status".  Since pension funds can only invest in investment grade instruments, they will be forced to liquidate their holdings in the affected securities.  This will cause a spiraling decline in value of the investments.  Someone is going to lose a lot of money.  "1929" is now being mentioned in the press with regard to this global financial event.

See: http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/12/23/cccrisis123.xml&CMP=ILC-mostviewedbox

An article in the Telegraph (U.K.) this weekend discusses the need to reduce the capital reserve requirements of banks (see http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/12/15/cnbanking115.xml).  The reserve requirements of a bank dictate or govern the amount of money banks can loan.  It is a "buffer" or reserve of cash to guard against bad loans.  For example, if the reserve requirement of a bank is 10% and the bank has a capital structure of $100 million, then the bank can loan up to $1 billion.  If you reduce the reserve requirement to 5%, then the bank can loan up to $2 billion.  With one change to a bank regulation, the bank could double its lending capacity.

Another regulation impacts the concentration of loans.  In the past, a bank could not loan more than 10% of its capital structure to any one customer.  In the above example, the maximum loan amount to one customer would be $10 million.  These regulations promoted safety to protect the bank’s capital which is its capacity to "keep the doors open".

Capital reserve requirements were put in place to protect the bank against itself.  The regulators found that a bank could weather economic cycle downturns if it did not overextend itself.  These requirements regulate the leverage capability of the bank.  If a bank suffered a loan loss, it was a direct reduction in the capital structure.  In the above example, if the bank had to write off a $10 million loan thus reducing its capital structure to $90 million, the resulting lending capability would $900 million (at a 10% reserve).  Reduced lending ability of banks causes a contraction in the economy.  With less lending capacity in the banking system, businesses and individuals cannot borrow money to finance expansion.  If the contraction is severe, existing notes of borrowers are "called".  In the fine print of loan documents, the bank generally can change the due date to "today" or change the due date by some formula.

On the other side of the bank’s balance sheet, they can restrict the cash outflow.  In their contract with you, the bank may restrict withdrawals or bank transfers. The also can delay withdrawals for a period of time.  If a bank gets into trouble due to its lending or investing practices, the depositors can be adversely affected.  The law (banking regulations) was designed to protect the banking system.  The depositors only have easy access to their funds if everything is operating normally.  However if the bank (or banks) made poor investing/lending decisions, the depositors are the last to know and will be limited to their deposit withdrawals.

The derivatives crisis is not over, I believe it is still in its early stages.  The fallout will be global.  "Reliquifying"  the banking system will be hyperinflationary.  Letting banks fail would cause a severe economic downturn.  This is ugly.  The central banks are attempting to inject huge amounts of cash into the banking system which ultimately is inflationary.  The unregulated derivatives market produced investments that banks participated in.  Those investments are moving from "investment grade" to "junk" status.  A bad investment is no different than a bad loan when considering its impact on the capital structure of the bank.

Protect yourself!  You’ve been warned.

Many people who read this site have financial assets whether they be bank deposits, stocks, or bonds.  In recent years, the financial industry has promoted the use of electronic deposits of stocks, bonds, and other instruments.  I am no longer confident that this method is safe from disruption.  I recommend that you take action now.  I recommend that you take possession of your stock/bond certificates.  If you have funds exceeding the FDIC limit within one bank, I also recommend that you distribute those funds among several banks to minimize possible exposure and disruption.  Keep some cash available, 1 to 2 months’ expenses if possible.

Recently, The Comptroller of the Currency in the U.S. approved the Basel II Capital Rule which specifically details capital requirement calculations of risk-based assets.  This "Rule" establishes the criteria for valuing risk-based assets that formerly had no regulation.  Without regulation, the financial institutions had no incentive to re-value a "junk" asset to market value. By keeping the original cost of the asset on the books rather than reducing the asset’s value based on market demand, the institution reports inflated asset valuations and correspondingly misrepresents their capital structure.  If you suffer a loss on the asset side, there is a corresponding reduction to the entity’s capital.  With less capital, the entity may not qualify to transact certain business that is reserved for the highest financially rated companies.

Ratings Agencies have been neglectful in analyzing those companies they classify.  Moody’s and other ratings agencies are the "watchdogs" of the financial arena.  Pension funds rely on ratings to determine what instruments they can invest in.  For instance, if Citibank issues "Commercial Paper" and has an investment rating of Aaa, a pension fund may be free to invest in the instrument.  However, if Citibank’s "Commercial Paper" grade is lowered to Ba1, Ba2, Ba3, etc. then the pension fund must divest itself of the investment.  A lowering of a company’s rating can have a dramatic, negative impact on its ability to borrow.  Also, if an institution has "off balance sheet" liabilities that would have an immediate and negative impact on its capital structure,  a pension fund could be investing in a "time bomb" and thus wipe out million’s of people’s retirement funds.  Enron was guilty of this type of scenario.  The ratings agencies were not oblivious of these "off balance sheet" investments.

What is Basel II?  (from Wikipedia) Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.

If you read the Basel II Capital Rule, you may fall asleep.  Once awakened from your slumber you will realize that the financial world has become so complicated that the average person has no chance of understanding the financial condition (strength or weakness) of their bank.  Anytime you encounter complexity in financial transactions, watch out!  In an earlier posting I covered the topic of "real money".  Complexities increase as the liability of the instrument increases.

What will be the impact of the Base II Accord?  Ultimately it will force the financial industry to come clean with the over-valued securities contained within their balance sheets (or sitting outside their balance sheets, possibly as a footnote).  The capital structure of a bank dictates the amount of money it can lend.  If the capital of the bank is reduced by bad investments, the bank will have to contract its loans.  Existing loans may be called or not renewed.  This ultimately causes a contraction in the economic system.  "Fractional Banking Reserves" allows a bank to leverage its balance sheet.  On a positive note, additional deposits in the bank allow for a multiplying effect for lending capacity.  For instance, an additional $1,000 in customer deposits would allow the bank to create $5-10,000 in loans.  The capital of the bank is also considered in the loan expansion.  Removal of deposits and/or capital will cause a contraction in loans (and the ability to loan).

Why is all of this important to you?  If the banking system becomes weak, your deposited assets are at risk.  If an Internet stockbrokerage firm files bankruptcy, you could wait up to two years to receive your certificates (depending on the judge).  When there are prevailing winds of instability in the financial system, it is better to be safe than sorry.  Our risk level of financial meltdown is "orange".

On a recent flight I sat next to a gentleman from Venezuela. We spoke about the economic conditions within the country. The people are restricted in their ability to purchase goods outside the country. The current political system has strongly endorsed the use of credit cards by its people. Why? They are using the infrastructure of the credit card companies to track the purchases of the people. They require transactional reporting from the credit card companies. More and more, businesses are requiring credit card use over cash. If you can control the monetary system of people, you will gain control of their activities. This is another aspect of fiat currency creation. Since fiat currencies are not tied to gold, their medium can be coins, paper, or digital, virtual valuations. Digital currency eliminates a lot of headaches for those in control. That is the ultimate control mechanism. By moving all currency to a digital environment, you can easily monitor all activities of the population.

In the 1970’s, I was involved in setting up a “clearinghouse” association among banks. The intent of the clearinghouse was to eliminate paper and to establish a transaction standard to be used by the banks of the association. Our intent was noble. It was all about efficiency and cost savings. This coincidentally happened just after the U.S. went off the Gold Standard. As you can see, this evolution of “digital” money did not just start recently.

Digital money has fundamental flaws associated with it. The Western view of financial institutions is that the people administering the financial systems are sufficiently regulated to insure stability without loss to the customer. These financial systems are only as good as the weakest link. Fraud and theft occur continuously in the system. Most instances are not publicized. One of my credit cards was recently canceled and replaced sine there was a major theft of credit card information of one of the retailers’ computer files. The proliferation of digital use of money causes an exponential exposure to financial loss.

A visionary could easily chart a course for control of the population. There are certain steps those in power must take to assure their continued position over the people. There is no need to control the people if your focus is to serve the people. We are called to be “fruit” inspectors. If we see policies established to control currency, ultimately this will result in controlling the population. Many reasons will be given to justify the policy. In the end, those with the power over the currency will force servitude on the population.

1 Timothy 6:10 “For the love of money is the root of all evil: which while some coveted after, they have erred from the faith, and pierced themselves through with many sorrows.”

In a recent trip abroad, I once again saw the continued decline of customer service. Doesn’t customer service mean “to serve the customer”? Unfortunately, customer service is interwoven with short term profitability, not long term sustainable growth and profitability. In the U.S., Southwest Airlines grew to the most profitable airline in the industry. It was all about the customer. People look for a reasonable service at a reasonable price… with a smile. Why do we look for the smile? The smile is an outward indication of joy. Joy is an indication that you are walking in your calling. This is a subtle truth. At Southwest, everyone was happy while at other airlines, half of the people worked with “scowls” on their faces. Yes, people complained that they were “herded” onto the plane like cattle since there were no seat assignments. That did not keep Southwest from becoming a major competitor in the U.S. markets. Their focus on customer service and treating the customer with respect and appreciation caused travelers to overlook the “no frills” aspect of their business plan.

What happened to customer service? The love of money. Losses in the industry enabled the airlines to cut customer service as an excuse for their inability to make a profit. It the 20 year plan, is selling that free snack going to matter? “No” for two reasons. First of all the airlines do not focus on a 20 year plan, it’s all about the next quarter’s profit. Secondly, by lowering your customer service you expose yourself to reduced future income. Continued absence of customer service will send your customers to your competition. That is precisely why Southwest was able to flourish.

What is the solution? You should hire people who have a passion for customer service to represent you to the public. Obviously the revelation of Love must come forth to provide an adequate supply of people to choose from. Is the person applying for the position because the love people, or just the salary? If you want to sustain your revenue stream, match the job with the person’s calling. A customer service person could become one of your most valuable assets.

Southwest Airlines is losing the revelation that brought them to prominence. “Without a vision, the people perish.” Herb (the founding Southwest CEO) is out of the picture. His successors are losing the vision. Ultimately they will lose customers to the next airline who can sustain the passion for “serving”. Serving mankind produces sustaining wealth.