Posted on 09/24/2008 10:08:17 AM PDT by politicket
Congress is about to pass legislation on Friday that will have a major effect on our country's economy. What is this bailout all about? And what effect will it have on our current economic problems?
Let's follow this through in the form of a story.
Jimmy Jones (no, not THAT Jimmy Jones) wants to buy a house. He and his wife find the perfect one and purchase it through their local mortgage lender.
After closing, the mortgage lender turns around and sells the loan "up the tree" and it eventually ends up being bought by Fannie Mae (or Freddie Mac) *Applies to about 80% of the loan market.
Fannie Mae takes Jimmy's loan and packages it with a bunch of other loans into a big "money pot" called a tranche. They then sell this tranche to the bond market and it is divided up into a bunch of individual bonds.
Now, along comes Oscar Wilson. He wants to diversify his portfolio by adding some bonds to it. He happens to obtain bonds that were created from the tranche the held Jimmy's mortgage loan.
Oscar, being the wise person that he is, doesn't absolutely trust that his bond will ever by paid, so he does what is wise - he buys insurance on the bond (just like you would buy auto, house, and life insurance).
Oscar finds an entity that is willing to offer insurance for a premium. Great! Oscar feels safer. This bond insurance in known as a Credit Default Swap.
OK boys and girls, hang onto your hats, because this is where it gets interesting.
There are other entities looking at that bond contract. Some of them think that the bond will never be paid, so the insurance company will need to make good on it. Others think that the bond will be paid on time.
These two parties decide to place a bet on their differing opinions - all related to a bond that neither one of them owns. You then might have a few, or a hundred, or a thousand, or more entities that will place the exact same type of bet with each other on whether the bond ever gets paid.
So far, so good?
Back to Jimmy. He is going through some very rough times and ends up having to default on his mortgage. Not only that, but other mortgages that were part of the original tranches have either defaulted, or became late in payments.
Things get so bad that the bond that Oscar holds cannot be serviced through the existing cash flow and the bond goes into full or partial default.
The insurance company makes good on their obligation and everything is rosy, right? Not so fast. All of the side bets that had been placed on that bond get triggered as well and there are winners and losers.
In other words, Jimmy's orginal 200K default, along with other underperformers in the tranche, could have triggered a 10 or 20 million dollar cash event in the Credit Default Swap market.
Now extend this example through many millions of times until you get to the total amount of bets in the Credit Derivatives Market. You will come up with about $62 trillion dollars. That's a lot of bets!
Our story continues....
Along comes Secretary Paulson. The day is bright, the sun is shining, and he is whistling a happy tune. Why shouldn't he, he's carrying $700 billion dollars in his wallet and he can spend it on anything in the candy store.
Let's pretend that Paulson buys stops by Fannie Mae and buys up $700 billion dollars of toxic waste. What a day for Fannie Mae! It is now off of their books, they don't have to create tranches and sell it to the bond market, the bonds don't have to trigger Credit Default Swaps, and all is right with the world. The American taxpayer has come to the rescue. Our economy is saved!
Well............maybe not. Because Secretary Paulson has to do a lot more shopping and Congress limited him to only spending $700 billion dollars at any one time - he has to sell all of what he bought.
How is he going to do this? By dividing the $700 billion dollars up into $50 billion dollar tranches and selling to the bond market with a 'Aaa' government taxpayer-backed guarantee.
The bond market will divide this up into a bunch of bonds. Sam Miller will come along and buy a bond for his portfolio. Sam will buy insurance (a Credit Default Swap). Others will bet on that insurance (a bunch of other Credit Default Swaps) and the whole process will begin anew - except it is now the taxpayer responsible for maintaining the cash flow to make the bond be paid in time.
Meanwhile, back at the ranch, Secretary Paulson gets to buy up a fresh batch of $700 billion in toxic waste. He will repeat the process ad naseum. It will be trillions upon trillions of dollars that are funneled through the $700 billion dollar financial vehicle.
And Paulson will report to nobody...
In San Ity...
Sorry for some of the grammar. I didn’t proof-read well enough.
Good post! Bookmarked.
Interesting. Thanks for posting. Cue the “Las Vegas calling, baby!” commercial.
Does this mean that, absent the new round of credit default swaps, this bailout may actually work?
PS I did hear something about these “spectuative” derivatives possibly being classified as the equivalent of “naked shorts” and possibly banned. Does anyone have any more info?
Does anyone in the whole country really know what’s going on?
No, because if you take the "insurance" part of the Credit Default Swap away then nobody will buy the bond.
What if I told you that you couldn't buy insurance on your house that was stationed next to a raging forest fire. Would you still buy the house?
Paulson isn't carrying around $700 billion in cash...he's carrying around a credit card with a line of $700 billion and a variable interest rate, with payment guaranteed by the taxpayer.
I understand, but I was trying to make my story an easy read. :-)
Thanks for the post. This seems like an election year deceptive fix having maybe 3 months life. The AIG situation really scares me, because this article says the credit derivatives market is 50 times the mortgage problem.
To paraphrase Genesis the passage should read: “When the financial trader saw that the credit derivative was good for bonuses and brought delightful acclamation and power, then he wrote contracts with ever smaller risk assumptions to book ever larger accrued incomes, demonstrating a wisdom far exceeding his competitors”. Here is a link to an article explaining this financial instrument: http://www.safehaven.com/article-11267.htm.
Yes, depending on price. I would pay the land value if I liked the location.
The same will apply to securities backed by mortgages. If the mortgage lending rules require buyers to be qualified and to put a 10-20% down payment the odds on those loans going bad are small. As far as the credit swap market, to heck with them.
I respect your effort to put this in laymen’s terms, but this simplification seems to imply something odd.
First, the bundle of contracts are not worth nothing. If the mortgages have any equity and the properties have lost 30% of their value (high side), we could be off only about 15% - 20% of the total outlay. This is not a big deal. Last year the public spent $ 1.2 billion on joint operations for their dogs (actual numbers, folks).
Second, who cares what the bets are? Some will win, some will lose. But, these are security players, traders with a lot of other trades occurring. Options expire all the time with no excercise. These are really no different. And a lot of folks have had a decline in their portfolios, so really what is the big deal?
Third, didn’t the Gov. “...stop by...” the banks rather than Fannie Mae? The Fannie Mae was a backstop assurance, not a bailout. AIG was a bailout, but with a 80% stake and assets that are about to begin being sold (aircraft leasing, commercial insurance, etc.) Some of this will come back to the gov. and mitigate the loan costs.
Finally, even if the whole $ 700B is gone, that is really only about $ 1,400 per person in the US. Many of my clients blow that at the casinos in one weekend, no mattter how much I chide them. If $ 700B rescues most of the Freepers retirement plans, I’m in. That is a drop in the bucket to the rest of my tax bill, and probably most folks. Come on, my retired widows are dropping $ 24K in tax a year from IRA distributions and divs.
Dude, you're missing two important points:
1. Holders of CDS are, in effect, short sellers; they have a motive to tank the system, which is exacerbated by the real-time mark to market rules. The creation of an RTC entity ('the bailout') is meant to slow down the downward spiral (by deflating the bubble, not letting it pop) by providing a more orderly re-rating mechanism.
2. CDS are going to be regulated to avoid repeating the same mistakes.
If either of these two components are missing, the bill will not pass, nor be signed by Bush.
You did fine. btt
Any casino owner that tried a scheme like this would be arrested for racketeering. Unlike Wall Street, Las Vegas has standards. ;)
Well, is the problem with bond insurance, or the people betting on the bond? Or what about taking mortgages & loans and turning them into other things? Maybe loans should stay what they are and not end up to the point where they aren’t recognizable and nobody know what’s what?
“We’re from the guvvermint, and we’re here to help....”
Actually it is much, much larger. I was keeping my story simple.
A straight mortgage bailout without the derivatives market would have been around $250 billion when accounting for the value of the land holdings. The derivatives problem has a maximum exposure of $62 trillion dollars. It won't be that much, but it could definitely be in the $10 trillion dollar range.
By comparison, banks have deposits of about $4 trillion.
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.