Everything You Wanted to Know About the Credit Crisis But Were Afraid to Ask

Yahoo ^ | 9/23/2008 | Ben Stein

[politicket]

Ben Stein blasts it out of the ballpark in an easy to read format. I pray that people will read this and truly understand the gravity of what is actually happening. Congress and the President are not being straight with us.

[palmer]

So Stein capitulates. He has written much incoherent trash about the economy and how wonderful it was with cheap credit for everyone. Now he has realized, a bit too late, that cheap credit causes long term problems although I’m still not sure he sees the connection.

[randita]

I’m at the Economics 101 level. Can someone explain, in layman’s terms what Credit Default Swaps and derivatives are?

Thanks.

[Perdogg]

I am still confused about CDS. Is this same concept, let’s say, a collection agency buying a debt at a discount to go after the debtor?

[Perdogg]

I got a business degree 20 years ago and I am somewhat confused.

I think it has something to do with buying debt contracts at a discount then getting the annuity at a higher rate.

[palmer]

Read this:
http://www.financialsense.com/fsu/editorials/amerman/2008/0917.html

[i_dont_chat]

Yeah, and come to find out — there is nothing to go after. . . . .

Bad swap — and they are crying. They want to undue the swap.

[palmer]

Read this
http://www.financialsense.com/fsu/editorials/amerman/2008/0917.html

[skeeter]

The profit can be wildly out of proportion to the real amount of defaults, because speculators can push down the price of instruments tied to the subprime mortgages far beyond what the real rates of loss have been. As I said, the profits here can be beyond imagining. (In fact, they can be so large that one might well wonder if the whole subprime fiasco was not set up just to allow speculators to profit wildly on its collapse...)

According to Stein the max value of foreclosed mrtgages is 250 billion. The other 450 billion is for whom?

And we're asked to bail these guys out.

[afortiori]

It's a financial contract that pays off if there is a default. Although mortgage holders might use it to hedge their position in case of default, some may buy them simply speculate. From Wikipedia:

A credit default swap resembles an insurance policy, as it can be used by a debt holder to hedge, or insure against a default under the debt instrument. However, because there is no requirement to actually hold any asset or suffer a loss, a credit default swap can also be used for speculative purposes and is not generally considered insurance for regulatory purposes.

[Perdogg]

I understand now.

[good1]

I still don't understand it. I need someone to start with: Joe Poor wants to buy a house, but doesn't have any money or job. His bank lends him the money anyway. It seems to me that the guy who stamped "APPROVED" on his loan application just co-signed for Joe's loan.

Someone take it from here and explain the rest to me. I couldn't follow Ben's explanation.

[Kevmo]

OK, here’s a question I’ve been afraid to ask. It looks like this crisis has been building for a long time. What are the chances that the TIMING of this crisis was manufactured for most impact against republicans in this election? How would we go about verifying something like that?

[Jim Robinson]

How did it happen?

Here s one big part of the answer. First, the alert reader will notice that Ben Stein said many times that the amount of money at risk in the subprime meltdown was just not enough to sink an economy of this size. And I was right...to a point. The amount of subprime that defaulted was at most - after recovery in liquidation - about $250 billion. A huge sum but not enough to torpedo the US economy.

The crisis occurred (to greatly oversimplify) because the financial system allowed entities to place bets on whether or not those mortgages would ever be paid. You didn't have to own a mortgage to make the bets. These bets, called Credit Default Swaps, are complex. But in a nutshell, they allow someone to profit immensely - staggeringly - if large numbers of subprime mortgages are not paid off and go into default.

The profit can be wildly out of proportion to the real amount of defaults, because speculators can push down the price of instruments tied to the subprime mortgages far beyond what the real rates of loss have been. As I said, the profits here can be beyond imagining. (In fact, they can be so large that one might well wonder if the whole subprime fiasco was not set up just to allow speculators to profit wildly on its collapse...)

These Credit Default Swaps have been written (as insurance is written) as private contracts. There is nil government regulation of them. Who writes these policies? Banks. Investment banks. Insurance companies. They now owe the buyers of these Credit Default Swaps on junk mortgage debt trillions of dollars. It is this liability that is the bottomless pit of liability for the financial institutions of America.

Because these giant financial companies never dreamed that the subprime mortgage securities could fall as far as they did, they did not enter a potential liability for these CDS policies anywhere near their true liability - which again, is virtually bottomless. They do not have a countervailing asset to pay off the liability.

Now these greedy high rollers want the taxpayers to bail them out? F'em. I feel sorry for the tens of millions who are going to lose their retirements, but there are also tens of millions of us who are going to have to work until we die because we can't afford to retire. Yet they want to waste untold trillions of dollars of tax money (our money) to bailout the greedy thieves? Hell NO!!

[palmer]

max value of foreclosed mrtgages is 250 billion. The other 450 billion is for whom?

My previous link points out other securities (not mortgage related) that add up to many trillions which we will pay. If anyone thinks 700B is it, I have a really nice tract mansion to sell them.

To directly answer your question, once mortgages were bundled and tranched, a relative few defaulting mortgages can destroy the value of the security because the securities were tranched and priced assuming a lot fewer defaults. House prices would rise forever so the securities got default insurance (now defunct) and fraudulent "AAA" ratings (and subsequent high prices).

Then the buyers of the securities used leverage (cheap short term credit) so when the price went down a little they were forced to sell driving down the price to, in many cases, a dime on the dollar.

[EBH]

Listening to them guys up on the hill today they was tryin’ real hard to explain, theys don’t know how to value them things. And that bein’ why they really don’t know how much $$ they really need.

Least that is how I understood them. Was really kind of frightening to listen too.

[counterpunch]

The only answer is to outlaw financial derivatives such as Credit Default Swaps retroactively, and nullify them.

[Oldexpat]

If these companies owe so much money on these defaults..who owns the benefit? Somebody wins and somebody looses in a futures market. Unless they were trading them back and forth..then it is fraud.

[politicket]

in layman’s terms what Credit Default Swaps and derivatives are?

Derivatives comprise a whole market of different financial instruments. Unlike the commercial banking industry, or the stock market, the derivatives market is "self-regulated" - primarily by the investment banks.

Credit Default Swaps (CDS's) are one segment of the derivatives market (probably making up about 1/15 of the market). Think of CDS's as bets in Las Vegas. There can be winners, losers, and pushes. The CDS market was valued at around $900 million dollars in 2001 (not actual dollars - but the total amount of "bets"). That grew to over $45 Trillion dollars by 2008 (see the problem here...).

A Credit Default Swap is a contract with a buyer and seller. The seller in this case might be an investment bank - and they "sell" asset-backed (could be mortgage) paper to the buyer. The buyer "wins" when the seller defaults, and the buyer gets the spoils.

Now, to make things more complicated - this is an international market and there can by many entities involved in CDS's for a particular tranche (or bucket of money). You have what are know as "counter-parties". These counter-parties can be greatly affected if something "out of the norm" happens to a particular contract.

So, if Paulson rushes in and starts affecting the CDS market you will see an "unwinding" of contracts all of the planet due to the "counter-party" exposure. It will literally implode on itself.

If Paulson doesn't do anything, then the "bets" that are set to go bad will continue to go bad. Liquidity in our market will be gone and we will enter a depression.

Pick your poison - but I opt for the depression because it will be shorter in duration because market forces will "self-cleanse".

[palmer]

The only answer is to outlaw financial derivatives such as Credit Default Swaps retroactively, and nullify them.

The marketplace was doing that nicely before Paulson intervened. The problem with nullification is lots of corporate equity will vanish with the financial shock. So it has to be done slowly and carefully.