Posted on 10/31/2008 10:18:48 AM PDT by PajamaTruthMafia
By Theodore F. di Stefano
E-Commerce Times
10/31/08 5:30 AM PT
We are all painfully aware of what is happening on Wall Street. In fact, I think that it might take several years for the stock market to regain the value that it has lost in the past year (approximately 35 percent). No doubt, there is plenty of blame to go around as to who is primarily responsible for this financial debacle. However, most experts agree that a prime candidate for blame is the credit default swap.
Michael Greenberger, a former staff member of the Commodity Futures Trading Commission, describes a credit swap as follows: "A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails. It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated." A credit default swap is an investment instrument that is a so-called derivative security. This term simply means that the value of a derivative derives from an underlying (but not always visible) asset. Examples of such assets would be stocks and bonds. Another example -- and this might come as a surprise -- is the insurance policy on your house. The policy itself is a derivative asset. Even your life insurance policy can be regarded as a derivative. In fact, if you are elderly or in poor health, you can sell your life insurance contract (see my article on life insurance settlements). How did derivatives gain such a bad reputation? This type of investment has been around for many years. In fact, six years ago we had approximately $106 trillion in derivatives. Today, we have an amazing $531 trillion. The billionaire and investor Warren Buffet has called this type of investment "financial weapons of mass destruction." With over $500 trillion now invested in derivatives, you can see the potential for disaster if something happened to this market. Well, actually, something is happening to this market. Simply put, it's been crashing. The types of derivatives that are losing so much of their value are the exotic pools of mortgages that have been sold to banks, investment banks and institutional investors. What happened is that a bunch of smart MBAs convinced investment banks that they found a way to "slice and dice" pools of mortgages thereby creating a wide array of financial instruments that would appeal to a broad group of investors.
Let's say that a mortgage bank has lent $500 million to various homeowners. Within the $500 million are some good loans and some bad loans. The bad mortgage loans would be those that were lent to borrowers who had poor credit and/or very little equity in their homes. These are the so-called toxic assets. The mortgage bank would then go to an investment bank to sell the entire loan pool or loan package. The investment bank would then split the original pool into various parts, also called "tranches." The individual tranches would each be unique in that some would offer a high rate of return with a greater degree of risk, while others would offer a lower rate of return with less risk. The trick for the smart MBAs would be to make even the higher-risk loan packages look attractive. They did this by creating a credit-default swap for these loans. What this means is that basically a third party would guarantee the pool if some of its loans began to turn sour. The guarantee, the credit default swap, is basically an insurance policy, thus a derivative security. It seems perfectly logical and prudent for an investor to buy a mortgage pool that is "insured." The problem is that the insurers, in some instances, were writing so much insurance on so many bad mortgages that if the eventuality ever occurred -- and it did -- that massive pools of mortgage would become toxic, or in the words of Warren Buffet become financial weapons of mass destruction, then the very insurance company that wrote the credit default swap would be in danger of collapsing. This, in fact, is what happened with AIG.
Thus, investors that buy pools of mortgages became less diligent in verifying the soundness of their pools and thus were lulled into a disaster. They stopped checking the soundness of the pools and just assumed that, in the event that the housing market collapsed, they would be made whole by the insurance company since the pool that they bought had a credit default swap. What makes this situation even more convoluted is that investors that had pools of mortgages with credit default swaps could actually increase their yield on their investment if they sold their credit default swaps as a separate financial instrument. Remember, a life insurance policy can be bought by an individual seeking protection for his/her family and later can be sold by that individual as a separate instrument, resulting in the loss of protection to the buyer's estate. Investment banks and other investors thus sold the protection that they originally bargained for as part of the purchase of a pool of mortgages, thus exposing them to the risk of owning an uninsured pool. The rest is history. There is a silver lining to this sad tale. That is, governments throughout the world have decided that it is in their national interest to prop up faltering banks that have made less than sound investment decisions. While this doesn't undo all of the bad that these "investments of mass destruction" have caused, it does, to some extent, mitigate the losses on these investments. Good luck! Credit Default Swaps Explained
A Short History of Derivatives
The Creation of an Exotic Pool of Mortgages
The Inherent Danger in Credit Default Swaps
The Trading of Credit Default Swaps
A Silver Lining
Here’s my question. These underlying mortgages become toxic and default when their adjustable rate goes up and therefore increases the payment beyond what the borrower can pay. But rates are still low. (Heck, I have an adjustable rate mortgage that recently reset to 4.6%, though it had gone as high as 7.).
Is the default rate really that high or are we being sold a bill of goods?
Problem is, when you have lots of people close to the edge, any move up in the rate or anything that sucks additional cash out of the budgets (like higher gas prices) pushes them over the edge. Now, since many of them bought at the height of the market, they owe more than the home is worth so they can’t refinance hence, they walk away.
In addition, in some areas where housing prices have fallen substantially, people under-water figure it makes more economic sense to simply walk away and start over than stay in a home that’s worth 20- 30% less than they agreed to pay...
“An easy to understand explanation of the financial crisis”?
Hardly. It’s easy to understand, but it’s woefully incomplete.
As long as you call CDS “a” major cause rather than “the” major cause, it’s not unreasonable to blame credit default swaps for the mess we’re in. But CDS are certainly no less a factor in creating this mess than the following:
* credit quality deterioration caused by CRA, particularly
_ subprime mortgages
* non-CRA subprime mortgages
* general credit quality deterioration in prime and
_ not-prime (Alt-A) categories of mortgages
* Federal Reserve monetary policy
* mortgage and other debt securitization
* absolutely insane mortgage products
* incompetent and fraudulent real estate appraisals
* fraudulent mortgage applications
* the insane management of Government Sponsored
_ Enterprises (Fannie Mae and Freddie Mac)
* massive deficits, and the dismal failure of our
_ educational system to educate students about how a
_ free enterprise system works and how they should
_ use it to their long term benefit.
The underlying cause of the mess is an insane deterioration of credit quality coupled with insanely low interest rates. Both were created by bad regulations rather than deregulation.
The deterioration in credit quality was so insane that reasonable people simply could not quantify the risk they were taking when they took the bad end of the swap. Unfortunately, Fannie, Freddie, the Federal Reserve Bank of Boston, and (of course) the US Congress convinced many investors that things are different now, that what was commonly viewed as patently insane had become quite normal, and even admirable. CDS makers drank the Feds’ koolaid ... and the results were similar to those of the original koolaid drinkers.
The fact that you could hedge your risks helped make most of the things on your list possible. The minute you stop caring about the ability to repay (you get paid if they pay or not) everything else breaks down.
Oh, it’s bad. For example, less than one-half of subprime and Alt-A loans are current in Florida and California, where such loans comprise over 30% of the total number of mortgages.
The New York Federal Reserve has a nifty interactive map that illustrates the current situation.
http://www.newyorkfed.org/mortgagemaps/
What I would really like to know is
(1) When small down payments were required most banks/brokers required the borrower to pay mortgage insurance. Someone collected all that mortgage insurance money, but clearly, it has nothing to do with the credit default swaps of the various layers of mortgage pools. Where did that money go, what firms went bankrupt for failing to pay off the bad loans say made by Washington Mutual, which States regulated such “mortgage insurance” and failed to live up to their regulatory obligation?
(2) A key aspect of the sale of layers of mortgage pools was having one of the three major rating agencies look at the mortgage pool, look at the credit default swap and then issue a investment rating or risk associated with the financial instrument. Obviously, Moody's, S&P and Finch missed the mark because so many were rated AAA. I saw last summer where some of the agencies did settlements for what seemed like “chump change” on some claims to major investment banks that the rating agencies had screwed up. Is anyone going to seriously go after the rating agencies or punish the rating agencies for their “critical enabling” role in this mess? They are critical in making the market function, but have clearly proven that they can not be counted on when the chips are down.
(3)Many, many mortgage brokers were undercapitalized and viewed themselves as agents to get a borrower and a lender to exchange paper obligations and yet many of the small mortgage brokers theoretically have a huge ultimate financial responsibility in buying back defaulted mortgages. How does society make sure that those brokers who falsified records or failed to properly investigate the credit worthiness of a borrower have to pony up their assets to help repay this mess. Can someone point me to a state where a huge number of mortgage brokers have gone bankrupt and the financial institutions or the state has gone after the personal assets of the corporations and their management team to try to repay society for the damage done?
In a free market there is a theory that “reward follows risk.” What I see is that there were lots who profited at various stages in creating the toxic mortgage mess but how are laying low and getting off paying little or next to nothing based out of their profits.
Those who are loosing their shirt seem to be investors in stock exchange listed firms where the firm has gone under by a combination of firm mismanagement of risk and by wrong doing by lenders who could not live up to their contractual obligations, undercapitalized mortgage brokers didn't properly rate borrows or who didn't buy back defaulted mortgages, those that insured individual loans, those that defaulted on credit default swaps obligations, and by those who rated financial instruments as AAA or slightly lower when they were junk.
If the NYSE is to truly regain the value it has lost, the average American (and international investor) is going to have to be convinced that the investment game isn't a “rigged game” designed to con anyone who is not an insider. I think that the only way the stock values will return is if “people” feel they are not going to be cheated by the market. I see the only way to develop that trust by future investors is by punishing those who created this problem to the extent that those who replace them in the future understand that they need to “play the game in an ethical way or not play at all.”
Nice graphic, I guess the problem is worse than I thought.
I tend to be an optimist, especially when the media throws around fears of the Great Depression returning.
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