Well said. I’ve learned a lot about this topic by reading and reading, and asking questions from people who know what they are talking about.
It seems to me that without the ultimate buyer of these loans being the GSEs, the subprime market could never have built up the huge inventory of bad loans. Since the government was the buyer of last resort, and since the GSEs were buying without any qualms about the quality of the paper, it seems like the banks and brokerage houses thought they had found the real key to eternal prosperity - leave the taxpayer holding the bag, if everything failed. Of course, failure was not a possibility for them.
I had no idea the portfolios were valued at as low as 11% of their face value. I knew the Lehman Bros. auction of their Credit Default Swap instruments resulted with a 5% face value, but the underlying loans themselves are only 11-23%? Whoa! That means the banks are in a world of hurt.
The story of the CDS division at AIG is a story unto itself. The New York Times had an excellent story on it.
Behind Insurer’s Crisis, Blind Eye to a Web of Risk
http://www.nytimes.com/2008/09/28/business/28melt.html?_r=3&ref=business&oref=slogin&oref=slogin&oref=slogin
With all these entities strung out to the end of their resources, I wonder how many banks are truly solvent. If they all used the “bolt-on” CDS paper to hedge their potential losses and then maybe even loaned out more money based on the value of the CDS, then the banks are all essentially defunct, with or without their equity in Fannie or Freddy becoming equal to zero earlier this year.
I know we need financial entities, but maybe the banks should fail, hit the FDIC limits and everyone gets their money according to the original FDIC insurance. Of course then the “right people” would suffer, so that will not happen as long as Paulson can help it.
“It seems to me that without the ultimate buyer of these loans being the GSEs, the subprime market could never have built up the huge inventory of bad loans.”
Certainly not as quickly as it did, producing the near exponential blow-up of housing prices 2002-2006, gaining 15%-20% per year, multiple standard deviations higher than any historical period, and making the inevitable collapse so much more drastic.
“Since the government was the buyer of last resort, and since the GSEs were buying without any qualms about the quality of the paper, it seems like the banks and brokerage houses thought they had found the real key to eternal prosperity - leave the taxpayer holding the bag, if everything failed. Of course, failure was not a possibility for them.”
Pretty much. Actually the GSEs weren’t particularly intended to be “holders” of these loans...primarily only “bundlers/resellers”. But they like everyone else drank the invincibility kool-aid as the CDS industry developed so fast. And, in that era of very low yields, the GSE imprimateur on the loan bundles gave everyone involved such a nice warm feeling...including the Chinese, who were the prime beneficiaries of the first Paulson bailout. DESPITE the black-letter language on the face of FNM/FRE offerings clearly stating “....guaranteed ONLY by FNM/FRE and NOT by the full faith and credit of the US Govt” [or words to that effect]...the holders of FNM/FRE debt were made whole in that first sweeping move where money market funds as well were made to be “same as Treasuries” = loss proof.
“I had no idea the portfolios were valued at as low as 11% of their face value. I knew the Lehman Bros. auction of their Credit Default Swap instruments resulted with a 5% face value, but the underlying loans themselves are only 11-23%? Whoa! That means the banks are in a world of hurt.”
Oh yeah, once the kimonos were fully opened, the true nature of the underlying loans became evident; It became sickeningly clear that each and every player along the way...the borrower, the appraiser, the loan originator, the bundler, the rater, the trancher, the CDS writer...had not only lied through their teeth (or blithely ignored any risk) as to both their due dilly but also their financial capabilities, and that EACH had a quasi-legal claim on either the originating fees or the servicing fees or the prin and interest, and that EACH was expecting to make money from the deal! I recall reading about tranches of debt that fell sixteen/seventeen notches from “AAA” or “AA”!! And don’t forget that many, many holders of this type of debt are forbidden by their charters or corporate bylaws or even statute to hold anything less than investment grade stuff; And I’m hardly exaggerating one bit as to the low quality of some of these tranches; One I looked at was 98.3% LTV loans on new construction in Stockton, CA, probably $550K+ homes on what was farmland 1.5 years earlier, in an area of very few non-agricultural jobs, median home price maybe $175K 3 years earlier. I saw others that were 3 year no payment mattress/big screen deals. I kid you not, it was surprising the paper it was printed on wasn’t scorched! There are still lots and lots of insanely distressed debt tranches at markit.com where these things are priced. (convoluted and hard to use/navigate site, but it’s the place where the world prices debt risk)
“The story of the CDS division at AIG is a story unto itself. The New York Times had an excellent story on it.
Behind Insurer’s Crisis, Blind Eye to a Web of Risk
http://www.nytimes.com/2008/09/28/business/28melt.html?_r=3&ref=business&oref=slogin&oref=slogin&oref=slogin";
I read that. Still pretty remarkable how a 250-person division could dump a giant company into a black hole; but at the same time, we’ve seen these stories, starting with Nick Leeson and Baring’s Bank in (?) 1999-2000-2001.
“With all these entities strung out to the end of their resources, I wonder how many banks are truly solvent. If they all used the “bolt-on” CDS paper to hedge their potential losses and then maybe even loaned out more money based on the value of the CDS, then the banks are all essentially defunct, with or without their equity in Fannie or Freddy becoming equal to zero earlier this year.”
Absolutely. The vaporization of FNM/FRE preferred debt only added to the black hole, and collapsed some modest number of otherwise “conservative” smallish, sub-regional banks, some of whom had substantial portions of their statuatory-reserve assets so parked, and who probably thought they were in the clear since they hadn’t written but certainly weren’t holding much of this trash. The big money center banks are solvent only by virtue of their near-infinite credit lines with the Fed; of which some are members and in the case of JPMorgan, sitting board members.
“I know we need financial entities, but maybe the banks should fail, hit the FDIC limits and everyone gets their money according to the original FDIC insurance. Of course then the “right people” would suffer, so that will not happen as long as Paulson can help it.”
Well, ultimately, the FDIC and the PBGT and SIPC and all these other pools of mystery money are kind of one and the same. And, they’ve been overdrawn to an extent that nobody ever dreamed of. So, where anyone can draw some kind of line and say “this part is fact and this part is vapor” is somewhat arbitrary. Paradoxically, this is what IMO has been the salvation to date, that since nobody can say what’s real, it has given Paulson & Bernanke the ability to say that ANYTHING (they say) is real. For now.