Posted on 07/22/2016 4:07:28 AM PDT by expat_panama
It looks like AIG was the player foolish enough to make the CDS bet without protecting themselves.
http://www.reuters.com/article/us-how-aig-fell-apart-idUSMAR85972720080918
‘Over the past few years, CDSs helped transform bond trading into a highly leveraged, high-velocity business. Banks and hedge funds found that it was much easier and quicker to just buy and sell CDS contracts rather than buy and sell actual bonds. As of the end of 2007, they had grown to roughly $60 trillion in global business.
‘So, what went wrong? Many CDSs were sold as insurance to cover those exotic financial instruments that created and spread the subprime housing crisis, details of which are covered here 1. As those mortgage-backed securities and collateralized debt obligations became nearly worthless, suddenly that seemingly low-risk event-an actual bond default-was happening daily. The banks and hedge funds selling CDSs were no longer taking in free cash; they were having to pay out big money.
‘Most banks, though, were not all that bad off, because they were simultaneously on both sides of the CDS trade. Most banks and hedge funds would buy CDS protection on the one hand and then sell CDS protection to someone else at the same time. When a bond defaulted, the banks might have to pay some money out, but they’d also be getting money back in. They netted out.
‘Everyone, that is, except for AIG. AIG was on one side of these trades only: They sold CDS. They never bought. Once bonds started defaulting, they had to pay out and nobody was paying them. AIG seems to have thought CDS were just an extension of the insurance business. But they’re not. When you insure homes or cars or lives, you can expect steady, actuarially predictable trends. If you sell enough and price things right, you know that you’ll always have more premiums coming in than payments going out. That’s because there is low correlation between insurance triggering events. My death doesn’t, generally, hasten your death. My house burning down doesn’t increase the likelihood of your house burning down.
‘Not so with bonds. Once some bonds start defaulting, other bonds are more likely to default. The risk increases exponentially.
‘Credit default swaps written by AIG cover more than $440 billion in bonds 2. We learned this week that AIG has nowhere near enough money to cover all of those. Their customers-those banks and hedge funds buying CDSs-started getting nervous. So did government regulators. They started to wonder if AIG has enough money to pay out all the CDS claims it will likely owe....
A lot of folks seem to act that way but time and again I come across the fact that Americans are smart and that finance is not nearly as mysterious as folks like to say it is. My take is that there's got to be some other reason.
They are right but nobody cares...
I think you missed the part where they labeled them as "not crap" (Grade A) when they resold them.
Buying a Yugo is fine. Reselling the Yugo is fine. reselling the Yugo dressed up and labeled as a Ferrari is not.
Wait a minute. Did someone force you to buy the Yugo in the first place before you resold it? I agree, fraudulently reselling it is wrong . . . but how about proximate cause?
Yes, AIG was world class stupid in their behavior leading up to the crisis.
They thought their CDS was free money.
Fractional reserve banking != capitalism
I thought it said, "We aren't going to change the way these OTC derivatives are currently regulated (if at all)"
I could be wrong.
The GSE’s purchases of all mortgages slowed in 2004, as they worked to overcome their accounting scandals, but in late 2004 they returned to the market with a vengeance. Late that year, their chairmen were telling meetings of mortgage originators that the GSEs were eager to purchase subprime and other nonprime loans.
This set off a frenzy of subprime and Alt-A mortgage origination, in which–as incredible as it seems–Fannie and Freddie were competing with Wall Street and one another for low-quality loans. Even when they were not the purchasers, the GSEs were Wall Street’s biggest customers, often buying the AAA tranches of subprime and Alt-A pools that Wall Street put together. By 2007 they held $227 billion (one in six loans) in these nonprime pools, and approximately $1.6 trillion in low-quality loans altogether.
From 2005 through 2007, the GSEs purchased over $1 trillion in subprime and Alt-A loans, driving up the housing bubble and driving down mortgage quality. During these years, HUD’s regulations required that 55% of all GSE purchases be affordable, including 25% made to low- and very low-income borrowers. Housing bubbles are nothing new. We and other countries have had them before. The reason that the most recent bubble created a worldwide financial crisis is that it was inflated with low-quality loans required by government mandate. The fact that the same government must now come to the rescue is no reason for gratitude.
I’ll have to see what I can dig up. Apparently CFMA kept Credit Default Swaps unregulated and that played a role in the meltdown. Most of what I recall concerning unregulated derivatives trading centered around Brooksley Born during Clinton.
Here’s a NYT article that touches on some CFMA background although most of it involves Enron.
http://www.nytimes.com/2008/11/17/business/17grammside.html
The law begins-- H. R. 5660 To reauthorize and amend the Commodity Exchange Act to promote legal certainty, enhance competition, and reduce systemic risk in markets for futures and over-the-counter derivatives, and for other purposes.
--and goes on making OTC derivatives simple and uncomplicated for the next 262 pages. I tried reading more but I kept passing out.
“I think he means OTC derivatives. “
You’re right, I did mean OTC derivatives.
I’ll have to dig up the debates and warnings about CFMA instead of relying on my dubious memory. expat is doing a good job of making me go back and examine this stuff.
“As we’ve noted literally dozens of times before, the financial crisis’ origins lay in Bill Clinton’s decision in the early 1990s to use Big Government to force banks to make mortgage loans to low-income people who were bad credit risks. “
From what I’ve read the majority of high risk subprime mortgages, and certainly the riskiest, were written by ‘shadow bank’ firms that were completely exempt from the Community Reinvestment Act. These loans were entirely voluntary on their part, unlike deposit-taking banks which were covered by CRA.
They were writing these mortgages because they wanted the high-yield paper as fodder for the MBSs and derivatives they were creating from them. There was very big money in this business until it blew up.
You're very kind ::placing check in envelope:: but this thing about checking facts is a really big thing that a lot of us people are finding ourselves forced to do.
It's kind of like the info age begain in the 1600's w/ the printing press becoming available on the retail market and it had a huge effect on governments. For hundreds (thousands) of years senators and members'o'parliment could say whatever they felt like w/ impunity but it all changed. Instead they'd wander over to the coffee house (England had coffee decades before it had tea) and hear everyone quoting them word for word because some clown wrote it down and ran off a broadside sheet.
Now we got the same thing on steroids in the internet, everyone's got info and everyone can publish and broadcast. ::breathing into a paper bag again::
Encouraged, in part, by government mandated demand from the GSEs.
The bubble likely would have still happened, but probably have been smaller, without the GSE involvement.
“Encouraged, in part, by government mandated demand from the GSEs.”
Yeah that could well be part of the incentive that the non-CRA lenders had in creating subprime paper. With Countrywide that may have been especially true, I seem to recall them having a relationship with one of the GSEs.
Some of the books I read on all of this were ‘Chain of Blame’- Padilla and Muolo, ‘ECONned’- Yves Smith, ‘Fool’s Gold’- Gillian Tett, ‘The Sellout- Charles Gasparino.
Early on, before most anyone was talking “Bubble” I ran across a very interesting website called The Housing Bubble Blog where some knowledgeable real estate types had gathered and were sharing their concerns that something very peculiar was going on in the housing/mortgage world. I already was personally acquainted with people who were at the epicenter of the subprime world, just a fluke of living in Orange County were it began.
Between the blog and picking the brains of people I knew I was convinced that we were in a housing bubble at a pretty early stage, and I tried to ferret out what was fueling it. My biggest surprise was how huge it turned out to be. I knew it was big but not until after it blew did I find out about the enormous amount of paper that Wall Street had pyramided on all of these dubious mortgages.
Well you’re doing a service by making us go back and examine our assumptions. The financial meltdown was something of a perfect storm and it’s hard to sort it all out even for the tiny number of us who find all of this engrossing.
I’ve been a critic of those who want to blame it all on the CRA because I was aware of the huge amount of exotic mortgages that were cranked out by the shadow banks that were exempt from the CRA- they were rolling their own CDOs and derivatives built upon them because they were making a fortune doing so, and stealing market share from stodgy old Fannie and Freddy with their low-yield conforming paper. But toddster dug up that info about the GSEs being pressured to make 55% of their loans Alt-A so the gov’t role may be bigger than I was accounting for.
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