“That’s right. They purchased the potentially bad loans from Fannie and Freddie. “
Nope. Fannie and Freddie had nothing to do with OTC derivatives in any fashion. Fannie and Freddie paper was composed of boring, low yield conforming loans even when it was subprime. It was of no interest to investment banks and hedge funds. The IBs generated their own subprime paper through their networks of mortgage brokers. These loans were exotic, high risk, and high yield. This is where the financial weapons of mass destruction grew.
“The issue is that government oversite over government sponsored programs and mandates made the choice to allow it to happen”
This isn’t an inaccurate statement. The vast majority of the problem paper was privately issued by firms that weren’t covered by gov’t programs like CRA. It was created by investment banks and non depository mortgage originators because it was extremely lucrative for them. There was no government oversight because these firms wanted it that way and used political influence to make sure it stayed that way. This is a variation of what is called regulatory capture.
“They were hot potatoes. When full mortgages were chopped up into parts in order to minimize risk they didn’t bother to remember that markets like real estate go up and down rapidly.”
The IBs didn’t care what the RE market was going to do. They were all hedging themselves using a formula based on Li’s Gaussian copula function and had fooled themselves into thinking that they were bullet proof. They weren’t. And they weren’t tranching mortgages to minimize risk, they were doing it in order to market their paper to different buyers.
” The government sponsored worthless paper.”
There is enough of interest in this whole affair without pursuing misleading explanations that appear to offer political gain. The big players who cranked out trillions of dollars of dangerous financial paper weren’t depository institutions and weren’t covered by gov’t mandates. They were developing and farming the riskiest parts of the subprime market because it offered them extremely high yields. The government sat by and allowed this risky paper to be created in the private markets because during both Clinton and Bush II we had officials who were committed to the idea of self-correcting unregulated markets, and they were happy to accommodate the financial firms who didn’t want regulation. You might want to pick up a copy of Yves Smith’s “ECONned”. It’s a good new book on what happened by a very good financial writer.
So why did Fannie and Freddie go into conservatorship? What happened to the toxic mortgages?
Mortgage-backed security:
http://en.wikipedia.org/wiki/Mortgage-backed_security
“First, mortgage loans are purchased from banks, mortgage companies, and other originators. Then, these loans are assembled into pools. This is done by government agencies, government-sponsored enterprises, and private entities, which may offer features to mitigate the risk of default associated with these mortgages. Mortgage-backed securities represent claims on the principal and payments on the loans in the pool, through a process known as Securitization. These securities are usually sold as bonds, but financial innovation has created a variety of securities that derive their ultimate value from mortgage pools.
Most MBS’s are issued by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as “private-label” mortgage securities.”
http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
Subprime mortgage crisis
“In 1995, the GSEs like Fannie Mae began receiving government tax incentives for purchasing mortgage backed securities which included loans to low income borrowers. Thus began the involvement of the Fannie Mae and Freddie Mac with the subprime market.[106] In 1996, HUD set a goal for Fannie Mae and Freddie Mac that at least 42% of the mortgages they purchase be issued to borrowers whose household income was below the median in their area. This target was increased to 50% in 2000 and 52% in 2005.[107] From 2002 to 2006, as the U.S. subprime market grew 292% over previous years, Fannie Mae and Freddie Mac combined purchases of subprime securities rose from $38 billion to around $175 billion per year before dropping to $90 billion per year, which included $350 billion of Alt-A securities. Fannie Mae had stopped buying Alt-A products in the early 1990s because of the high risk of default. By 2008, the Fannie Mae and Freddie Mac owned, either directly or through mortgage pools they sponsored, $5.1 trillion in residential mortgages, about half the total U.S. mortgage market.[108] The GSE have always been highly leveraged, their net worth as of 30 June 2008 being a mere US$114 billion.[109] When concerns arose in September 2008 regarding the ability of the GSE to make good on their guarantees, the Federal government was forced to place the companies into a conservatorship, effectively nationalizing them at the taxpayers’ expense.”
http://en.wikipedia.org/wiki/Federal_takeover_of_Fannie_Mae_and_Freddie_Mac#Credit_default_swaps "In the credit default swap (CDS) market, the standard contracts typically used between parties to a swap define the action of placing Fannie Mae and Freddie Mac into conservatorship to be equivalent to bankruptcy, because of the change in management control. In CDS parlance, this is termed a credit event, and that triggers the settling of outstanding contracts for the derivatives, which are used to hedge or speculate on the potential risk that a company will default on its bonds. The two GSEs have approximately US$ 1.5 trillion in bonds outstanding, and since the market in credit default swaps is not public, there is no central reporting mechanism to verify how many credit default swaps are linked to those bonds. One estimate floated is US$ 500 billion, and that the entire CDS market has a notional value in the vicinity of US$ 62 trillion.[40][41] Settlement on the contracts, will likely be the largest in the market's decade-long history.[41] Credit-default swaps on Fannie and Freddie have been among the most actively traded the several months leading up to the conservatorship. "Thirteen 'major' dealers of credit-default swaps agreed 'unanimously' that the rescue constitutes a credit event triggering payment or delivery of the companies' bonds," according to a memo circulated by the International Swaps and Derivatives Association (ISDA) after the conservatorship announcement.[42] The day after the conservatorship announcement, the International Swaps and Derivatives Association, which sets industry standardized contracts for financial derivatives and swaps, announced it was working on a protocol on how to evaluate and settle Fannie Mae and Freddie Mac credit default swaps.[43] Most of these swaps were settled on October 6, 2008."