My friend Michael Bishop emailed this to me (and to a number of other folks as well) This is a nice description of how the credit default swap brought down the financial system, and a good outline and devastating attack on the Republican fairy tail about how this mess came about. Have a read
From the Daily Kos
by Devilstower
Sun Nov 16, 2008 at 07:00:03 AM PST
History may be written by the winners, but that doesn't stop the losers from wasting a lot of ink in the attempt. This time, it's the GOP revanchists who are busy trying to come up with a reason -- any reason -- for the economic crisis that doesn't point directly to their conservative ideology and the greedy green horse of the Apocalypse, deregulation.
There are dozens of letters percolating through Republican chain mail, and a matching number of posts on right wing blogs, all trying to spread the same message: Democrats loaned money to black people!
Here's an example plucked from my own mailbox.
We're on the brink of an economic disaster and another Great Depression. This was not caused by Republicans. This was caused solely by Democrats.
In 1977 Democratic President Jimmy Carter passed the Community Reinvestment Act to provide housing to poor people. In the 1990s Bill Clinton had Attorney General Janet Reno threaten banks under red lining rules into giving loans to people who could not afford them. Then in the last 8 years, the leftist group ACORN, which has ties to Barack Obama, went to banks and threatened them to relax their rules again. Banks had to give loans to people who had no jobs or no identification.
You have to hand it to them. In terms of bringing together the maximum number of Republican demons -- Carter, Clinton, Reno, Obama -- with the smallest amount of connecting narrative, this is a keeper.
It's a satisfying bedtime story for the right. They can snooze and dream of revenge, when the wonders of True Conservatism will pave the streets with a mixture of gold and liberal bones. Unfortunately for them, it's not only simplistic, not only demonstrative of deep prejudice, it's also dead wrong.
The Community Reinvestment Act and other red lining laws weren't passed to force banks to make loans to African-Americans and other minorities. They were there to make the rules consistent. Previous to the passage of the CRA, minorities were often required to have better credit, and make larger down payments to get loans equivalent to those awarded whites. Nothing in these laws required that banks lower their lending standards, only that they be fair, consistent, and operate in a "safe and secure" way. There was no evidence then, and no evidence now, that minorities with the same initial credit rating as whites tend to default on their loans at any greater rate.
Want proof? Mortgage failure rate in 2000: 1%. 2001: 1%. 2002, 2003, 2004, 2005, 2006? One (1) as in ONE percent. But wait! Everything that Carter, Reno, and Clinton could do was already in there. The nefarious community organizers of ACORN had already grown their little oak trees of pressure. Carter's poor people had been sitting in their new homes so long, that many of those initial mortgages were paid off and gone.
What does legislation passed 31 years ago have to do with problems today? Nothing. Neither do tweaks Clinton made to that legislation in the mid 90s. The real culprits require a much shorter trip down memory lane.
Subprime mortgages (and all mortgages, really) are a fraction of the current problem. The bailout would have been enough to buy out every subprime mortgage in foreclosure across the country. In fact, it was enough to do that several times over. So why not do that?
The reason is that the purpose of the bailout (at least as Treasury Secretary Paulson sees it) isn't to stop mortgage foreclosures, but to save the banks. And the banks have some self-inflicted problems that make those mortgages an afterthought.
For example, the wonderful credit default swap. In essence, credit default swaps are (or were) nothing but insurance policies for loans. And yet in 2007 the total number of credit default swaps traded far exceeded the value of all loans. In fact, it may have touched $70 trillion dollars, which puts it above the gross domestic product of the entire planet.
How is that possible? Come with me back to the primitive world of 1999, when SUVs ruled the roads and cell phones did not yet shoot video, and let's see how this clumsy bit of fiscal jargon conquered the planet.
The Evolution of the Credit Default Swap
Stage 1 (Perturbo mutans)
You have just made a loan to someone, and now you're nervous that this scoundrel might not pay. What to do, what to do? Ah, but you need not worry! I happen to have assets on hand that can easily cover your petty loan. What's more, for a small monthly fee, I'll be happy to provide you with insurance of a sort. Should the person to whom you've extended a loan prove unreliable, I'll shoulder the burden -- so long as you keep up the payments. Let's call this insurance a... credit default swap.
In 1999, these credit default swaps already existed, but they were a niche product. Only a fraction of banks employed them and then only on a fraction of loans. Without some knock to the system, swaps would probably have remained a relatively small player.
Stage 2 (Perturbo furtiva)
Knock, knock. In 2000 Republican economic hero, Phil Gramm, with the assistance of a small legion of lobbyists, created the Commodity Futures Modernization Act. Along with ushering in the Enron disaster, this bill provided the one thing that credit default swaps needed to grow and mutate -- invisibility. Thanks to the CFMA, not only were credit default swaps unregulated, they were impossible to observe directly. Like black holes in deep space, you could only spot swaps by looking at how other things acted nearby.
So, now you've made a loan to someone, and you're worried about it. I want to offer you a credit default swap so I can collect the fee. Trouble is, I don't have the assets to cover your loan. So how can I... hold on, credit default swaps are so unregulated that no one says I actually have to be able to deliver on my promise. Hey, over here! Have I got a swap for you, and it's a bargain.
So now the CDS is a means of moving the risk, but the risk is still as high (or higher, since the original lender might have been better able to cover the loss). In fact, credit default swaps have gone from being a risk mitigator, to a risk magnifier.
Stage 3 (Peturbo veloxicresco)
You have a loan you're worried about. That's good, because lots of people want to offer you swaps. After all, you don't have to have any assets to issue a swap. The investment bank of First Me and The Change I Found In the Couch Cushions can offer swaps for all the debt at Morgan Stanley, and that's okay. I get free money for issuing the swaps, and the swaps have value on the books. So both me and my pal Mr. Stanley have values that are inflating faster than a tick in a blood bank.
Now you can get a swap for any loan you want, and with all the competition, the cost of these swaps is lower, and lower, and lower. Here's an idea: why not go out and make more loans, riskier loans. Why not offer anyone you can collar on the street a loan, no matter whether or not they can pay it off, not because some 30 year old law makes you do it, but because your friend the credit swap makes it perfectly safe!
So many people are offering these things that you could give a loan to Saddam while the bombs are falling without a care in the world. You can always get a swap.
Stage 4 (Fatum casus)
I have a swap. I really, really want someone to take my swap. Only even with every incentive I can offer, not enough people are loaning. Sure, there's a record amount of hypothetical money sloshing around the system thanks to me and my swaps, but it's still not enough. So what can I...
Wait a second. Swaps are unregulated. No one says I have to have enough resources to cover the swap, and even better, no one says I have to offer the swap to the person who actually made the loan! Hey buddy, see that loan over there? You may think it's iffy, but I think it'll hold up. In fact, I'm so sure it will, I'll sell you a credit default swap on it that pays off if it fails. You don't make the loan, you don't have to pay off on the loan, you don't have anything to do with the loan. You just pay me the fee. And if that guy loses his money, you collect. How sweet is that!
This mutation is enormous (see how the genera changed up there?). At this point, credit default swaps have become completely divorced from the original function. A single loan can be covered by multiple swaps. There's a complicated fiscal term for this. It's called gambling, and at this stage, that's all that remains of those little "insurance" policies. They no longer protect anyone from anything, they just offer a chance to place enormous overlapping side bets on everything.
Stage 5 (Fatum insanus)
I have swaps! Get your swaps here! Want a swap on a loan you made? Okay. Want to bet that the bozo in the next cube is making bad loans? We can do that. Want to bundle up some loans and bet on those? Buddy we can do better than that. I can give you a swap on the value of other swaps. Now we're really in business.
Who owns the original loan? Don't know, don't care. Who's actually responsible for the money if that loan should fail? Ehhh, can't really say. Has anyone noticed that a single bad loan could cause a cascade of swap calls that bounce around the system like a rocket-power pinball? Shut up.
Isn't anyone worried that this is the most massive house of cards ever constructed in human history? Lookit, what part of "we took 120 billion in bonuses out of this place in the last five years" are you missing?
Stage 6 (Fatum exicelebritas)
Hey, my loan went bad. Can I have my money from that swap, please?
Stage 7 (Fatum cerus)
Oh shit.
Now that people are paying attention, it turns out that the value of most credit default swaps is not just bupkis, it's Bupkis Plus. More computer power went into modeling these things than has been invested in predicting climate change, but everyone overlooked the giant "and then a miracle occurs" at the center of all the equations that allowed credit default swaps to generate revenue ex nihilo.
Trying to blame the 1977 Community Reinvestment Act for the current fiscal crisis is like blaming a spot on your windshield for engine failure while ignoring the gaping wound in you head gasket. Republicans are scribbling hard to create their new version of reality, and you never know what's going to sell. After all, people bought a "Book of Virtues" authored by Bill Bennet.
But in this case, even the Mock Turtle and the March Hare think the GOP line is too outlandish.
2 comments:
Article filled with inaccuracies!
The author has misstated the size of the CDS market, you have made false claims about the assets of the participants, and you have falsely claimed that the market lacks any regulation. I apologize if the explanation of how this article is inaccurate is too technical; however, I felt it was important to support my claims of inaccuracies with supporting evidence.
Size of the Market:
Fact 1: Contrary to many reports, the CDS market is much smaller than the bond market and nowhere near $70 trillion. The CDS market related to mortgages is even smaller.
The author stated “And yet in 2007 the total number of credit default swaps traded far exceeded the value of all loans. In fact, it may have touched $70 trillion dollars, which puts it above the gross domestic product of the entire planet.”
Evidence 1: The $70 trillion that you are quoting the gross size of the amount insured of the global CDS market. The net amount is much, much smaller and the value of that net amount is a fraction of that. The net amount of CDS is much lower because the same investor both buys and sells CDS. Under pressure from the Fed (note: a regulator), over $25 trillion of needless CDS trades have been torn up in the last several months without a penny change in the actual value (www.isda.org).
Evidence 2: When there is a default, up 95% of CDS contracts cancel each other out. Why? Every 3 months, the CDS changes the standard maturity that is traded. Currently, the liquid CDS contacts that are traded will expire on December 20, 2013. On December 21st of this year, the CDS market will trade contracts that expire March 20, 2014. If you bought insurance the expires December 20, 2013 and sold an equal amount of insurance that expires on March 20, 2014, you have two very different instruments that you do not cancel each other out today as a default could occur after December 20, 2013 but before March 20, 2014. If there is a default, the only question is “Do you have valid insurance?”. It doesn’t matter if you insurance expires the next day or 100 years later. If there is a default before December 20, 2013, the CDS in our example completely cancel each other out. Pre-default you can only cancel out CDS with the same maturity date (e.g. the $25 trillion reference above.)
Evidence 3: The amount covered by a CDS contract is nowhere near its value. If you buy $100,000 in insurance on your home, the insurance policy isn’t worth anything near $100,000. Its value is close to zero as the premiums that you pay for the insurance is roughly equal to the value of the protection (plus some incentive for the insurance company). By comparing the gross amount of what is insured in the CDS market (which is nowhere where near the value) to the GDP of the planet, the author is comparing apples to oranges. One is value. The other is not.
Evidence 4: The amount of money lost (and gained) in CDS is a very small fraction of the amount lost on bonds. The amount lost (and gained) on Lehman CDS ($5.2 billion) was less than 1/20th of the amount of CDS lost on Lehman Brother bonds (www.dtcc.com). At the insistence of the Fed (note: a regulator), a central database was set up at DTCC to administer the cash payments in CDS. The amount of CDS on the top 1,000 entities is available free to the public at www.dtcc.com. You can compare for yourself the amount of net CDS to the bonds of the companies.
Evidence 5: You will notice on the DTCC website the significant amount of CDS that is not related to mortgages (e.g. State of Italy, General Motors). Most CDS has nothing to do with the mortgage market. If the author is going to reference to overall gross amount of the CDS market in an article related to mortgages, they should at least note that only a very small fraction of that amount is related to the mortgage market.
Fact 2: You do need assets to be in the CDS market.
The author claims that “You don't have to have any assets to issue a swap. The investment bank of First Me and The Change I Found In the Couch Cushions can offer swaps for all the debt at Morgan Stanley, and that's okay.”
There are zero retail investors investing in the CDS market. By suggesting that anyone can buy and sell CDS, the author is doing a major disservice to their readers. The market is entirely an institutional market.
While there may be a concern that your CDS counterparty does not have enough assets to cover their obligations when they are due (e.g. AIG), that does not mean that they did not have any assets when the contracts that were first made. If the assets that your counterparty has when you initially make the trade are mortgages back by subprime mortgages, you may have a problem. The problem with counterparty risk is precisely why central clearing agencies are being set up (at the demand of regulators). The central counterparty in CDS will not make bets in risky assets like subprime mortgages. It will simply offset risks… and demand collateral. The concerns with the ability of participants to honor their obligations are legitimate; however, the contention that no assets are needed to participate in the CDS market is completely inaccurately. It is time the CDS discussion had reasonable and informed voices.
Fact 3: Swaps are not unregulated
While most would agree that the CDS market needs additional regulation, regulators that claim it is unregulated are trying to expand their regulatory authority at the expense of other regulators. (How many comments do you see from the Fed and from the Treasury that the CDS market is unregulated?) While the CDS market may not be covered by state gambling laws, that does not mean that it completely lacks regulation. To claim it is unregulated does disservice to some regulators but (more importantly) masks the problem. Regulation doesn’t keep investors from making bad investment decisions. When additional regulation comes, the ability for AIG (or the likes of Lehman Brothers or Bear Stearns) to make poor investment decisions will not disappear.
Fact 4: CDS is no more gambling than buying a bond or stock is gambling.
The author claims “A single loan can be covered by multiple swaps. There's a complicated fiscal term for this. It's called gambling, and at this stage, that's all that remains of those little "insurance" policies. They no longer protect anyone from anything, they just offer a chance to place enormous overlapping side bets on everything.”
Anyone that thinks investing in CDS is gambling must think that investing in bonds is gambling. Selling CDS on General Motors is in many respects the same as buying a General Motors bond.
You buy the bond to make a return. You sell the CDS to make a return.
If GM defaults, you can loose the same amount in the bond as you did in selling the CDS.
While more regulation is needed in the CDS market, it seems that those that claim there is a problem with selling insurance on an asset that you don’t own are people that haven’t considered why people invest.
Unlike a house or a car, you don’t buy a bond or stock to use it. You buy it for the return for a given amount of risk. If you can do that in a more efficient way (e.g. CDS), you do.
You may lose money but that is a reflection more of your investment decisions that the tool itself.
When all the investors that bought General Motors bonds/stocks loose when GM defaults, will we call for a ban on bonds and stocks?
I would like to thank anonymous for the comment. It's apparent that "anon" is familiar with derivatives. Still, I have some unanswered questions. I can accept that the 70 trillion dollars is the gross size of the global amount insured (under Credit Default Swaps) and that there may be some "net" figure which is smaller and perhaps more realistic. Anonymous doesn't offer any suggestion as to what that net number might be or how it would be derived. He does suggest that the value of an insurance policy on one's home isn't the $100,000 that the home is insured for, but rather it is equal to roughly zero since the premiums merely cover the risk plus earnings for the insurer. Still, if your house burns down, the insurer will be obligated to pay $100,000. Therefore, I don't think it unreasonable to sum up the risks at stake and regard that dollar total as interesting and an obligation to someone. In the end, however, Anonymous doesn't give us any figure for the actual dollar totals involved nor any method we might use to figure it out for ourselves.
Finally, it's odd that after bashing the concept of a $70 trillion size of the CDS market, Anonymous claims that $25 trillion dollars of "useless" swaps have recently been "torn up". Is this $25 trillion figure derived in the same manner as the $70 trillion figure he dismisses?
I confess I was unable to follow the reasoning in Evidence 2, where it is claimed that when there is a default up (to) 95% CDS contracts cancel each other out. That's all I can say.
Again, in Evidence 3, while the value of an insurance policy is, itself, close to zero, it does represent an obligation and a risk. If, again, the house burns down, $100,000 must be paid; if the policy expires during a period of no damage to the house, all is well. Of course, if, in financial markets, default becomes widespread, the obligation to fulfill the swap becomes quite real and measurable.
That much of the CDS market is in other than mortgages is interesting but not central to any argument being raised either in the initial posting or in Anonymous' comment.
I think, further, that the original posting's author was simply being sarcastic in suggesting that he could initiate a CDS with the change found in his sofa. The point is that CDS were written by outfits that patently didn't have the resources to cover their obligations (i.e. AIG).
As to the difference between a CDS and buying a GM bond, I believe in the latter case one is, in effect, lending money to GM, and one stands first in line among creditors should GM go into bankruptcy. If you sell a CDS against a GM bond default and GM defaults, you must pay the value of the bond to your client. Presumably, you have no standing as a GM creditor and no claim to GM assets. You've simply "bet" that GM wouldn't default. You've done no more than assume a risk for a given reward. This is remarkably close to gambling.
I also wonder about the fact that CDS are virtual insurance. As a CDS purchaser, I am making a payment in order to "insure" against default on a credit instrument that I hold. If I did this transaction with an insurance company, that company would be required by regulators to hold a certain level of assets to pay it's potential obligations. Insurance companies are subject to extensive regulation. My understanding is that CDS markets are not subject to regulation--despite your mention of regulation and regulators (only the FED is expressly cited, but I would guess that FED involvement in investment banking and derivative markets is quite recent). Indeed the Counterparty Risk Management Group recently concluded that "finance and financial institutions must be subject to a higher degree of official oversight than is necessary for virtually all other forms of commercial enterprise".
"http://www.crmpolicygroup.org/
That level of official oversight has, obviously, been lacking.
The same policy group also concluded that the derivative instruments had become so complex and opaque that many, even high level, people in the industry did not properly understand them.
From all this, I would conclude that the CDS market had become huge, highly complex, and largely unregulated It involved risks the coverage for which there were inadequate resources. As such, the market could only perform if actual defaults were minimal. They proved to be common and widespread. The problem, then, was with the financial system, not, as some conservatives like to claim, with crazy democrats and community organizers forcing banks to lend to black people.
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