I've been posting this for over a year now, but I like to repost every now and then to see how people reactions change with the passage of time. So here goes: With our financial system in disarray, it seems no one really can put their finger on what the cause may be, and why the federal government is having to bailout these large companies. Why can't they fail? Why do we have use our money save them? Specific answers are hard to come by. My goal here is to give you a little glimpse into the financial world. You will be surprised to find out how things really work in this country in 2008. I am going to break this down into layman's terms, so hopefully everyone can develop a better understanding of the problems before us, and though there is much blame to go around, perhaps identify some of the root causes of this crisis. It's going to take us a while to get thought the terminology, but education can only be a good thing. First, we need to make a few things clear, otherwise the points may be lost on most people as the financial world is riddled with complex sounding labels. But as you will see, the concepts are simple enough. It all starts with a certain financial instrument called a derivative. A derivative is just something which has a value that derives from something else. For example, lets say you have a treasure map that shows the exact location of a $10 million treasure. Does the map have value? Yes and no. The map itself is just a piece of old paper, but the map makes it possible for you to acquire a $10 million treasure. You could then say that the map is worth $10 million, which is a value derived directly from the treasure.Easy enough right? The financial world is chalked full of derivatives: futures,Options, CDSs, and on and on. We said our treasure map is worth $10 million because the treasure is worth that much, right? Now imagine if you found out the treasure was actually worth $20 million. The value of the map goes up too doesn't it? Now let's say that the value of the treasure is constantly fluctuating. One day its worth $10 million, the next day it's worth $15 million. The value of the map fluctuates with it. Welcome to our financial derivatives market system. Substitute treasure with, stock, oil, grain, pork belly or bond and substitute map with option,future, CDS, etc and you have a derivatives market that resembles our own.So we now know what a derivative, I want to focus on is the credit default swap. It may sound intimidating, but like all Wall Street gibberish, its easy to comprehend once you get past the terminology. Credit just refers to a loan, default refers to someone not paying you back a loan, and swap just refers to something changing hands,-in this case the risk is what is changing hands. Imagine if you were to loan a friend $100 and he agreed to repay you $120 for giving him the loan(this is the credit part), we'll call him the poor friend. That is $20 profit in interest. So you go through with it, but you soon start to notice your friend isn't doing well. He lost his job. You aren't certain, but you have a feeling he may not be able to pay you back (that's the default part). So you go to another friend who has lots of money and you say to them "I will give you half of my $20 profit, if you agree to pay me back my full $100 if he goes broke". We will call him your rich friend. He doesn't believe your poor friend is really that bad off. This way you are giving away some profit, but you are insured against any loss of your principal. You "swapped" the risk of your credit to somebody else in case they default. There, that is a CDS. So now your wondering what the heck this has to do with anything. Answer: the bond market. Bond is just a another word for a shared loan. In our example above let's say that the $100 loan that was given to your friend was actually given to him by you and 3 others, each investing $25. Each of you invested in a bond that was used to give your poor friend some money. Well it just so happens that there are all kinds of people and institutions that would take the role of your poor friend. The government needs money, those are called treasury bond, cities need money for streets and hospitals, those are called municipal bonds. There are bonds secured by real estate, these are also commonly referred to has mortgage backed securities. There are all kinds of bonds you can invest in.Essentially you are loaning your money to these people and companies and they pay you interest. Simple as that. Now lets say you invested $250,000 in a bond for company XYZ. However, like your poor friend, you found out that the company wasn't doing well. Fearing they may default and you might lose your whole$250,000 ( or some portion of it) you went out and got a CDS. The next day,company XYZ defaults, but since you are insured via the CDS, you get all your money back. There are agencies in our country that rate other companies based on how credit worthy or likely to default they are. However, for a host of reasons, these ratings agencies failed us and many of the large companies that defaulted had some of the highest credit ratings.(you can thank congress for that). There is one crucial difference though. When you take out insurance on your house so that if it catches on fire you get paid back, you have to OWN the house. With a CDS you don't have to actually own the bond or be invested in the loan to buy insurance on it. You may be wondering why you want to pay for insurance on something you don't own. Well what if you saw that there was a hurricane coming toward Miami. You could buy insurance on every single house there, knowing that a few of them would get wiped out and you would rake in the cash. At the same time, lets say you had information that told you the hurricane was actually going to miss Miami. You then could sell a CDS on the houses and you would just make boat loads off of the premium when the hurricane misses. In short,the CDS has become a way to bet on our against certain bonds, or the market in general. Just one more thing though to tie it all together. Most people think that when you get a loan for your house, that the lender has money of their own, they lend it to you and you pay them back interest which is how they make their money. Sure that's the case sometimes, but most of the time the "lender" only holds the loan for a little while before your loan, along with many others gets packaged with other loans similar in size, length and risk profile, and then is turned into something called a Collateralized Mortgage Obligation (CMO) and is sold on the bond market. So basically in a reverse way, anyone in the US can put money into a bond (or CMO to be more specific) that money then gets put into a lender like Washington Mutual or Lehman who then use the money to lend to people to buy houses. This is commonly referred to as the secondary mortgage market. As you may have guessed, the riskier loans are packaged into higher risk CMOs that yield higher interest. The more risky loans in the CMO the higher the interest rate pay out, but the more likely you may lose money if borrowers start to default. So in essence, the bond market provides the funding for the mortgage market. Now that all that is out of the way, let's see what this has to do with today. How we can put all of this together to equal an epic financial crisis? A lot of the blame seems to fall on subprime loans. And surely they do deserve it, but that is drastically over simplified.If you look at this graph you will see that the amount of originated subprime loans increased dramatically starting around 2002-2003, but why? Subprime loans have been around for a long time, why the sudden spike in subprime loans originated?As we now know mortgage loans are just a product of the bond market, or Collateralized Mortgage Obligations (CMOs) to be more specific. The vast majority of loans made are bought by the secondary market. So now that we know the mortgage market is merely a reflection of the bond market we can ask a more informed question: what caused a spike in the demand for risky subprime backed mortgage bonds which then tricked down to Main Street making them more easily attainable? They were always there, why did the demand for them suddenly increase, causing ultimately subprime lending to increase? (continued)
Enter the CDS. With the advent of the CDS, bond holders could "insure" themselves against any losses. So why not bet on the high paying, risky bonds?Worst case is that you make nothing, if the bond holders default you get your money back and if they don't default you might as well be printing money. Basically the demand for high yield, risky debt soared because of the false sense of security CDSs provided. Do you think its a coincidence that the CDS market grew 1000%(one thousand) between 2002 and 2007? The exact SAME time the subprime lending increased (see the chart)? Of course not. The demand for subprime backed bonds grew, which in turn means lenders on main street started doing all they could to close more subprime loans to satisfy the now subprime addicted secondary market, hence the drastic increase is subprime loans and CDSs. All ofthis because bond holders could now, ostensibly, eliminate their risk. That is where the subprime mess started. CDSs in themselves though aren't bad. They serve a good purpose. But some of you are wondering how on earth so much debt could be insured. The answer: it can't, but no one knew that, or at least no one cared. The reason no one knew is because CDSs are completely unregulated, and as a result there is notransparency in the market.The big financial companies were doing something called "netting". The value, or spread, of the CDS terms would of course fluctuate and they could take advantage and ostensibly insure everything. For example. Lets say you want to buy $10 million in risky subprime bonds, you want the nice return but you don't want the risk. You come to me and we enter into a CDS for lets say2% of the total value per year. You're off the hook, but I am on the hook for the $10million. I don't like all this risk though and want to protect my principal investment. Next week the market improves a bit and I go to another person, call them Bob, and say I want to insure $10 million worth of the same risky subprime bond. Bob says OK, I'll do it for 1.75% of total value per year. Perfect! Now I'm making 0.25% risk free, but I didn't tell you that. I have a CDS with Bob. The market starts to head south a bit. Bob then is like "Uh oh, I'm on the hook for $10 million", looking to protect himself he goes to another person and says "I need to insure $10 million I have in this risky subprime bond", they agree because its likely they are insured VIA a CDS by someone else. I'll do it for now he has 0 risk. Do you see the problem here? When the markets are unregulated and not transparent it was impossible to see that the risk was just being transferred around so much that everyone thinks they are completely covered when actually if there is a default there is not going to be enough money to go around. Now what happens if I, you, Bob or anybody else defaults? If you default, I default, Bob defaults and so on down the line. This is exactly what the financial companies were doing when subprime loans started to default, large companies holding billions in debt began to say "OK I'm insured,where is my money" the company that sold the CDS to them (the insurer) then went to another company and said the same thing until eventually they get back around to the original company. So where does the money come from. Since CDSs aren't regulated no one has any idea of the solvency of the company who they just bought this "insurance" from. Imagine not knowing for sure if your car insurance company has enough money to actually pay for your car if you have an accident.So basically if one company fails the rest of them default as well. Now we know why certain companies were propped up so quickly. All this because CDS are evil? No. Because they HAVE zero regulation. Imagine the stock market during the 1920's and you get some idea of what is going on in the $50 trillion CDS market, right now, TODAY. You really can't even say there is a "market" because CDSs don't have any centralized exchange, the deals are just done via email or instant message. The government was forced to bail out these companies because the potential domino effect would have been too much for us to handle. Now we have to us tax payer dollars to keep these companies alive in order to prevent a total meltdown. This is nothing more than the worldslargest casino. It's out there right now and its worth more than the stock market,futures market, bond market, insurance market, gaming market and the real estate market. Only all of those industries are regulated. The CDS market isn't. It's like the wild west out there. Our most respected financial institutions are really less respectable than any casino. That is a hard truth to swallow. I'm a believer in freemarkets. I do like less government intrusion and I think there are areas where we need to drastically reduce government involvement. However this should be proof to you that as much as we need less government, there are some very important places in which we need more. I hope now we can all get a sense of why more regulation is needed and how deregulation is largely responsible for this meltdown. Deregulation isn't always a bad thing, but I think when things get this out of control we can see that a change is needed and in this case, it looks like we really need some big government.
Thanks for the lesson. If lending out deposits is Plan A. CDS, ABS, etc, is plan B. What now? What is plan C? We have a credit crisis.
Jonbig04 Thanks for the great work on putting the mess into understandable context. I am going to print this out and have my kids and some of my friends read it. I have tried to explain it to them but they just look at me dazed and confused. I think your explanition is just what the doctor ordered. Mike
Wow, thanks for the in-depth explanation (and re-posting it so that I could find it.) I am a Business major, and I didn't find out about the derivatives market or the secondary market until a guest speaker came in last April -- way after the market crashed. A lot of this isn't "textbook" material, but it is invaluable to understanding how we got into this financial system. I too am going to print this out and bring it home this weekend. I remember reading a piece from Graham Summers that helped explain how the US started taking on too much credit. We re-opened trade with China in 1971, and outsourcing helped shift our economy from manufacturing to services (mainly financial services). As evidence of that move, almost 1 in every 3 dollars of profit out of the S&P 500 was coming from financial companies in the 90s. During these decades, there was a massive drop in real US incomes -- this drop wasn't realized of course, because standards of living were maintained with the use of credit. The use of credit became much more profitable for banks after this trend started developing.
JonBig, people will say you are the communist for asking for some regulation. But what you are saying is a swap on the swap on the swap on the swap give people confidence to NOT have enough money to cover thier bet if they lose. Everyone think someone else can pay for their bad bet, so no one has the money to pay because they think they have insurance.
What I don't get is that everyone says that we couldn't let these entities fail, yet now they are limping along today and they aren't even fulfilling their normal roles of operations (i.e., bank lending). Gee, I'm really glad that we saved some crappy banks so that they can be banks in name only. I want to see the alternate universe where we allowed all of these idiots to fail and let other more well capitalized entities take their place.
thanks for the kind words. I love derivatives and the free market. I day trade ES. I think we can be lovers of the free market and still have common sense about aspects that need to be regulated.
So, is the regulatory solution a system to verify that you are not actually insuring yourself (which is a zero sum). Like if you need car insurance, but you actually own the company, or would owe the company had you filed a claim for your coverage. As long as one separate entity is insuring another, that sounds fine to me. Thats a pretty simple deal.