The root of our financial crisis?: Look here.

A Financial Crisis

It seems no one really can put their finger on what is causing this financial crisis, and why the federal government is having to prop up these companies. Why can't they fail? Why do we have use our money save them? No one seems to know. I hope this gives 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 laymen's terms, so hopefully everyone can understand the problem before us.

You may have gathered by now that CDSs are basically insurance for people who invest on bonds. The only reason its not called credit default insurance, is to keep if from being regulated. 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 CDSs you don't have to actually own the bond, or be invested in the loan to buy insurance on it. You may be thinking "Why would you want insurance on something you aren't invested in"? 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 the CDSs on the houses and you would just make boat loads off of the premium when the hurricane misses. In short, CDSs have become a way to bet on our against certain bonds.

Ok so finally we have an understanding of how CDSs work and how bonds work. 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 the higher the interest rate pay out, but the more likely you may lose all your 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 thats 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. Collaterlized Mortgage Obligations (CMOs) to be more specific. The vast majority of loans made are bought by the secondary market (before you go thinking just Fannie Mae, remember fannie mae only holds around 10% of all the subprime 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 back mortgage bonds? They were always there, why did the demand for them suddenly increase, causing ultimately subprime lending to increase?

<img src="http://www.irvinehousingblog.com/wp-content/uploads/2007/03/subprime-mortgage-portion-of-market.jpg">

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 of this because bond holders could now, ostensibly, eliminate their risk. That is where the subprime mess started.

<img src="http://www.credit-deriv.com/credit%20derivatives%20growth.JPG">

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 knows that. The reason no one knows is because CDSs are completely unregulated, and as a result there is no transparency 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 dont want the risk. You come to me and we enter into a CDS for lets say 2% of the total value per year. You're off the hook, but I am on the hook for the $10 million. 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 untl eventually they get back around to the original company. So where does the money come from. Since CDSs arent 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 worlds largest 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. Thats a hard truth to swallow. I'm a believer in free markets. 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. Everything you just read seems to be lost on congress. I understand of course that congress is looking to another stimulus package, and no doubt that will help. However I believe that until we do something about this unregulated CDS market , our problems will persist. We need to set up an exchange for CDSs and set up a regulatory body to preside over said exchange, perhaps a new branch of the CFTC.




Jonathan Biggerstaff

 

Yes Jonathan, the cause has already been identified. In fact, it was foretold a long time ago. But as usual, the masses don't listen to anything seriously unless it comes from the stupid box with rabbit ears. There are also threads about it on ET.

 

Oh thats cool. I haven't seen any but I dont come in this section often.

 

The Birth of Credit Default Swaps (CDS)
A young Cambridge graduate by the name of Blythe Masters came up with the idea of “Insurance per Betting” which was quickly put into reality by all the leading banks. The Credit Default Swaps (CDS) were born.
No longer “due diligence” seemed to be necessary, when approving loans. In case of credit default the buyer of the risk paper had to pay. This buyer, like an insurance, is paid regular premiums by the lending bank.
As a result of this madness, 40% of all the recipients of loans are not creditworthy, according to Fitch’s rating agency. A direct result of the “insurance-mentality”. In 2002, in the early days of CDS, it was just 8%.

 

damnit. i thought it was just me. lol oh well.

 

i enjoyed reading your explanation. too bad the general population won't understand it.

 

Thanks. Actually this is only half of it, the first half i spent explaining what a derivative is, what a bond is, what a CDS is, how the secondary market works etc in very very laymen friendly terms. I left all that out here. I sent it to friends and family and they seemed to be able to comprehend it....not that anyone will do anything about it though! haha.

 

Then you haven't been looking.

 

Thank you very much for your explanation.

I was lurking around here for a while, and I found a lot of interesting posts in this forum.
IMHO this one is one of the best, because it add simplicity to good contents, so it worth my first reply here.
Maybe sometime media will become such informative.

I will be very glad to read all next post by you. Please continue...

 

Thanks. There is a lot to be said for simplicity especially when your trying to explain a derivatives market to someone who doesn't know derivatives exist. I wrote this mainly for friends and family...who wonder how in the world I know that without being in college. And of course, they say, the people my age in college know all about this stuff already. lol..hmm...

There is a lot of BS on ET, but once you get an eye for it you can easily by pass all the BS and get straight to the good stuff. There are some diamonds in the rough