This is the fourth article in a series entitled “The Financial Crisis – It’s Not That Complicated.” 

The first article in this series described the size of the subprime mortgage problem and how it could not, by itself, cause the meltdown.  The second article examined the Collateralized Debt Obligation (CDO) and in the last article we looked into the murky world of a financial derivative called a Credit Default Swap, (CDS.)  If you missed those articles you may want to backtrack and read them so you’ll have a handle on the jargon and concepts discussed here. 

Here’s how our Federal Government helped set the stage for the crisis.

On November 12, 1999 congress passed the Financial Services Modernization Act.  This legislation allowed banks to act as insurance companies and insurance companies to act as banks.  It also erased the differences between commercial banks and investment banks.

This paved the way for insurance companies, like AIG, to get into the Credit Default Swap business.  It also allowed commercial banks, like Bank of America, to become sellers of CDSs.  Before the 1999 Financial Services Modernization Act was passed, only investment banks could sell CDSs.

Most insurance that is sold is regulated at the state level.  In order to prevent oversight and regulation, the banks, hedge funds and insurance companies that bought and sold CDSs were careful to call them “swaps” instead of insurance.  The term “swap” in the financial world is applied to the instrument that transfers, (swaps,) the risk of the underlying asset from the buyer to the seller.

In the second article of this series we followed the crisis timeline to the spring of 2008 when Bear Stearns was bought by JP Morgan for $2 a share in a deal backed by the Feds with a $29 billion guarantee.  The demise of Bear Stearns was due in large part to their participation in the sale of Credit Default Swaps (CDS) contracts written on mortgage-backed Collateralized Debt Obligations (CDOs.) 

Between March 16, 2008 when Bear Stearns was purchased by JP Morgan, and September 7, 2008, when Fannie Mae and Freddie Mac were taken over by the Feds, many of the big mega-banks were having major losses.  At the time we were told that most of the problems were due to subprime mortgages defaulting. In fact, the problems were due to the derivatives based on subprime mortgages. All of the banks in difficulty were heavily involved in CDOs and CDSs.  The subprime mortgages going bad were causing big losses in CDOs and big payouts for the sellers of CDSs.

Then, in September, the Feds took over Fannie Mae and Freddie Mac. This in turn triggered the payout of billions of dollars for CDSs written against bonds and mortgage-backed securities sold by Fannie and Freddie. In the meantime many of these mortgage-backed securities had been tossed into CDOs which in turn had become part of mores CDOs. As these derivatives fell like dominoes they triggered even more CDS payouts.

That is how $1 million in mortgages might produce $3 million in CDOs and another $20 million in CDSs.  Remember, most of the CDSs were sold to people that didn’t own the underlying securities. They were just speculating on the failure of the shaky sub-prime mortgage debt. If the $1 million in mortgages defaults it starts a chain reaction all the way up to the Credit Default Swaps. The $1 million problem becomes a $24 million problem overnight.

That’s why Merrill Lynch was sold to Bank of America, Lehman Brothers went bankrupt, AIG was bailed out and Washington Mutual Bank was seized by the FDIC. This all happened between the 7th and the 25th of September 2008.  All of these institutions were heavily involved in mortgage-related CDOs and CDSs.

But how did the smart people on Wall Street allow things to go so bad?  How could they possibly convince themselves that Credit Default Swaps were a good thing?  To understand that you need to know a little bit about what makes Wall Street tick.

The raw material that Wall Street uses to make money is money itself.  It’s not like digging iron ore out of the ground and making steel from it.  Everyone has to use the same raw material and everyone has equal access to it.  To make money in the financial world you can lend money, invest money, sell financial products or sell insurance.  All of these activities involve risk.  If you are better at assessing risk than your competition and you are willing to put money behind that assessment you will beat them.

The problem is that Wall Street relied on a faulty method to asses the risk involved with the derivatives based on subprime mortgages.  Remember David Li’s Gaussian copula function from the article on Collateralized Debt Obligations?  They used that same model to estimate the risk of default for the Credit Default Swaps they were buying and selling.  Even after David Li pointed out the flaws in the theory, they continued to use it.

Wall Street was making a ton of money layering derivative upon derivative.  They could avoid risk by repackaging the junk and passing it off as a safe investment to people that relied on the ratings of Moody’s or Standard & Poor’s.  The rating companies, either by collusion or reliance on faulty risk evaluation standards, made the scam possible.  And companies like AIG, Lehman Brothers and Bear Stearns were making money selling CDSs to holders of the end products and the larger market of speculators betting on the failure of the junk investments.

That’s what led to the events of September 2008.

In the next article of this series we’ll discuss the role Credit Default Swaps play in the ongoing crisis and the affect they are having on the efforts to fix things.  I think you’ll be amazed at what’s going on!
COPYRIGHT 2009 by Ray Wood