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WPCNR QUILL & EYESHADE. News & Comment by Don Hughes. October 5, 2008: Personally I believe in free markets and limited government regulation. However, as the following discussion – which is based on The $55 Trillion Question in the 13 October 2008 FORTUNE and How to Burn the Speculators in the September/October 2008 Mother Jones – shows, there is a significant difference between ‘limited’ and ‘no’.
After 1933 and the passage of the Glass-Steagall Act much of the commercial banking industry was regulated. The 1933 laws were in response to the mixing of commercial and investment banking that started in the 1920s and which had led to significant opportunities for fraud and conflicts of interest.
And while the regulations almost guaranteed small but steady profits, they limited the opportunities for spectacular profits. Historically, local banks took in deposits and then used that money to make loans. There were strict requirements on how much cash a bank needed to keep on-hand and on the ratio of their assets to their capital. However because of the anemic US savings rate, the demand for loans exceeded large bank’s ability to attract deposits and thus to make loans and to make profits. Some banks turned to other sources of income such as credit cards and checking accounts and their seemingly unlimited opportunities to impose new fees.
Enter Derivatives
In the financial world there are instruments called derivatives – things that have no intrinsic value themselves, but derive their value from some underlying asset. Banks made use derivatives called’mortgage-backed securities’. They repackaged their loans as MBS and then sold these ‘securities’ toother institutions. Since the banks technically no longer owned these loans, it allowed them to avoid the regulations on the ratio of assets to capital which then allowed them to make additional loans and to create huge financial empires on fairly modest foundations.
A private firm called the Federal National Mortgage Association or Fannie Mae which started as a governmental agency in 1938 and another firm call the Federal Home Loan Mortgage Corporation or Freddie Mac created in 1970 arose to provide a secondary market for these MBS. As of last month, both are now wards of the government.
License to Derive
In 1999 the Gramm-Leach-Bliley Act repealed parts of the Glass-Steagall Act and allowed many new players into the mortgage market. Perhaps 80% of mortgage loans are now made by non-banks. At this point, the people making the loans had only a passing interest if the loans were ever repaid. They made their money initiating the loans and passed the risk on to others.
And they were largely unregulated. Predictably, they started making loans to people who were worse and worse credit risks (the subprime market). A number used deceptive advertising and empty promises to attract these new borrowers — practices that would have landed their regulated predecessors in jail.
The Motivation Changes
To review: if you make your money on the difference between the interest you receive from mortgages and the interest that you pay depositors, you are going to want to protect your interest income by only making loans to people that you are fairly certain will pay you back.
However, if you make your money from the loan origination fees, processing fees, and late fees, you are more interested in just making as many loans as possible. You may actually make more money in fees from people with poor credit than from people with excellent credit.
It is easy to blame the borrowers for getting in over their heads, but all of us make decisions based on information that we assume to be correct. We buy milk assuming that it is milk and not water mixedwith melanine, we buy fire insurance assuming that if we have a fire that we will get paid, and we buy plane tickets assuming that the planes will not crash into each other in the air.
Government regulation is what make these reasonable assumptions.
Betting on Your Assets–No House Manager.
The financial institutions realized their own risks, and just like homeowners purchase mortgage insurance, they purchased a different kind of derivative called ‘Credit Default Swaps’.
A CDS is a contract where the buyer pays the seller an amount suspiciously like a premium and in return the seller agrees to make a payment if a particular event, such a a loan default, occurs. Used in moderation, these can be very useful instruments.
But there is a reason that the markets pushed CDS instead of insurance.The insurance industry is regulated, CDS are not. In fact, Congress went out of its way to insure the they were not. As reported in the FORTUNE article:
“in 2000, Congress with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm – most recently in the news when he stepped down as John McCain’s campaign co-chair this summer after calling people who talk about a recession “whiners” — crowed that the new law “protects financial institutions from over-regulation … and it guarantees that the United States will maintain its global dominance of the financial markets.” (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would “supersede and preempt the application of any state or local law that prohibits gaming …”) Not everyone was a sanguine as Gramm. In 2003, Warren Buffett famously called derivatives “financial weapons of mass destruction.””
Instant Money
Because they are simple contracts rather than securities or insurance, CDS (Credit Default Swaps) are very easy to create — deals can be done in a one-minute phone conversation.
The response of Wall Street to the opportunity to make deals that can be quickly struck, require little or no cash investment, involve almost no paperwork, can cover anything, and are not subject to any regulation, was predictable – the volume of CDS exploded to a recent peak of $62 trillion. Compare that to the total corporate debt estimated at $6.2 trillion, or the estimated $10 trillion of asset-backed debt. That’s $50 trillion or so of nothing more than smoke and mirrors.
One of the interesting aspects of CDS is that you don’t have to own, or even have any interest in, an item to buy a CDS against it – anyone can place a bet on whether a loan will fail. Indeed the majority of CDS now consists of bets on other people’s debt. Again from the FORTUNE article:
“It’s sort of like I think you’re a bad driver and you’re going to crash your car,” says Greenberger, formerly of the CFTC. “So I go to an insurance company and get collision insurance on your car because I think it’ll crash and I’ll collect on it.” John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investor’s subprime mortgages bonds would default. So what started out as a vehicle for hedging risk ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world’s largest casino.
A Ponzi Scheme. Gambling Safer.
I hope that you noticed the word ‘gaming’ in the 2000 legislation mentioned several paragraphs back.
It was no accident. But there is a big difference between gambling and trading CDS (Credit Default Swaps). The casinos are regulated and you can be pretty sure that if you win, you will get paid. The CDS market offers no such assurances.
Many of the firms playing in the CDS market are only slightly more solvent than your neighborhood minimart. Wachovia and CitiGroup are in court with a hedge fund located in the Channel Islands over two $10 million credit default swaps that represent over 40% of the fund’s capital. The likely outcome is that the fund will simply declare bankruptcy and Wachovia and CitiGroup will never see a dime of their money.
Just like any other Ponzi scheme, as long as the bubble keeps expanding and nobody looks too closely, you can convince yourself that things are different this time. Many of the loans were made with teaser rates – 0% INTEREST!!! $0 DOWN!!! NO PAYMENTS FOR TWO YEARS!!! — you have seen the ads.
Rising Interest Rates Burst Bubble
Well the two years went by and the fine print kicked in and the interest rates adjusted to market-plus. Suddenly people were unable to make their payments and started defaulting on their loans. Owning mortgage-backed securities was no longer a smart move and the firms originating the loans were no longer able to pass them downstream and they started running out of funds to make new loans and keep the pyramid inflated.
Large firms such as Wachovia with huge portfolios of mortgage-backed securities and who thought that they had protected themselves with CDS discovered otherwise when they tried to unwind their positions. And since the CDS sellers were unregulated, the firms had little recourse for recovering their money. If the mortgages were worthless, then their cost and their ‘insurance’ was just worthless. The value of their assets plummeted and soon were below even the minimal capital requirements imposed by the remaining limited regulations.
Rising Tide Overruns Assets
Large financial institutions such as Wachovia continually borrow the funds they need on a daily basis from other major lenders in the form of short term liabilities. When their creditworthiness deteriorated, they were unable to borrow the money they needed to stay in business. They were bankrupt.
Energy Speculation Rears
But CDS (Credit Default Swaps) are not just about mortgages. As reported by Mother Jones, CDS (Credit Default Swaps) provide an enormous back door into the commodities markets basically permitting speculators making bets in the commodities exchanges to be treated as “commercial interests” and avoid limits normally applied to financial institutions on the size of their bets.
In Senate testimony in May, Michael Masters testified that the speculative demand for Texas oil futures is now five times the actual 2003 baseline stockpile. He attributes this to the jump of index speculation investments from $13 to $250 billion since 2003.
Again as reported by Mother Jones: The 2000 legislation mentioned above also allowed energy futures to escape all federal and state regulation. [And] in a separate bit of absurdity, in January 2006, the Intercontinental Exchange (ICE) of Atlanta, which trades bench mark US oil futures came to be treated by the CFTC as a British market so that US regulators do not even track what is going on.
So the US market for US oil futures traded in the US is not regulated or even monitored by US regulators.
Manipulated Prices?
Now consider the situation: huge firms with no regulation placing tremendous bets on certain outcomes. Is it too much to expect that they will put exceptional effort into seeing that those outcomes come to pass? What drove the cost of crude to $145/bbl had little to do with increased demand from China, hurricanes in the Gulf, or the lack of offshore drilling, but everything to do with the fact that about 70% of the oil futures now traded are purchased by speculators who are not subject to any regulation. And according to Attorney General Michael Mukasey, significant positions are controlled by international organized criminals.
The bottom line is that in order to increase their profits, financial institution found creative ways to skirt existing regulations. A compliant Congress enabled their deception in the name of free markets.
The banks rolled the dice and the taxpayers lost. We need to restore reasonable regulation – but not go overboard as Congress did with overreaching Sarbanes-Oxley laws passed after the last financial crises.
It is noteworthy that the New York State’s insurance commissioner, Eric Dinallo, announced new regulations that would essentially treat sellers of some CDS as insurance entities, thereby forcing them to set aside reserves and otherwise follow state insurance law.
