Two of her recent guests have written articles that have helped elucidate how we got into this economic tragedy. Rachel really likes to push that the reason we ended up in this mess is because of the Gramm-Leac- Bliley Act of 1999, which deregulated the financial industry such that investment banks, commercial banks and insurance companies can all be part of the same company. Thus we ended up with financial giants which CAN NOT be allowed to fail and need to be bailed out by taxpayers.
One the of the guests on Maddow's show, Senator Byron L. Dorgan (D) from North Dakota, wrote an article back in 1994! warning the readers of Washington Monthly about derivatives.
The article called "Very risky business - derivatives" explains that
One form of derivative--the most simple--is a futures contract, which is the traditional device for a company to lock in a price for materials at a future time. Say a company that manufactures film--Company X--needs to buy silver every year and wants to guard against rising silver prices. So in 1994 it enters into a contract with a mining company to pay the going 1994 rate in 1995. This is a risk for X if silver prices tumble, because they will be required to pay the higher price. But if prices rise, X wins because it will be able to buy the silver for less than the 1995 market price. Of course, speculators can buy and sell such commodities contracts with no intention of actually obtaining the commodity, hence gambling on the fluctuation of prices. But this kind of traditional futures trading takes place on organized exchanges that are well-regulated and well-understood.
The troubling derivative deals are much different. They take the basic futures idea a quantum leap further into a netherworld of high finance. Let's take a simple example. Say Company X is under an obligation to sell film in Japan next year. Assume further that the company's analysts believe the value of the yen will fall against the dollar. The analysts would like to protect against the risk that silver and yen prices may fluctuate over the course of the year, thus hedging their original hedge. The company can't go to an exchange in Chicago and get that precise deal, so it gets on the telephone to its bankers and suggests that the bank write a customized contract that is based on the delivery price of silver in yen, not in dollars. This is called an "over-the-counter," or OTC, transaction, since it does not take place on an organized exchange.
The new speculative twist is much, much riskier for both Company X and the bank. It doubles the stakes: now, instead of betting just on the price of silver, it is also wagering on the value of the yen. Why would X do this? Because doubling the bet may hedge their risk in both the silver and yen markets. Why the yen? Because its analysts, in consultation with the bankers, used complex mathematical models and probability charts to decide the yen bet was a good gamble.
If the analysts were right about the yen, of course, it all works out. But if they were wrong about the yen, and wrong about the silver, too, the result would be like having two lead weights slide to one end of a see-saw.
Unlike a traditional future, moreover, these exotic derivatives are almost impossible to sell if one of the two bets goes south. They are especially tailored to X's needs, and are therefore unattractive to other buyers.
And that's a simple example. Currency fluctuations are just the beginning. Interest rate gambles are common, too, and in this volatile year have led to many of the big losses, including the $700 million that Piper Jaffray, the respected Minneapolis firm, lost on behalf of clients that included small city governments and the local symphony association. Piper Jaffray had decided on the basis of obscure mathematical formulas that interest rates would not rise. Unfortunately, the formula didn't anticipate the Federal Reserve Board's rate hikes this year.
More trouble comes from exotic new derivatives called "swaps." Say Company A has borrowed money at a floating interest rate but is worried that rates might rise. It wants to lock in the rates at the lower level. So it calls a derivatives dealer--often a major bank--to find another company, call it B, which is willing to bet that the floating rates will be more favorable than the set rate. A swap results: Company A will pay a fixed rate of interest to Company B, which will pay a floating market rate to Company A. The risk to Company A is that rates will fall but A will be obligated to pay the higher, fixed rate. The risk to Company B is that B will end up paying higher rates than the fixed rate it receives from A. If you had trouble following that, then you are starting to get the idea. And all of this can be done without anyone even knowing, since such transactions can be done "off book"--effectively concealing them from stockholders and employees.
Matt Taibbi from Rolling Stone Magazine, another guest on the Maddow Show wrote "The Big Takeover" very recently :
From which I understand a bit more about "swaps" or "credit default swaps"(CDS) and collateralized debt obligations(CDOs).
He writes:
The mess Cassano created had its roots in an investment boom fueled in part by a relatively new type of financial instrument called a collateralized-debt obligation. A CDO is like a box full of diced-up assets. They can be anything: mortgages, corporate loans, aircraft loans, credit-card loans, even other CDOs. So as X mortgage holder pays his bill, and Y corporate debtor pays his bill, and Z credit-card debtor pays his bill, money flows into the box.
The key idea behind a CDO is that there will always be at least some money in the box, regardless of how dicey the individual assets inside it are. No matter how you look at a single unemployed ex-con trying to pay the note on a six-bedroom house, he looks like a bad investment. But dump his loan in a box with a smorgasbord of auto loans, credit-card debt, corporate bonds and other crap, and you can be reasonably sure that somebody is going to pay up. Say $100 is supposed to come into the box every month. Even in an apocalypse, when $90 in payments might default, you'll still get $10. What the inventors of the CDO did is divide up the box into groups of investors and put that $10 into its own level, or "tranche." They then convinced ratings agencies like Moody's and S&P to give that top tranche the highest AAA rating — meaning it has close to zero credit risk.
Suddenly, thanks to this financial seal of approval, banks had a way to turn their shittiest mortgages and other financial waste into investment-grade paper and sell them to institutional investors like pensions and insurance companies, which were forced by regulators to keep their portfolios as safe as possible. Because CDOs offered higher rates of return than truly safe products like Treasury bills, it was a win-win: Banks made a fortune selling CDOs, and big investors made much more holding them.
The problem was, none of this was based on reality. "The banks knew they were selling crap," says a London-based trader from one of the bailed-out companies. To get AAA ratings, the CDOs relied not on their actual underlying assets but on crazy mathematical formulas that the banks cooked up to make the investments look safer than they really were. "They had some back room somewhere where a bunch of Indian guys who'd been doing nothing but math for God knows how many years would come up with some kind of model saying that this or that combination of debtors would only default once every 10,000 years," says one young trader who sold CDOs for a major investment bank. "It was nuts."
Now that even the crappiest mortgages could be sold to conservative investors, the CDOs spurred a massive explosion of irresponsible and predatory lending. In fact, there was such a crush to underwrite CDOs that it became hard to find enough subprime mortgages — read: enough unemployed meth dealers willing to buy million-dollar homes for no money down — to fill them all. As banks and investors of all kinds took on more and more in CDOs and similar instruments, they needed some way to hedge their massive bets — some kind of insurance policy, in case the housing bubble burst and all that debt went south at the same time. This was particularly true for investment banks, many of which got stuck holding or "warehousing" CDOs when they wrote more than they could sell. And that's were Joe Cassano came in.
Known for his boldness and arrogance, Cassano took over as chief of AIGFP in 2001. He was the favorite of Maurice "Hank" Greenberg, the head of AIG, who admired the younger man's hard-driving ways, even if neither he nor his successors fully understood exactly what it was that Cassano did. According to a source familiar with AIG's internal operations, Cassano basically told senior management, "You know insurance, I know investments, so you do what you do, and I'll do what I do — leave me alone." Given a free hand within the company, Cassano set out from his offices in London to sell a lucrative form of "insurance" to all those investors holding lots of CDOs. His tool of choice was another new financial instrument known as a credit-default swap, or CDS.
The CDS was popularized by J.P. Morgan, in particular by a group of young, creative bankers who would later become known as the "Morgan Mafia," as many of them would go on to assume influential positions in the finance world. In 1994, in between booze and games of tennis at a resort in Boca Raton, Florida, the Morgan gang plotted a way to help boost the bank's returns. One of their goals was to find a way to lend more money, while working around regulations that required them to keep a set amount of cash in reserve to back those loans. What they came up with was an early version of the credit-default swap.
In its simplest form, a CDS is just a bet on an outcome. Say Bank A writes a million-dollar mortgage to the Pope for a town house in the West Village. Bank A wants to hedge its mortgage risk in case the Pope can't make his monthly payments, so it buys CDS protection from Bank B, wherein it agrees to pay Bank B a premium of $1,000 a month for five years. In return, Bank B agrees to pay Bank A the full million-dollar value of the Pope's mortgage if he defaults. In theory, Bank A is covered if the Pope goes on a meth binge and loses his job.
When Morgan presented their plans for credit swaps to regulators in the late Nineties, they argued that if they bought CDS protection for enough of the investments in their portfolio, they had effectively moved the risk off their books. Therefore, they argued, they should be allowed to lend more, without keeping more cash in reserve. A whole host of regulators — from the Federal Reserve to the Office of the Comptroller of the Currency — accepted the argument, and Morgan was allowed to put more money on the street.
What Cassano did was to transform the credit swaps that Morgan popularized into the world's largest bet on the housing boom. In theory, at least, there's nothing wrong with buying a CDS to insure your investments. Investors paid a premium to AIGFP, and in return the company promised to pick up the tab if the mortgage-backed CDOs went bust. But as Cassano went on a selling spree, the deals he made differed from traditional insurance in several significant ways. First, the party selling CDS protection didn't have to post any money upfront. When a $100 corporate bond is sold, for example, someone has to show 100 actual dollars. But when you sell a $100 CDS guarantee, you don't have to show a dime. So Cassano could sell investment banks billions in guarantees without having any single asset to back it up.
Secondly, Cassano was selling so-called "naked" CDS deals. In a "naked" CDS, neither party actually holds the underlying loan. In other words, Bank B not only sells CDS protection to Bank A for its mortgage on the Pope — it turns around and sells protection to Bank C for the very same mortgage. This could go on ad nauseam: You could have Banks D through Z also betting on Bank A's mortgage. Unlike traditional insurance, Cassano was offering investors an opportunity to bet that someone else's house would burn down, or take out a term life policy on the guy with AIDS down the street. It was no different from gambling, the Wall Street version of a bunch of frat brothers betting on Jay Feely to make a field goal. Cassano was taking book for every bank that bet short on the housing market, but he didn't have the cash to pay off if the kick went wide.
In a span of only seven years, Cassano sold some $500 billion worth of CDS protection, with at least $64 billion of that tied to the subprime mortgage market. AIG didn't have even a fraction of that amount of cash on hand to cover its bets, but neither did it expect it would ever need any reserves. So long as defaults on the underlying securities remained a highly unlikely proposition, AIG was essentially collecting huge and steadily climbing premiums by selling insurance for the disaster it thought would never come.
Initially, at least, the revenues were enormous: AIGFP's returns went from $737 million in 1999 to $3.2 billion in 2005. Over the past seven years, the subsidiary's 400 employees were paid a total of $3.5 billion; Cassano himself pocketed at least $280 million in compensation. Everyone made their money — and then it all went to shit.
II. THE REGULATORS
Cassano's outrageous gamble wouldn't have been possible had he not had the good fortune to take over AIGFP just as Sen. Phil Gramm — a grinning, laissez-faire ideologue from Texas — had finished engineering the most dramatic deregulation of the financial industry since Emperor Hien Tsung invented paper money in 806 A.D. For years, Washington had kept a watchful eye on the nation's banks. Ever since the Great Depression, commercial banks — those that kept money on deposit for individuals and businesses — had not been allowed to double as investment banks, which raise money by issuing and selling securities. The Glass-Steagall Act, passed during the Depression, also prevented banks of any kind from getting into the insurance business.
But in the late Nineties, a few years before Cassano took over AIGFP, all that changed. The Democrats, tired of getting slaughtered in the fundraising arena by Republicans, decided to throw off their old reliance on unions and interest groups and become more "business-friendly." Wall Street responded by flooding Washington with money, buying allies in both parties. In the 10-year period beginning in 1998, financial companies spent $1.7 billion on federal campaign contributions and another $3.4 billion on lobbyists. They quickly got what they paid for. In 1999, Gramm co-sponsored a bill that repealed key aspects of the Glass-Steagall Act, smoothing the way for the creation of financial megafirms like Citigroup. The move did away with the built-in protections afforded by smaller banks. In the old days, a local banker knew the people whose loans were on his balance sheet: He wasn't going to give a million-dollar mortgage to a homeless meth addict, since he would have to keep that loan on his books. But a giant merged bank might write that loan and then sell it off to some fool in China, and who cared?
The very next year, Gramm compounded the problem by writing a sweeping new law called the Commodity Futures Modernization Act that made it impossible to regulate credit swaps as either gambling or securities. Commercial banks — which, thanks to Gramm, were now competing directly with investment banks for customers — were driven to buy credit swaps to loosen capital in search of higher yields. "By ruling that credit-default swaps were not gaming and not a security, the way was cleared for the growth of the market," said Eric Dinallo, head of the New York State Insurance Department.
The blanket exemption meant that Joe Cassano could now sell as many CDS contracts as he wanted, building up as huge a position as he wanted, without anyone in government saying a word. "You have to remember, investment banks aren't in the business of making huge directional bets," says the government source involved in the AIG bailout. When investment banks write CDS deals, they hedge them. But insurance companies don't have to hedge. And that's what AIG did. "They just bet massively long on the housing market," says the source. "Billions and billions."
And the article goes on to talk about how this whole thing was not at all regulated and what caused AIG specifically to lose so much money.
Anyway, I guess I am posting this to point out a couple of good sources that explain a little bit about how the economy went under when the housing markets did. Another good source is the EconTalk Podcast with John Cochrane
Although, he does argue for NOT spending our way out of the crisis. I think in the next post I want to discuss what different people think is the best way out.
If you guys have come across any well written articles, please do share with a comment.
