The US Treasury, through the leadership of Henry Paulson, has been pouring hundreds of billions of dollars into the US mortgage markets for well over a year now. And that hasn't solved any of our problems. As a matter of fact, the problems are getting worse. We are on the verge of a complete financial meltdown across the world. The United States is not the only country in dire straits. Many of the European markets are also struggling. They too have been pouring billions of dollars into their financial markets to shore up their declining balance sheet positions.
What happened? It all started with the Community Reinvestment Act passed by Congress to provide easy credit to the marketplace in a provision designed to provide mortgages to lower-income families with low credit scores. These low-cost-of-entry loans referred to as subprime mortgages were loaded up with features that made them irresistible to many un-savvy first-time home buyers: little down-payment requirements, lower upfront interest rates, and even financial incentives to people who were willing to sign on the dotted line for a mortgage they truly could not afford. In addition, those signing up for the loans were told that the risks were minimal, as housing prices were strong and if they ran into difficulty, they could always sell their homes. These loans were doomed to failure.
So how did these loans get sold to the secondary market if the consumers behind them had poor or low credit scores and the loans were doomed to failure? Wall Street and other firms would peddle these loans by pooling similar mortgages into one larger financial security called mortgage-backed securities. These securities were rated by bond rating agencies (Moody's and Standard & Poor’s) and these ratings established the effective interest rates used to price the securities. In an effort to improve the credit worthiness of the mortgage backed securities, insurance policies called credit default swaps were used to reduce the underlying security's risk (the subprime mortgage risk). These credit default swaps (CDS) are unregulated derivative securities that work a lot like insurance policies on a house. The CDS instrument allows the holder of the policy to collect the face value of the mortgage-backed security if the underlying entity holding the original mortgages goes into default. This type of protection significantly reduces the risk of the default to the holders of the swap. The ability of banks and Wall Street to sell these securities at inflated credit ratings allowed them to set into motion the current devastation we now are witnessing on the financial markets around the world. Mortgage-backed securities became the latest and greatest tool used by the banks and by Wall Street to generate massive profits.
These securities in many cases ended up in 401(k)s and other mutual funds and investors were told that these "investment grade securities" were a good bet in an over-heated real estate market. Unfortunately, the investors buying these securities weren't told that they should also purchase an insurance policy against default: the credit default swap. So what about those savvy enough to purchase the insurance? Now that a vast majority of these loans are in default, those holding the credit default swaps are swarming. In addition, credit default swaps, operating outside of the regulatory arm, were sold to speculators betting against the market that the mortgage-backed securities would go into default. At one point it was estimated that there were 100 insurance policies for every mortgage-backed security. To more fully develop what’s going on here, I need to talk in more detail about credit default swaps.
Like I said, these instruments are like insurance policies. Those holding them are protected when the value of the underlying security goes down. When you own the underlying security, in this case the mortgage-backed security, the credit default swap provides protection against default. On the one hand, when you hold the underlying securities with the credit default swap, your position in the security is said to be risk neutral. On the other hand, when you hold just the credit default swaps without the underlying asset, your position in the security is exposed. This is called a "naked" position, and it is not risk neutral. You are betting that the market is going to go down on the underlying security (the mortgages) and you stand to gain a substantial amount of money if this happens. This is like buying insurance on your neighbor's house. You don’t own the house, but if it burns down you collect the insurance. If you're unethical, you don't really care if the house burns down.
This market has grown significantly as the value of mortgage backed securities has dropped like a rock. The house of cards is falling, and those that bet against it are holding out their hand. Those able to enter these positions have pushed the market for mortgage-backed securities into a death spiral because so many people were betting against it and the cost of the insurance (the swap) ramped up over night. The number of credit default swaps has grown tremendously and has been estimated at 100 contracts for every house involved. If the average mortgage is $100,000, credit default swaps exist to the tune of $10,000,000 (yes, $10 million), betting on its default. It is extremely expensive to buy swaps now, as the value of the underlying security, the mortgage-backed security, has been destroyed. No one wants the mortgage-backed securities; no one is buying them.
That is why the credit markets are frozen. No one wants to extend any more debt. We are done. We are all borrowed up. This is the making of the most giant Ponzi (pyramid) scheme ever! And our government wants us, the taxpayer, to buy these securities. I don't know about you, but I don't want them. Paulson himself admitted that it would take fifteen-twenty years, if we were lucky, for these securities to increase in value. He has obligated a generation of taxpayers to pay for the reckless greed of Wall Street and the corruption of paid-off government officials willing to turn the other cheek. What's our exposure in the credit default market? How about a whopping $54.6 trillion! The International Swaps and Derivatives Association posted this information on their web site on September 24, 2008: "According to the Survey, notional amount outstanding of credit derivatives decreased by 12 percent in the first six months of the year to $54.6 trillion from $62.2 trillion, but the annual growth for credit derivatives was 20 percent from $45.5 trillion at mid-year 2007. For the purposes of the Survey, credit derivatives comprise credit default swaps referencing single names, indexes, baskets, and portfolios." (Retrieved from http://www.isda.org on October 3, 2008).
In many cases, if the underlying "referenced" entity goes into default, the holders of the credit default swaps will be able to exercise their swaps and force the entity on the other side of the position to pay up. On September 8, 2008 Biggadike and Harrington write that: "Investors may be forced to settle contracts protecting more than $1.4 trillion of Fannie Mae and Freddie Mac bonds against default after the US seized control of the companies in the bid to bolster the housing market. Thirteen 'major' dealers of credit default swaps agreed 'unanimously' that the rescue constitutes a credit event triggering payment or delivery of the companies' bonds."
Here's where we run into a major problem, and this problem is far more dangerous to our financial security than the subprime mortgage mess. The credit default swaps, unlike the insurance industry or even the derivatives industry, is unregulated, meaning that there are no legal requirements for those writing these policies to maintain reserves or funds to cover their exposure on these swaps when the market goes south. Who's holding the "writer's" side of these exposed positions? AIG was... Bears Sterns was... Lehman Brothers was... and we all know what's happened to them. And the truth is that your tax dollars have been spent to bail out these firms for entering these positions, these naked positions without having the reserves to back them up. This is pure speculation, people. We are bailing out poor judgment and highly risky behavior that we would never engage in ourselves. It is high stakes gambling. Paulson is pouring our money down this hole to hold up the banking industry. It is about to collapse.
The truth is, I don't know exactly who is on the various sides of the swap positions or whether or not the firms that have them are naked or covered. However, I'm not willing to make any bets on our commercial banks either. According to an article on Time.com, Janet Morrisey says, "Commercial banks are among the most active in this market, with the top 25 banks holding more than $13 trillion in credit default swaps--where they acted as either the insured or insurer--at the end of the third quarter of 2007. According to the Comptroller of the Currency, a federal banking regulator, JP Morgan Chase, Citibank, Bank of American, and Wachovia were ranked among the top four most active." (Retrieved on 10/3/08.)
So what do you do? One real test will be to see how the $700 billion affects the liquidity of the market. Money should begin to flow once the mortgage-backed securities are purchased.Will it be enough? Time will tell. And although the $700 billion will stabilize the market to some degree, it doesn't change the fact that we now own billions of dollars of worthless mortgage-backed securities. My advice to you is to stabilize your investments until you know what will happen to the market. We should know what direction the markets are headed in the next couple of months. Stay in safe FDIC-insured accounts. Is there a chance that we're going to come out of this mess? Yes, there is a chance, and in time we will recover. But it is going to be long, hard, deep and slow. Trust me, you'll have plenty of time to get back in at a low point before things begin to recover. We are in for a long rough ride.
Do I think the bailout is the right thing to do? I think we need to move slowly and I think we need someone else in charge of making the decisions. Paulson has a serious conflict of interest. He was the CEO of Goldman Sachs, and you don’t see them struggling. Buffet invested in Goldman too. Paulson is going to pick and choose the worst of the mortgage-backed securities that are out in the open market, since these are the ones putting the clog in the drain. There are other ways to accomplish this goal and to get liquidity to the market. We need someone who has no vested interest. We need a team of experts to figure this out to save our markets. We do not need a Wall Street bailout.
It’s important that the American people get an answer to this mess. We need to know the whole picture and the magnitude of the damage to the market. We need hearings and accountability. We need strong principled regulation to stop this madness. We need leadership, not a knee-jerk reaction to pour more of our hard earned money down this hole. Start calling your senators, your House representative. Now is the time to speak up before we have no options at all.
Morristown, New York
Oct 4 2008 - 7:18am