Day 304 – Punters and Touts

Shame on us if we don’t stop the banks from continuing to fleece the country. They will be happy to blame someone else for the problems they created. In fact they’ve already done it. Do Bank of America or Citibank or JP Morgan or Goldman Sachs take any responsibility for the financial crisis? Do they think the Great Recession has anything to do with predatory lending policies and profiteering on unregulated derivatives, or do they want to lay it all at the feet of people who defaulted on their mortgages? 

There is no way that the threat of foreclosures on subprime loans brought the global financial system to its knees. The math doesn’t work. If all the subprime loans that are going to go bad went bad on the same day, the carnage still wouldn’t add up to what we got. What we got was a ridiculous multiple of the actual problem. And the reason we got a ridiculous multiple is the extent to which the banks leveraged their own folly.

The value of all residential mortgages outstanding in mid 2008 was $10.6 trillion. This number includes good mortgages and bad. Of this total 9.2% or just under $1 trillion were either delinquent or in foreclosure in August of 2008, the month before Lehman Brothers collapsed.

Of this amount there was still some residual value in the underlying residential real estate. Average home prices had declined about 20% by that time. If you consider that the homes with delinquent mortgages were probably in worse shape than the average home, the value lost might have been as much as 40%. So the actual losses on mortgages in default in August of 2008 was something like $400 billion. How did this amount devastate the nation’s economy and send our largest banks into a tailspin?

The answer is twofold—leverage and speculation. The five major investment banks (Bear Stearns, Merrill Lynch, Morgan Stanley, JP Morgan, Lehman Bros. and Goldman Sachs) were leveraged between 25- and 32-to-one at the end of 2007. That means for every dollar of assets they had $32 dollars of debt. They were at the limit of their capital requirements, so their leverage played heavily in determining their soundness. Because of the leverage, if a bank had a million dollars of losses in their loan portfolio and took the loss—that is marked their portfolio down to its realizable value—it would have to come up with $25 to $32 million of additional capital. As you can imagine, this is a pretty scary place to be. This is why no one wanted to write their assets down. This is why they invented accounting chicanery and subterfuge to get the bad assets off their books at full value. At this point, not that I would suggest this is what happened, even fraud would have seemed a better alternative to telling the truth. The consequences certainly would have been less onerous—a few hundred million in fines and sanctions against losing the company entirely.

Speculation just made the problem worse. While there were $10 trillion in outstanding U.S. residential mortgages in 2008, there were $47 trillion in nominal value of credit default swaps circulating in the largely unregulated over-the-counter derivatives market. No one really knew how much was outstanding because the market was unregulated. The market was unregulated because Alan Greenspan, Bob Rubin, and Larry Summers decided to keep it unregulated back in the late 90s. Not only that...they saw to it that Brooksley Born, then head of the Commodities Futures Trading Commission, was silenced for daring to suggest that an unregulated market this size might turn out to be a problem.

Today Greenspan at least admits that this was a mistake. Rubin has denied any complicity in the decisions, and in a Herculean revision of history akin to cleaning out the Aegean stables, now claims that he always thought regulation of the derivatives market was a good idea.

Credit default swaps are like insurance contracts put into place to cover the losses should some mortgages stop performing. The derivatives protect the income stream of the investment in the mortgage. If the homeowner defaults, the derivative pays off. The investor, the organization in this case that bought a package of securitized mortgages, is whole. This is the ostensible purpose of CDS, but if this were their real application why in the world would we need $47 trillion of swap contracts to protect us from $400 billion in losses? That is 117.5 times more protection than was needed.

The speculative part of the problem comes in because, in the world of derivative contracts, you don’t have to own a mortgage to insure against mortgages defaulting. These things are traded in banks and brokerage houses, but they would be more at home in betting parlors. They are not investments. They are wagers.

Derivatives are gambling in its purest form. They are perfectly analogous to a pari-mutuel ticket on a horse race. When you bet on a horse race, you do not have a stake in the horse. You have no interest or participation at all in the horse racing industry. Your only interest is in the outcome of the races on which you have bought tickets. Derivatives are the same. You are betting on the outcome of an event. You don’t have to have a stake in the event other than your contract. You don’t care about the owner of the mortgage, or its originator, or the homeowner, or the value of the mortgaged property. You only care if the mortgage stays good or goes bad. One way you win. One way you lose. Whatever else happens is not your concern.

You can buy a contract on anything. This is what our august financial institutions were doing—gambling on outcomes in which they had no stake other than the outcome. Because the market was unregulated and thus hidden from scrutiny, no one had any idea how deeply the problem ran. The banks were betting against their bets against their bets against their bets that mortgages wouldn’t go bad.

Of course the problem was that If a bunch of mortgages went bad, the companies that sold the derivative contracts were going to have to pay off three and four times...or 10...or 117. No one was prepared to do that. No one could. There wasn’t enough real value in the system to allow that to happen. The whole thing was an enormous house of cards that spun off hundreds of millions of dollars of profits over a decade or so, but which was so fragile that it would all come tumbling down in the balmiest zephyr of ill wind. That’s why now we taxpayers are going to have to pay off the losses three times over before we’re out of the woods.

This is crazy. This kind of stuff is no longer about saving the financial system or shoring up the markets against unforeseen volatility. This is about a handful of guys that we trusted because they were supposed to be the smartest guys in the room betraying that trust and using their smarts, their cultural advantages, and their connections, to systematically strip us of the wealth many of us actually worked for…and they’re still at it.

The banks are still lobbying for less regulation, still trying to keep unfettered access to derivative plays, still anxious to package and sell collateralized debt obligations, and still especially vested in remaining too-big-to-fail because that takes all the risk out of the game for them. Staying too-big-to-fail insures that they will be bailed out by the taxpayers whenever their risk models fail. They reap huge profits on inordinate risk, and we back their play. Who wouldn’t want a piece of that action?

For an excellent discussion of the events and failures leading up to the financial crisis you can stream the broadcast of episode 355, titled "The Giant Pool of Money," on This American Life, aired by Public Radio International in May of 2008 in plain English with stunning clarity!