The Financial Crisis in a Nutshell
(updated below with an even better analogy)
For over a month now, the world has watched in horror as a financial crisis of epic proportions has gripped the global economy. During that time, there's been a lot of commentary about the crisis and countless attempts to explain how this all happened. Most of the coverage I've seen has been pretty wildly off the mark. Tonight's 60 Minutes was a rare exception. If you have 12 minutes, and really want to understand how this all happened, watch this segment:
The unraveling of the credit default swap market over the last month has led to a lot of litigation and forced litigators like myself to grapple with some of the complex and ill-advised derivative investments that are at the heart of our current mess. The key point that the 60 Minutes piece makes is that this crisis really isn't about the housing market or the mortgage industry. Yes, we had a major housing bubble and it led financial institutions to make a lot of ill-advised loans. But that alone could have been managed. The real problem are the side bets that were placed on these loans, the derivative transactions that have exponentially magnified the fallout.
The seeds of the economy's destruction were planted when Congress passed an obscure piece of legislation in the waning days of the Clinton administration. The Commodities Futures Modernization Act of 2000 was introduced as an amendment to an omnibus budget bill and passed without debate in both the House and Senate (it was sponsored by McCain adviser Phil Gramm, but, in fairness, it was signed by Bill Clinton and no Democrats raised any objections at the time).
The result was a completely unregulated derivatives market which allowed investors to place unlimited side bets on the performance of various investments. The analogy to sports betting is apt. When you bet on who's going to win the Super Bowl, you're not investing in anything. You're just placing a bet that is tied to an external event. That's what the derivatives market is. And for the financial industry, the bursting of the housing bubble was the equivalent of the Giants beating the Patriots in last year's Super Bowl, an unexpected outcome that caused a lot of people to lose money.
But if it hadn't been the housing market, it would have been something else. The system was deeply flawed. The big financial institutions were placing too many bets; they were writing swap contracts that they didn't have nearly enough capital to honor in the event they all came due.
The saddest part of the whole story, though, is that the event that brought the whole house of cards down really wasn't unexpected; it wasn't the equivalent of the Giants beating the Patriots. That was a genuine upset. Not too many people placed large bets on the Giants winning that game. But lots of people saw the collapse of the housing market coming. There were numerous scholarly papers written on the subject. And there were lots of investors who were willing to bet big on the impending collapse. Those people are all billionaires now. And the companies who took their bets--venerable institutions like Bear Stearns, Lehman Brothers, and AIG--are bankrupt.
It's all pretty unbelievable.
UPDATE: Here's another way of looking at the problem. Credit default swaps are basically insurance contracts. The counterparty (i.e., the insurer) is agreeing to pay you a certain sum if people default on their loans. For those who were heavily invested in mortgage-backed securities, credit default swaps were a useful way of hedging their bets, of insuring against catastrophic loss. But because the derivatives market was unregulated, there was no requirement that you actually use such swaps as insurance, i.e., that you actually hold the loans that are the subject of the swap.
Imagine, for instance, if you could take out a home owner's insurance policy on someone else's home. If you were allowed to do that, you wouldn't be "insuring" anything; you'd just be betting on something bad happening to someone else. That's essentially what happened here. Not only were loan holders buying credit default swap contracts, but so were a bunch of other people, mainly big hedge funds that were betting on a wave of defaults. They saw the housing collapse coming and started buying swap policies like mad.
To put this in perspective, imagine if--pre-Katrina--you were able to buy insurance policies on property in New Orleans that you didn't actually own. Most experts knew that it was just a matter of time before a hurricane leveled that city. Speculators could have made a fortune betting on the destruction of other people's property. Now imagine further that these vicarious insurance policies were completely unregulated so that the companies underwriting them didn't have to comply with basic capital requirements and other practices that insurers typically follow.
That's pretty much what happened on a very large scale.
For over a month now, the world has watched in horror as a financial crisis of epic proportions has gripped the global economy. During that time, there's been a lot of commentary about the crisis and countless attempts to explain how this all happened. Most of the coverage I've seen has been pretty wildly off the mark. Tonight's 60 Minutes was a rare exception. If you have 12 minutes, and really want to understand how this all happened, watch this segment:
The unraveling of the credit default swap market over the last month has led to a lot of litigation and forced litigators like myself to grapple with some of the complex and ill-advised derivative investments that are at the heart of our current mess. The key point that the 60 Minutes piece makes is that this crisis really isn't about the housing market or the mortgage industry. Yes, we had a major housing bubble and it led financial institutions to make a lot of ill-advised loans. But that alone could have been managed. The real problem are the side bets that were placed on these loans, the derivative transactions that have exponentially magnified the fallout.
The seeds of the economy's destruction were planted when Congress passed an obscure piece of legislation in the waning days of the Clinton administration. The Commodities Futures Modernization Act of 2000 was introduced as an amendment to an omnibus budget bill and passed without debate in both the House and Senate (it was sponsored by McCain adviser Phil Gramm, but, in fairness, it was signed by Bill Clinton and no Democrats raised any objections at the time).
The result was a completely unregulated derivatives market which allowed investors to place unlimited side bets on the performance of various investments. The analogy to sports betting is apt. When you bet on who's going to win the Super Bowl, you're not investing in anything. You're just placing a bet that is tied to an external event. That's what the derivatives market is. And for the financial industry, the bursting of the housing bubble was the equivalent of the Giants beating the Patriots in last year's Super Bowl, an unexpected outcome that caused a lot of people to lose money.
But if it hadn't been the housing market, it would have been something else. The system was deeply flawed. The big financial institutions were placing too many bets; they were writing swap contracts that they didn't have nearly enough capital to honor in the event they all came due.
The saddest part of the whole story, though, is that the event that brought the whole house of cards down really wasn't unexpected; it wasn't the equivalent of the Giants beating the Patriots. That was a genuine upset. Not too many people placed large bets on the Giants winning that game. But lots of people saw the collapse of the housing market coming. There were numerous scholarly papers written on the subject. And there were lots of investors who were willing to bet big on the impending collapse. Those people are all billionaires now. And the companies who took their bets--venerable institutions like Bear Stearns, Lehman Brothers, and AIG--are bankrupt.
It's all pretty unbelievable.
UPDATE: Here's another way of looking at the problem. Credit default swaps are basically insurance contracts. The counterparty (i.e., the insurer) is agreeing to pay you a certain sum if people default on their loans. For those who were heavily invested in mortgage-backed securities, credit default swaps were a useful way of hedging their bets, of insuring against catastrophic loss. But because the derivatives market was unregulated, there was no requirement that you actually use such swaps as insurance, i.e., that you actually hold the loans that are the subject of the swap.
Imagine, for instance, if you could take out a home owner's insurance policy on someone else's home. If you were allowed to do that, you wouldn't be "insuring" anything; you'd just be betting on something bad happening to someone else. That's essentially what happened here. Not only were loan holders buying credit default swap contracts, but so were a bunch of other people, mainly big hedge funds that were betting on a wave of defaults. They saw the housing collapse coming and started buying swap policies like mad.
To put this in perspective, imagine if--pre-Katrina--you were able to buy insurance policies on property in New Orleans that you didn't actually own. Most experts knew that it was just a matter of time before a hurricane leveled that city. Speculators could have made a fortune betting on the destruction of other people's property. Now imagine further that these vicarious insurance policies were completely unregulated so that the companies underwriting them didn't have to comply with basic capital requirements and other practices that insurers typically follow.
That's pretty much what happened on a very large scale.
posted by A.L. at 10:11 PM
8 Comments:
Hello A.L.,
So, why should all of humanity be forced to suffer and struggle any longer, now that the entire global financial system has been exposed as a mind-boggling deception, within many other deceptions? No one in their right mind would continue to be enslaved by a proven deception, which is also proven to be undeniable slavery-by-proxy !!!
The derivatives scams alone have grown to more than 10-times the entire global GDP (at last counting) and are now failing because the scam/pyramid scheme broke and exposed the deception for all to see. A significant portion of global wealth and power was created and propped-up using these and other now-proven smoke and mirrors and house of cards illusions and delusions.
These deceptions have grown many times larger than the rest of the entire world economy. Consequently, there is no way that all of the world's governments combined, who themselves borrow so-called "money" from other central-bank smoke and mirror deceptions, can solve this debacle, by using more smoke and mirrors money scams. The only solutions they are offering will take centuries to repay, if ever.
Here is Wisdom...
I listened to the whole thing and found it interesting. However, I believe many have fallen into a trap of trying to find a "root cause" when in fact there are many causes to the financial meltdown. I can see that this buying and selling of derivatives without regulations was a problem, but not the problem. The problems with how Fannie and Freddie were being regulated (through HUD, instead of through the Treasury Department; the two departments support goals that are mutually exclusive) should have been included. And what about those regulations and laws that didn't catch this problem? Sarbanes-Oxley (SOX) was meant to rein in overreaching corporations yet did nothing in this case.
Also not included in this report is how business goes through regular cycles and ends up in downturns every so often. It happens. No amount of regulation or deregulation is going to change that.
Anyway, that's my two cents on it.
Steveil,
The magnitude of the housing shortfall is in the 10's of billions of dollars. The CDS pyramid contains losses that can only be estimated, since nobody really knows how much was floating, but it's been estimated in the trillions, as high as 100 times the housing losses.
Does the sliver in your finger hurt when you have third-degree burns over forty percent of your body? (The analogy is rough unless we posit that, in reacting to getting the sliver, you knocked over the stove and caused the fire that burned you.)
My understanding of Sarbanes-Oxley is from the standpoint of what we needed to do to comply from the corporate aspect, but it's a reporting requirement, not an honesty requirement. (So far as I know, no law on the books compels honesty -- that would seem to violate the 5th Amendment.)
The magnitude of the housing shortfall is in the 10's of billions of dollars.
It would seem to me to be at least in the hundreds of billions since that is what the government said it would need for the current situation, and possibly in the trillions.
Look, all I said is that there are several things going on here, not just one. I also did not disagree that this issue with derivatives wasn't a problem, but only part of the problem (an obviously very big problem, that looks to get even bigger). I don't believe it is just one thing, but a series of things.
My understanding of Sarbanes-Oxley is from the standpoint of what we needed to do to comply from the corporate aspect, but it's a reporting requirement, not an honesty requirement.
SOX requires the appropriate executives (CEOs, CFOs, other CxOs) to sign their names on financial documents to indicate they are valid. If the CxOs of the companies that fell apart are signing their names on to crap, then they are in violation of the law, or complicit with those violating the law. This has nothing to do with the 5th Amendment.
Steveil,
On the outside chance that your problem is ignorance, I'm going try once more. Since the problem Paulson is trying to fix is the lack of liquidity in the financial system, which is a result of "mortgage backed securities" (which, if you watched 60 Minutes or read a real analysis, was only triggered by the housing value collapse, not "caused by it") -- the money required is far greater. They could buy all the houses and give them to the people with failing mortgages and it wouldn't cure the problem.
Since the Sarbanes-Oxley requirement is signing financial statements -- not guaranteeing everything in them is true, but only that they believe them to be true -- all it does is create a circumstance where executives are possibly subject to suits by shareholders. See Citigroup. The executives can simply claim that "that's what the auditors told me" and, if they can demonstrate that, they'll be off the hook. The shareholders can then go after the auditors, and I wish them luck.
They'll see little or none of the losses recovered. The people that made billions off the pyramid scheme are those that got out before it crashed, same as any Ponzi game.
Now, if your ignorance is feigned, or if you are incapable of understanding -- hey, it wouldn't surprise me either way.
c2h50h,
I tried to keep with the non-partisan spirit of the post, but you simply don't want to. Since you can't have a civil discussion with anyone without resorting to name-calling, and considering how much you know about SOX (which is nothing), I will consider this discussion closed.
Dear Anonymous Liberal:
This is a great explanation of the credit crisis. Succinct and full of excellent analogies. I will have to remember all these things on Thanksgiving, when I will sit down, a tall glass of whiskey in hand, to harangue my Republican in-laws about their misplaced confidence in McCain/Palin and in the ability of the market, i.e., the greed heads who run Wall Street, to regulate itself. Oh, how I look forward to all the gloating I will be doing on Thanksgiving. I've been waiting eight long years for this day.
Dear Anonymous Liberal:
This is a great explanation of the credit crisis. Succinct and full of excellent analogies. I will have to remember all these things on Thanksgiving, when I will sit down, a tall glass of whiskey in hand, to harangue my Republican in-laws about their misplaced confidence in McCain/Palin and in the ability of the market, i.e., the greed heads who run Wall Street, to regulate itself. Oh, how I look forward to all the gloating I will be doing on Thanksgiving. I've been waiting eight long years for this day.
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