Wednesday, October 15, 2008

Doing the Swap

The emerging Republican talking point on the financial crisis is that it was primarily caused by bad loans being given to poorer people (at the instigation of ACORN) and then those loans were badly managed by Fannie-Mae and Freddy-Mac so that their stink factor was obscured from viewing by the rest of the financial industry. Then, when the housing bubble popped, all those loans came due and the poor bankers got flushed down the toilet.

While its true that the junk mortgages were the proximate needle that broke this camel's back, they are a woefully incomplete explanation of what happened. Where it is incomplete is very telling. The one piece that is missing is the Credit Default Swap.

Now, I don't pretend to really understand the nature of these complex financial instruments (aside: for an amusing exchange on this see John Cole), but what limited knowledge I have of them is that they were essentially an unregulated form of insurance. The bankers spreading these bad mortgages around weren't entirely stupid. They knew these things gave off a bad odor. So much so that many of them weren't willing to buy into the housing market frenzy. So other bankers decided to sweeten the pot by essentially assuring other bankers that they needn't be afraid that the mortgage market would go bust (that there would be a "credit default") because all they would have to do was to buy a Credit Default Swap (a way of swapping the risk) that would essentially guarantee them some return on their investment, even if the original investment went down the toilet.

Fears calmed, investors went out and starting buying, slicing, dicing, mixing, matching and then reselling those bad mortgages. All with the reassurance that they didn't have to care about the odor coming off them because, "Hey! I'll still make money even if they go bad! Just not as much."

The problem, of course, was that these swaps would only work so long as only a small number of people ever claimed them. It was when the mortgage market as a whole crapped out that there was, in essence, a run on the swaps. And suddenly all the banks and insurance companies (such as AIG) that were backing them didn't have the money to meet the demand.

And that's where the whole system collapsed.

It is said that the credit market is frozen, in part, because of a lack of trust. The Credit Default Swaps appear to be the reason for that lack of trust. And who can blame them?

Here's the point that I don't think is being emphasized enough: The swaps are the main reason we are in this mess. With these vapor promises in hand, bankers went out and accelerated the slicing and dicing of the crap mortgages. In other words, if the financial industry hadn't created these swaps, fewer people would have risked their money on the crap and we would never have gotten where we are today.

I've heard estimates that the size of the CDS sludgepile is on the order of $70 TRILLION dollars. That is several times the size of the entire U.S. economy! And we have the wizards who created the swaps to thank for it.

Don't let them distract you with the bad behavior in the mortgage market. Don't let them blame this on ACORN. Know where the real blame lies and watch your wallet.


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