60 Minutes and 60 Trillion Dollars of Credit Swaps

You are right. My measured, balanced and fact based approach won't do, the world will clearly not be safe from CDS and the strangelets and mini black holes they will produce unless we gather the torches and chase the scary monsters into the sea.

If you have to get rid of the bathwater, hey, sometimes a baby must be sacrificed. If anyone disagrees, then we will mouth off about how they just do not understand how much bathwater there is. Sure, they may have posted long (LOOOONG) posts suggesting that they are somehwat familiar with the baby and bathwater in question, byt screw 'em and ready your pitch forks.

It does seem odd that the people most afraid of CDSs tend to be the journalists (many of whom became journalists because they were bad at math and not smart enough for law school), not, oh say, the academic economists who would understand them better and yet not have a stake in them the way professional finance types might. But hey, if Newsweek says swaps are bad, that's enough, right?

Up next, LIBOR, tool of the Devil.

 

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To Pandaemoni:

You know more than I do in this area but I would like your comments on post 17. Also, as I understand it, there would have been no need for the tax payers to assist AIG if everyone were certain that ALL mortgages in all of the various derivative packages were 100% guaranteed to be fully paid by the US government.

Is that correct? I.e. was the $85 billion +37.5 more today a needless waste if my recovery plan instead of modified Paulson plan was adopted? In the three days I was banned, I sent it to McCain, Obama, about 25 congressmen, posted it several times in on-line comments sections at Forbes, The Economist and five other forums, more concerned with economics and politics. Last night in the debate John McCain adopted the first part of it. (I understand why not the second essential part that calls for punishing the guilty.) Do you think my plan would be better and cheaper than the $700 dollar plan adopted?
Here it is in its most recent edition:

Paulson’s plan will fail because it treats only a symptom and not the cause of America’s financial illness, which is: Too many were persuaded to buy more house than they could afford by irresponsible, greedy writers of innovative new mortgage types. Everyone was operating on the “greater fool” theory and assuming the un-payable mortgage would clear later when the house was resold.
These un-payable mortgages were a criminal Ponzi scheme, designed to collect large bonuses.
Prosecute the writers, do not reward them. Prevent reoccurrence, do not make it certain.

A real cure must:
(1) Restore liquidity to financial system. (By insuring all mortgages will be paid.)
(2) Get Joe American into housing he can afford.
(3) Transfer real assets, not toxic trash, to Uncle Sam.
(4) Do not significantly increase US’s already excessive debt.
(5) Prevent repetition of the problem.

All five are simultaneously possible at less cost to Uncle Sam than Paulson’s plan as follows:
SUMMARY:
U.S.'s money automatically buys houses (fully or with mortgage holder keeping part) at foreclosure auctions if highest bid is less than the mortgage debt, not toxic trash from banks. The banks are helped as they know the foreclosure sales will cover the mortgage so this is an anti-dote to the toxic poison they now hold. I.e. from POV of the banks, not one piece of this paper is worth less than full expected value. Everyone knows this so, it becomes a marketable security. If the bank needs more liquidity, they can sell it and make new loans. Goal (1) accomplished.

The ex CEO of Goldman Sack’s plan helps GS and others holding toxic loans by transfer of them to Uncle Sam. Paulson's plan also does not prevent the banks who receive cash for their toxic trash from investing it in China for higher yields than available in the US's weaker economy or from buying banks and resort developments in Dubai, etc. It just sticks Joe American with the toxin but is no anti-dote for the poison.

Here is the anti-dote:

The government buys at least partial but usually full ownership of EVERY foreclosed house, if it would otherwise sell for less than the mortgage. (Bank or mortgage holder is allowed to buy part, if they desire.) Joe may remain in the house for up to one year with deferred interest bearing rent. During that year, Joe must find a home (house, apartment or trailer) he can afford, at least to rent. Then, when opportunity exists to recover the price paid, Uncle Sam sells his ownership share of house, which may be more than the price paid as this plan is taking houses off the market. - Keeping price of houses from falling every month as they are now, and will continue to fall under Paulson's plan, which only aids the banks, not the real-estate industry or evicted Joe. When Joe gets out from under some of his debt, he begins to pay his deferred months (<13) of rent and interest, over 5 years if need be.
Goals (1, 2, & 3) accomplished.

Goal 4: Instead of an immediate $700 billion increase in US’s debt ceiling, when a buyer or the mortgage holder retains an interest in the property, banks send bills to Uncle Sam for ONLY the DIFFERENCE between the unpaid mortgage amount and the price some buyer paid or bid at public foreclosure auctions as they occur, if sales price was less than the mortgage still due. Uncle Sam then receives that fraction of the house’s title in exchange for paying this difference. Individual auction sales are semi-automatic with bank processing all transactions details but periodically inspected. I.e. US can be a “silent partner” (minority owner or land-lord renting*) for a few years, but investors may buy the US’s share of title anytime provided US profit equals what US would have received in interest by investing in 10 year Treasury bond, as well as full repayment of the “difference funds” provided initially.

As individual auctions are expensive, many “under water” owners may avoid foreclosure auctions and simply transfer the entire title and mortgage debt to US (FHA?) for later sale** in collective auctions. By avoiding auction expenses, Joe homeowner hopes to get small check later, if the house sells for more than the mortgage debt. If house is re-possessed by the bank and not sold at auction, the bank may also transfer title 100% to US and receive the unpaid mortgage due. In any case, bank receives full repayment of the mortgage due. Probably, more than 90% of all foreclosures can be avoided. I.e. “Under-water Joe” homeowner can “walk away” with no risk that he will still owe the bank. In a foreclosure he runs that risk if the highest bid price at the foreclosure auction is less than the mortgage balance.
Goals (1) & (4) accomplished.

Goal 5 may require new legislation and/or adequate enforcement of existing laws; however, criminal miss-representation by greedy creators of these inventive new mortgage types should not go unpunished. Bonuses they received for writing and selling these trouble making mortgages should be return 100% with interest to their firms (golden parachutes of their now retired CEOs included). If they cannot afford to do so, some of their assets should be ceased. They also may transfer titles to US (FHA?) to avoid extra cost, criminal prosecution and probable*** jail time. It is a well accepted principle of law that criminals are not allowed to keep the loot they took. Ponzi schemes are illegal and these greedy CEOs should have known that was what they were doing. Do not let them now pass their toxic trash to Joe.

-------------------------
*If Uncle Sam receives a fraction of the title of house sold at auction, and it is rented by buyer, Uncle Sam receives that fraction of the rent and pays none of the maintenance expenses. If Uncle Sam has full title, the property is managed by a professional rent management firms, working for a fixed fraction of the rent, after Joe homeowner has moved to housing he can afford.

** Joe American remaining in “his house” after US (FHA?) holds the entire title via "rent to buy" instead of sale is best option, if Joe can afford it. Many who cannot pay their old mortgage will be able to, especially if they still have any equity in the house. Effectively, the US (FHA?) grants Joe a new mortgage with principle equal only to the old unpaid balance and longer amortization period.

“Better” socially and economically because Joe as renter will not damage “his house.” - That is hard to control. - It is very tempting (to a transitory renter) to sell the dishwasher etc. during the last month of the rental contract, if he is planning to move to another house. That renter can always claim it was broken and did not bother to tell Uncle Sam. - "I just discarded it as the repair man said it was not worth fixing." etc.

Second reason "rent-to-buy" is better is it eliminates the sales commission the real estate agents would take and other title transfer expenses. (Uncle Sam often gets the title directly from Joe without auction expenses. - No one can claim US does not own the house, even if not recorded at the local court house etc. but it should be. The county can contribute by making no charge to US for recording in land records as this plan helps hold up their assessment based taxes on the house.)

***Joe American is likely to be part of the jury.

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The typical Ponzi con-man's pitch was:

"You do not need any money down. We will not check your stated income. Do not worry that the rate can re-set. - It probably won't and even if it does that is three years from now and you can always make a profit by selling. ("to a greater fool" was never said.) Come on Joe, time is money; just sign on the dotted line. Trust me. You won't regret it. Act now while you can. These mortgage will not be available soon."

 

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I appreciate your sense on humor.
However, I've just looked what is happening:

Central banks are reducing rates, adopting huge bailouts - and nobody pays attention, simply sells, sells, sells...

Why? Because there is feeling that the system is broken, and it will swallow everything that is beeing thrown at it.

And funny thing, it is correct feeling

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But no, no, we will not correct the system - especially because it lets us to make money by swindling taxpaiers !!!!

eS

 

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Debt is ALL that america knows. I'm not sure if america knows how to make REAL money... LOL!!!

 

Why then the same crap is happening all over the world?

 

because they sold it all over the world

 

There are a few (mostly small, but see "Second" below) issues.

First, AIG's CDSs typically cover principal only. You'd need to check the mortgages and the note indentures on the deals AIG insures to see whether the government could guarantee *just* the principal payments on the mortgages, or if it would need to guaranty principal, interest and fees in order to prevent the noteholders from exercising against AIG under the CDSs. It's not unusual to state expressly that the first dollars in the door are treated as principal in those documents, but that's not universal. If they were all principal first, then the government could back the principal payments of the mortgage holders and not the interest. If they have to cover interest and fees, the price tag would be somewhat higher than the nominal amounts of the AIG contracts.

Second, the big issue, the aggregate principal amount of the "pool" of mortgage loans securing the payment of the notes will be *much* larger than the principal insured on the notes. There are two reasons for this. Reason 1, the notes that typically are insured under CDSs tended to be the highly rated "tranches." A typical CDO would have "A Notes", "B Notes", "C Notes" etc., the A Notes might be covered by a CDS, have the highest rating, but would receive the lowest interest rate. As you move down the chain, the interest rates get higher, but so do the default risks. The mortgage pool has to be big enough that (at the time the transaction is entered into) even the C, D and lowly E noteholders believe they will get paid back. In a deal where $100 million in A-Notes are issued (backed by a CDS) there might be $500 million in B-, C- and other Notes also issued, and the mortgage pool (which secures all of those notes, collectively) might have an aggregate principal amount of $800 million.

Why is the mortgage pool ($800 million) larger than the amount payable on the notes ($600 million total)? That's Reason 2, many of those mortgages *will* default. Even if we were in great economic times, many of those mortgages would have defaulted. A default under a mortgage is not enough to trigger payments under a CDS, because the notes being insured assume a certain default rate. In a sense, even if the CDS insured every note in the deal, guaranteeing every mortgage in a pool would be overkill, because no one ever expected that every mortgage would pay off in the first place. So there is something to be said for attacking the problem at the level of the indentures, rather than the mortgages (guaranteeing principal payments due to the holders of the A-Notes); that said, by giving AIG the money needed to cover its CDS positions, that is pretty much the same thing.

Third, post-downgrade, in order to stabilize AIG you need to guarantee the mortgages *and* give them enough cash that they can meet their collateral posting requirements. Certain of their swaps state that if their rating goes below "A" they need to put up cash collateral to back up their position. Failing to do that would be an AIG default under the swaps, and would trigger cross-defaults in any agreement AIG had that had a cross-default clause.

Fourth, but relatedly, the downgrade hurt AIG in other ways as well. For example, AIG also serves as "defeasor" (or "payment undertaker") in a variety of different kinds of transactions (completely un-swap related) and the downgrade required that they post cash collateral to cover those positions as well.

 

Dept is all that the world knows, all money IS dept.

And I for one do not like that.


Billy T, I'm a huge fan of yours, but it appears that the people in charge are utterly ignorant or bribed/in on it, that is probably one of the reason why your solution, posted in another thread, is not the solution they choose to us.

 

Thanks for the reply, but I did not understand it all, so I explain what I do understand. Perhaps you can help me by telling where my errors are?

I understand how government creation of 100 dollars credit in bank A that lends $90 out which gets deposited in bank B who lends 81 out ext, gets to be same as ~1000 new money in circulation; but do not understand the CDS or "tranches," except that the contain a mix of mortgages, some with low risk (and lower yield if paid) and some the converse. I also have the impression that AIG was acting as an insurance firm (but unlike a rose by another name, calling the insurance a "swap" made the insurance legally different - right there I would start throwing someone in jail for fraud.)

In My Simple Understanding, IMSU, if the thing (default in this case) insured against cannot happen (because government will pay defaulting mortgages and take title to the mortgaged house) then IMSU there insurance company cannot lose anything. Except for the cost it incurred in writing the policies, all money collected should be transferred to the agency making their no possibility of any claim against the insurance company. I.e. the government in this case could take the obligation to pay when default occurs and the fund AIG collected in excess of their “writing costs.” If this put AIG out of business –so what – I am not trying to save AIG or Goldman Sacks, etc. I just want that everyone knows the mortgage will ALL be paid. So any package of them, regardless of how “sliced and diced” ("tranches") will be worth the sum of it real inherent value, call that “V.” Now if Mr. “A” of firm “a” misrepresented "tranches 1" to Mr “B” of firm “b” as having value 2V instead of the true inherent value V, lets send Mr. A to jail, fine his firm 3V, give to Mr. B his 2V back. As firm “a” collected 2V form Mr. B, it is being in effect fined only V (the amount of the fraud). IMSU this is all fair and necessary to prevent repetition. Paulson’s plan only encourages repetition by rewarding Mr. A for what is basically fraud, IMSU.

If everyone knows with 100% certainty that no mortgage will not be paid, does than not make the trances, at least all which were not marketed above their inherent value V, very liquid assets? If at the end of a long fraudulent chain you paid 16 V for something inherently worth only V, you were either a fool or the victim of fraud. Fools are supposed to be separated from their money – sort of capitalism’s contribution to Social Darwinism. (We need intelligent people and firms in charge of the system.) If however, you (or your firm) were the victim of fraud, most if not all of your money should be restored to you as it was for “Mr. B” in my above example and the maker of the fraud, “Mr. A” in above example should be punished in proportion to the magnitude of his fraud, IMSU.

Now I admit I do not understand (I think they set it up very complex to insure that) all the details, but I understand fraud when I see it. This is just the world’s largest Ponzi scheme ever. No different from tell a potential buyer of a tulip bulb:
“Sure 100 Guilder is expensive fro one tulip bulb, but next month you will able to sell it for 200 Guilder."
Or from telling Joe American:
"You do not need any money down. We will not check your stated income. Do not worry that the rate can re-set. - It probably won't and even if it does that is three years from now and you can always make a profit by selling. ("to a greater fool" was never said.) Come on Joe, time is money; just sign on the dotted line. Trust me. You won't regret it. Act now while you can. These mortgage will not be available soon."

ALL “SELL TO A GREATER FOOL” SCHEMES ARE FRAUD, if the seller knows that buyer cannot afford the purchase and depends upon selling to the next greater fool. This is very different from say buying and selling stock (assuming the company actually exists). Everyone knows that the share price can go up or down; that it depends on the success of the company, etc.. Real estate agents selling house to people who could not afford them and especially the writers of these “designed to default” mortgages that made it possible, should go to jail, if it can be proved they knew what they were con-men misrepresenting, promoting a Ponzi scheme fraud, IMSU, anyway. They should be dam thankful I am not going to be the next POTUS. They have hurt the US more than any terrorist could. I’d show them a war on terror!

 

Let me restate by way of example. Say you are a bank that has a pool of 2000 mortgage loans, with an aggregate principal amount of $800 million. You would like to sell these to raise immediate money, get them off your books, whatever. You, as bank, know that some of these $800 million will default, but you don't know which. As a result, an individual mortgage loan is not very liquid. The pool as a whole is liquid, but few people want to buy $800 million in a lump sum.

Securitizations were invented just for this kind of case. here's how one might work.

First, you find an underwriter ("UW") to run your deal. UW tells you that you need to form a limited purposes, bankruptcy remote subsidiary ("SPV" or "special purposes vehicle"). The only business the SPV will engage in (or *may* engage in) will be buying these mortgage loans from you and raising the money needed to do it.

The UW sets up a system whereby noteholders buy noted from the SPV, and the SPV uses that money to pay for the mortgage loans.

Problem: The people out there who want to buy notes all have different preferences when it comes to risk and return. Some want low risk and are willing to accept a low return to get it. Others want big returns (by know that they will have to accept risk to get it).

Solutions (i) Well, because you are buying a pool of mortgages and not an individual mortgage, the risks are already somewhat reduced. If you take a singe mortgage, you are subject to the credit risk of the mortgagor, the more mortgages you take though, the more the "law of large numbers" let's you pin down the expected default rate. You know some will default, and you know some will not, but the variance in rates of returns on your pool of loans will be far less than it would be on any single mortgage loan.

(ii) Just as fundamentally, the UW will "tranche" the Notes. Because that law of large numbers effect, the UW thinks it can pretty good guesses, statistically speaking, of how much will be paid. For example, suppose the UW looks at data, runs it's models and concludes that the following is true about the pool as a whole:

(A) The odds that the pool will pay out at least $1,000,000 are 99.999999%.
(B) The odds that the pool will pay out at least $100 million are 99.9952%.
(C) The odds that the pool will pay out at least $400 million are 98.3273%.
(D) The odds that the pool will pay out at least $500 million are 94.2845%.
(E) The odds that the pool will pay out at least $600 million are 90.0884%.
(F) The odds that the pool will pay out at least $700 million are 81.3649%.
(F) The odds that the pool will pay out the full $800 million are 0.000000001%

Say, for simplicity, that all the mortgages have a fixed interest rate of 10%. The UW might believe that he can find people willing to take a 10% risk of loss if the return is high enough.

Tranching works like this: 99.9952% is a pretty good bet, you to find people who only want safe investments and tell them that the first dollars that come in from the mortgages will be specially allocated to them. Once those investors are paid in full, the next dollar can be used to pay the noteholders on the riskier notes. So, UW decided to set up notes as follows:

Tranche A: $100 million in notes (entitled to be paid first).
Tranche B: $300 million in notes (entitled to be paid only after the As are paid)
Tranche C: $100 million in notes (entitled to be paid only after the As and Bs are paid)
Tranche D: $100 million in notes (entitled to be paid only after the everyone else is paid)

Because Tranche A has the least risk, they get the lowest interest rate (lower than the 10% the mortgages are paying). The D's have a pretty signicant risk, so their interest rate will be higher than the 10% from the mortgages (but still paid for out of the interest paid on the pool of mortgages, which works because the A's (and B's and maybe C's) are getting less than a full 10%).

The thing to notice though iis that all of these notes are being repaid from the same mortgages. The noteholders have just agreed amongst themselves how the payments will be divided once received in the event of a shortfall.

Often the Tranche A noteholders will want to reduce their risk below that 99.52%, so teh UW qill arrange for a CDS to be put in place. Now, even if the 0.48% event occurs, you have the CDS, so the default risk from your perspective will be 0.48% * (the probability that the CDS counterparty will default).

Say you want to support the CDS counterparty, which mortgages do you guarantee? The CDS only relates to the A Notes, so what you want to guarantee is *not* individual mortgages (as within the pool, though are fungible, and there's $800 million worth of those, in any event). What you want to guarantee is that, if those mortgages pay out less than $100 million in principal, that you will make up the difference (but only up to $100 million and no more).

 

Thanks that was very helpful. I now understand what Tranches are. I think you dropped a couple of zeros in you example so reproduce why I think that and the part of your post which I think misses my point, idea.

The chance that Trance A will be happy to have paid for the CDS is only (1- 0.999952) or 0.0048% not your 0.48%, I think., but no matter, my concern is different:

With my plan, the chance that the full 600 million will be paid is unity because all 800 million will be paid, most by the home owners and small part by Uncle Sam. My plan effectively rewards the big gamblers of Tranche D more than the more cautious buyers of Tranche A. Perhaps they have a case to take to court, stating: “The government changed the rules of the game by making all $600e6 certain to be paid. Thus the rules of the interest distribution must be changed also to make all trances share equally the interest.” I do not know and do not want to get into discussion of the strength of that claim. Let the courts decide – that is what they are for.

To extend you numerical example, assuming my plan is in effect and that exactly the expected 10% total default on the $800e6 of mortgages actually occurs. (I am too lazy to compute the expected default which is consistent with your data but lets assume it is 10%.) and (worst case for FHA) that not one holder of any mortgage wants to share partial title to any house with the FHA. I.e. the US, via the FHA, contributes (not all at once, but spread over years as owners stop paying the mortgages) $80 million dollars and takes full title to 10% of the houses* (and of course the home owners pay $720 million dollars in annually decreasing amounts as some mortgages are paid off every year.) Also what was toxic trash with face value of $600e6 in the four tranches is now worth more than $600e6 in discounted or “present value” as it is essentially a US treasury bond with higher than normal rates. Say it is worth $700e6. Thus with the PARTIALLY DEFERRED expenditure of $80e6, Uncle Sam has converted toxic trash into an asset worth $100e6 more than face value for the Tranche holders!

I am not exactly sure where the difference between the expected payment $720e6 by home owners assuming now that my plan is not in effect, and the $600e6 of the face value of all the tranches goes, but until you are more clear on that, I will assume that part of that $120 paid lawyers and other over head and some was profit for the SPV corporation. Nor do I know what Paulson will pay for the $600e6 in face of the toxic trash. Surely not the full face value – that smells too much of “bail-out” yet if less than $400e6 some mortgage holder will say thanks but no thanks. (They will be the less desperate for cash ones – hoping the plan does recover the economy and the can sell later for closer to face value.) Thus a reasonable guess of Paulson’s offer on the $600e6 face of the tranches is $500e6.

Now let’s compare the merits of My Plan, MP, and Paulson Plan, PP:
MP converts toxic trash into greater than face value assets. PP mayor may not solve the liquidity problem.
MP costs $80e6, spread over many years; PP requires $500e6 in first year.
MP helps Joe American get into housing he can afford. PP ignores Joe.
MP punishes the guilty for creating this mess. (Recovers bonuses etc. funds and send some to jail.)
PP rewards the guilty, but may limit their reward to less than their usual bonuses and golden parachutes.
MP does not require an arbitrary assignment of value to the toxic trash. PP does.
MP is simple to implement (Most under water owner just mail the title and mortgage not to the FHA to avoid the cost of foreclosure auction. And hope for small check back later when FHA sells their house.)
PP is so complex they have not yet been able to figure out how to implement it.

Again I ask:
What do you think of MP?
What about post 17?
--------------
* These houses were probably worth at least $100e6 when they were mortgaged, in some cases many years ago.(I always put about 2/3 down to get lowest possible rate.) Let's continue being conservative and assume they were worth only $150e6 at the peak of the housing bubble. Surely if liquidity is restored they will be worth at least $100e6 again. Uncle Sam is a "vulture" taking poor Joe's house for a 20% discounted value, but needs to hold for a few years to let the real estate market work off the excess of unsold homes. When Uncle Sam sells, he should get about twice what he paid. I.e.$160e6 on his problem solving $80e6 investment.

 

As far as I can tell, in actual implementation your plan not only supports the current bubble price of houses (and rents) while encouraging banks to foreclose, simultaneously, thereby doing maximum damage to the local communities involved,

it involves the US government in a huge real estate management operation for which it has nowhere near sufficient resources of any kind,

and it rewards the banks, or other mortgage holders, for their role in creating this bubble. You are guaranteeing, by taxpayer dollar, the bubble payoff. Hence McCain's support.

You can't punish the people who created this bubble by law, except for the minority who actually broke the law. And with the carefully written new regulations, they didn't have to.

 

I do not see how you can think that. Perhaps it will slow the current rate of fall in home prices as it does take those about to default off the market, making them available to renters who bought house they could not really afford. If FHA takes full title, it does so paying ONLY the remaining balance of the mortgage, which the owner cannot pay on monthly. Uncle Sam keeps the mortgage and dose pay it monthly. Hopefully the rent will cover maintenance and perhaps a smaller than original mortgage (bank should gladlly agree to that now that risk is gone and in most cases forecloser/ auction expenses are avoided) and give small profit. How is that supporting bubble prices? Are you saying that everyone who owns a house and rents it is supporting "bubble prices" ?- That is all Uncle Sam is for a few years - another land lord.

Banks cannot foreclose on mortgages being paid. On one that is not being paid they will greatly prefer, even assist Joe to turn it and the title over to the FHA. Banks lose about $20,000 if they go to foreclosure. Few will actually foreclose under my plan. Far from "encouraging foreclosure" my plan should eliminate 95+% of them. From "under water" Joe's POV, my plan is a way to just walk away, debt free. If he lets house go to auction and the highest bid prices is less than the outstanding mortage balance, Joe remains in debt to the bank for the difference, unless he also files for bankruptcy.

Also false. Like many other land lords that owning more properties than they can manage themselves, Uncle Sam hires some of the mutually competiting companies already providing this service.

Just because McCain is a Republican does not mean he is for big business. He, and even Sarah, have shown (for a Republican) remarkable hostility to big oil, the alcohol lobby (even in IOWA he said he would end the corn and alcohol subsides and zero the import tariffs!) No, it does not reward the banks, except to get them liquid again. Not one penny goes to the banks fro toxic trash by my plan, which calls for sending as many as possible of their con-men Ponzi scheme "creative mortgage" writers and seller to Jail. The banks receive tax payer dollars only for houses they own or have mortgage on. Uncle Sam is getting these houses at a disconted value - only the remaining balance of the mortgage.

Here you are correct. I have explained how to send some to jail via the law. Ponzi schemes are illegal. Here is what some of these con-men said to Joe American:

"You do not need any money down. We will not check your stated income. Do not worry that the rate can re-set. - It probably won't and even if it does that is three years from now and you can always make a profit by selling. ("to a greater fool" was never said.) Come on Joe, time is money; just sign on the dotted line. Trust me. You won't regret it. Act now while you can. These mortgages will not be available soon."

Con-men promoting fraud and Ponzi artists are criminals, under existing law. Send them to jail, after recovery of their bonuses, with interest, (retired CEO’s golden parachutes also). Criminals are never allowed to keep their illegally obtained loot, even if the victim bought into the con-man's fradulent pitch and agrees.


Read my plan as you clearly do not understand it.

 

Let me ask a simple question - conceding that it may not be a simple answer...

What would be the detrimental effects (not to the institutions, but to the invidual investor, insured and market) to disallow such securities at all?

The way I see it, if you do not have enough liquid assets to cover more insurance policies than you currently have, that simply means you are not in a position to grow.
If you have not onvested wisely enough to grow organically, allowing "tools" such as CDS's gives you the freedom to invest more and insure more, making you less stable than before.
So, the end result is to allow executives who have not invested wisely enough to intrdocuce and even greater risk to those whom they insure.

The same goes for banks and those they loan to.
By permitting banks to utilize a CDS, does that not effectively fudge the value of their risk and allow them to invest more than what would make them soluable at a marginal risk?
If you need to have 70% liquid assets for all your debts, and you are able to offload some of those debts as CDS's, that allows you to loan at a greater rate, again, introducing greater risk to the investors, borrowers and depositors.

Am I viewing this wrong, or is there no real benefit to the consumer by allowing this, and only greater risk?

 

You are right. CDS encourage irresponsible behavior on large scale.
Until they are eliminated, the crisis will deteriorate.
Negatives of immediate CDS elimination are small.

eS

 

The money in my pocket is not debt. :bugeye:

 

You are reading it correctly, Raven. Just one minor correction: CDSs do allow more lending by decreasing the amount of fractional reserves a bank has to to hold - but the "insurance" aspect is only an illusion.

 

Not to you, true. To you it is credit, but to someone (usually a government, but not if it is limited circulation script such as was used to pay miners and force them to buy from the company store) it is a debt. This "for every credit there is debt" concept is standard accounting and extends far beyond money. I think it was the socialist Thevan (name probably not spelled correctly) Who more than 100years ago observed: "All property is thief." The America Indians did not have much of a Property concept as fas as land was concerned. It was thus easy to steal it from them initially.

 

The only issue with it is that securitizations do "add value" overall. There is nothing wrong with trying to decrease market risk and transaction costs by pooling assets. When you buy shares in a mutual fund, that is the theory behind them too. If you buy a single stock, the risk adjusted rate of return be higher (always) than if you bough that stock and some other stock in a bundle (unless the returns on both are perfectly correlated). The reason we diversify our portfolios (or are told to by our brokers, at least) is the same. The broader the pool, the lower the market risk faced by the pool as a whole.

A mutual fund is, in effect, a kind of untranched securitization vehicle made available to investors on stocks. The "shares" you but in mutual finds are, really no different than the securities sold in a securitization save that securitizations tend to deal in accounts payable (trade receivables, credit card receivables, lottery receivables, loan receivables), and mutual funds do the same with cash flows from equity securities.

I don't think that's quite true. Let's say you run an insurance company and have $100 million in assets. How much should you have outstanding in policies? If you answer $100 million, you are being very conservative. imagine we sell fire insurance. If you have $100 million in fire insurance outstanding, over say, 1000 homes ($100,000 worth of coverage each), what are the odds that they *all* burn down this year? Pretty small, on e would hope. In general you will hire actuaries to determine the expected numbers of housefires and the expected payouts in a given year, which on 1,000 homes should be pretty low, say $1 million (or whatever it is). If you sit on the whole $100 million, just in case all your policies become payable at once, you are going to have to invest it in very safe, short term investments, which will pay lower rates.

If your goal is to maximize profits, clearly you are not going to hold a 1:1 assets

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olicy coverage ratio. You will pick a number comfortably above the expected payouts for the next, say three months, and keep that in reserve. A lot of they money will be safe enough to write even more policies on, rather than invest it. The "correct" ratio will also be tricky to determine, as the shareholders have different interests that policyholders, and there is no objectively right answer.

Why? Sure you invest more and more, but you do so because your risks are lower than they were before you bought the insurance. In might be the case that you ratchet up the risk in the way you suggest, but it need not be. (Do you feel like buying homeowners insurance makes you take greater risks? Would you recommend abolishing auto insurance because insured drivers might take greater risks than the uninsured ones? Sometimes insurance creates moral hazards, sometimes it does not. Surely the answer is to regulate the moral hazards, than to ban anyone ever selling auto insurance ever again. I do not see why the answer in that context would not apply to the CDS markets.

In this case, imo, what happened was what happens in every bubble, very smart people blinded themselves to the risks. In this case, they lost sight of the systematic risks that were left over after the specific risks were diversified away.

Well, the risk to the insured is that their claim isn't paid, and their premia are lost, but that's it. Technically, whenever you enter any contract you should be aware that there is *some* chance the other guy doesn't perform. The CDS failures don't directly cost anyone anything more than that, unless the failure of CDS's ratchets up the default rates on mortgages. The mechanism for that to happen is not entirely clear, but presumably it would be because of further loss of confidence in the markets.

By law the reserve ratio is 10%. Banks need to maintain just 10% in reserve and can loan away the other 90%, and that is without CDSs. In practice, that number leaves them a very safe cushion.

There is some truth to what you say here, but only because the banks misjudged the systemic risk of the CDSs and CDOs (a mistake unlikely to be repeated any time soon). Bear in mind that the CDS providers had *better* credit than the banks. The only think that makes banks safer than the insurers is that the federal government guarantees the first $100K of deposits, take that away, and a number of the insurers looked to be healthier than those banks. So, in an FDIC-free world, you'd be, on average, better off of you ban be bought the insurance.

The insurance is no worse for the banks than it is for the private individual, but one of the issues is as you describe it. The banks would insure the loan, and then free up that capital, dollar for dollar, to make a new loan. It seems to me the obvious fix is to adjust the reserve accounting so that each $100 of CDS bought frees up not $100 of reserve capital, but say $70, or even $30. The exact number will require a good bit of number crunching, but it should free up enough capital to account for the reduction in the specific risks the bank faces, but still require some additional server to account for the systemic risk the bank and everyone else still retains.

The insurers likewise need to have a capital requirement on their policies, for much the same reasons they do on their traditional insurance business.

 

Either you are misunderstanding me or I am misunderstanding you.
I understand that insurance companies can't feasibly keep a 1:1 ratio, or they will not be able to invest much at all.
However, the law calls for let's say a 1:10 ratio.
Am I understanding correctly that insurance companies can utilize these CDS's to falesly inflate their capital assets in the same way that banks use them to falsely deflate their credit risks?

Whil I am not saying that "insuring" high risk credit invesrtments is, in and of itself, a bad thing, it does seem to me that by allowing banks to use these to make it appear as if they have more loans out than they actually do, and allowing them to lend more than what is considered "stable", then I don't see the benefit in that.
If banks are required to have 10% of deposits to cover credit products, for example, and these are used to fudge those numbers and get those risky loans off their balance sheet, regardless of whether they are insured, the bank will not be able to cover runs, and will therefore be less stable, no?
If not, why would they have a requirement to have 10% depositor requirement?