Friday, November 6, 2009

Nomenclature of the Sub-prime Meltdown

Please don’t let your eyes glaze over when you read this. I am the type that needs to know what happened. At first I thought it was Congress and Fannie Mae; but it really wasn’t. It was Wall Street greed and it’s far from over.

Credit Default Swap (CDS)- A private unregulated insurance policy originally created to as a hedge bet on risky investment. Due to the fact that they are unregulated, there is no requirement that the seller have the funds on reserve to pay the CDS if the insured investment fails. Further, since you can purchase a CDS without actually investing, it is the functional equivalent of walking into a retirement center and buying life insurance policies on those you think will die the soonest.

Mortgage Backed Securities (MBS) – Using the worth of numerous Mortgages, bundled together as collateral for a loan.

Derivative- A financial contract whose value is derived from the value of something else than the asset or index on which it is based. For the purposes of this discussion, mortgages of various risk and value are combined using mathematical formulas that take into account past rates of default and interest rates and a guarantee that home values will always increase. The idea is to mitigate the risk of economic loss arising from changes in the value of individual mortgages, known in the Derivative world as the “underlying”. These investments are defined as a Derivative because it’s worth is not determined by the worth of the mortgages, but the result the formula used to derive it’s value.

Government Sponsored Enterprise (GSE) A financial corporation crated by Congress. The primary purpose here, is to buy up mortgages from banks so they will have the capital to continue to lend and create new mortgages. Prior to Glass Stegal Act mortgages were bought and made in to MBS by private investments banks. Since a lack of regulation with these securities were part of the 1929 economic collapse, Congress created GSEs (i.e. Frederal Home Loan Bank, Fannie Mae, Freddie Mac) to regulate the home securities market. After the Glass Stegal Act was repealed, private investments banks could once again issue unregulated MBS.

Leveraging- Borrowing money to make investments. The idea is to borrow money at a lower interest rate than the return of an investment.
1907 New York outlawed Bucket Shops, (Credit Default Swaps). In 1933 the Glass Stegal Act also separated Commercial banking from Investment banking so you couldn’t bundle mortgages into securities. In 1938, since the investment banks could no longer buy up mortgages, GSE's (ie Fannie Mae) were created as a secondary market to buy mortgages and free up money to banks, so they could make loans to allow more home sales. Fannie Mae borrowed money from the Treasury to buy mortgages, thus it's portfolio showed up as part of the National Debt. In 1968, Fannie was privatized, becoming a Government Sponsored Enterprise (GSE) or stockholder based company. GSE's were also authorized as the only exception to Glass Stegal, and were allowed to create Mortgage Back Securities (MBS), first to replace treasury loans and later after 1968 to regulate the Home Securities Market. In 1970 Freddie Mac was created as a competitor to Fannie Mae as a GSE. Also, in 1968 Ginnie Mae was created by the government, however it remains wholly Government owned. It only holds government backed mortgages (VA & FHA). Historically, you can say that Ginnie Mae is the original Fannie Mae, though it only hold government back mortgages and only issues government backed MBS. Fannie Mae became a new and different entity, taking with it non-government backed mortgages.
 A Basic Time Table
In 1999, the Glass Stegal Act was repealed under the Financial Modernization Act (FMA), passed by the 107th Congress on its way out the door. A portion of the Act removed the separation of Commercial and Investment banking and another specifically denied the right of the states to declare CDS illegal gambling. Many of the previsions of the FMA were added under the last conference version of an Omnibus Appropriations Bill, meaning they were never voted on (This would become a major bone of contention when it was discovered that the so called Enron loophole was one of these additions). The same year Fanny Mae under the control of CEO Franklin Rains  (previously the Chairman of the US Office of Management and Budget under President Clinton)  launches the American Dream Commitment (ADC) with a stated goal of pledging $2 trillion dollars to increase home ownership for 18 million American families. Alan Greenspan then lowers the Federal Interest rate to 1%, guaranteeing low interest on Treasury bonds, CDs and the like and leveraging becomes the path to great wealth; everyone is taking out low interest loans and buying higher yield investments. This creates an increased demand on high yield mortgage securities. In 2004 Rains was forced into "early" retirement from Fannie May due to what was called accounting irregularities.The Office of Federal Housing Enterprise Oversight (OFHEO), the regulating body of Fannie Mae, of instituting  widespread accounting errors, which included the shifting of losses so senior executives, such as himself, could earn large bonuses.

Just prior to Franklin Rains departure, the sub-prime mortgage crisis began. With continuing pressure from HUD (The Department of Housing and Urban Development) and the (ADC) Fannie Mae was making a killing in the MBS market, so investment banks tried their own hand at issuing MSG, refereed to as "private label." These investment banks were willing to use lower standards, which produces riskier loans. These riskier loans were bundled as Derivatives. Using mathematical formulas only a physicist can understand, these Derivatives ratings are bumped from BBB to AAA. Investment banks leverage themselves to buy and sell these Derivatives as AAA investments and further sell a CDS to protect the investment. The CDS market then explodes from $100 billion to $100 trillion (or more). The GSE's (ie Fannie Mae), in an attempt to increase it's dwinding market share, also started buying these sub-prime mortgages.  The regulators (FDIC) start warning of a banking crisis but this shrugged off by Alan Greespan. The CDS market becomes so hot due to the toxic level (doomed to fail) of these Derivatives. There is a shortage of Derivatives, so Investment banks use the money from the CDS on an existing Derivatives to pay the interest of the actual CDS and than create a non-existent mirror Derivative so they can sell CDS on theses imaginary Derivatives. The world financiers leveraged 100 of Trillions of dollars to gamble on CDS.

Finally the mortgage bubble bursts when home values level off; the leverages are called and the CDS need to be paid. Most the investment banks are leveraged some 50 times their worth. The Derivative “Securities” held by the Investment banks are now worthless. Congress offers $700 billion dollars to back these Derivatives and try and open up the credit lines again, but these packaged Derivatives were put together by computer formulas and nobody really understands. Further there are still tens of trillions of unpaid CDS out there that must be paid before any of these Investment banks can become liquid again and there is a glut of unsold homes and still millions of foreclosures coming in the future, leaving home values sl low that many home owners will be underwater for years. Further the home construction industry and businesses that also profit from home construction will be flat for years to come.

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