Please learn about CREDIT DEFAULT SWAPS and how they're at the core of this mess

[magellan]

We American taxpayers are being swindled, and defaulting homeowners are being scapegoated!

Read this 5-page article that explains Credit Default Swaps, and how they've been used to make trillions of dollars by rigging the mortgage market to fail and then collecting on policies (CDSes) against the defaults.

Credit Default Swaps: The Insane Problem and the Radical but Sane Solution

The paramount reason for today's cancerous credit crisis is seldom even hinted and never explained.

First, a simple definition. A credit default swap is a form of insurance. A variant of mortgage insurance required of many home purchasers. An insurance policy that requires a company with financial strength to step up to the plate and pay the mortgage if for some reason the home buyer defaults.

A credit default swap is similar: If default occurs, an insurance company pays the income stream of the mortgage.

With one extremely important difference: Payments are made to the owner of the policy, not to the financial institution that stands to suffer a loss.

Much more....Please read it! It's impossible to make an informed decision about the latest bailout without understanding what caused the problem.

[PA Democrat]

1. That's what I've been trying to explain to people.

Oh, and people should also look at the Commodity Futures Modernization Act of 2000 which completely deregulated trading of credit default swaps as well as other forms of derivatives. Guess who sponsored the bill in the Senate? Phil Gramm.

[magellan]

6. It's difficult to wrap the brain around, it's so devious

...and flies in the face of what we expect.

As I said on another thread after reading this explanation, the decision to stop reporting M3 fits into this game they rigged. They turned on the printing presses to drive up inflation, putting further financial pressure on homeowners. That combined with job losses due to outsourcing, increasing health costs and adjusting ARMs spelled PAYDAY for them in the form of mortgage defaults.

Where is Phil Gramm these days?

[ljm2002]

30. So it's kind of like...

...taking out a life insurance policy on some random person, then if not hiring someone to kill them outright, at least ensuring conditions where they are exposed to all sorts of life-threatening risks.

Niiice.

[gopbuster]

2. This is what we really need to watch for in this plan IMO

As far as I'm concerned any institution that is exposed to liabilities due to CDS or other exotics, we should not provide or misallocate funds to that end of the spectrum.

[PA Democrat]

4. Well that has already happened. AIG got that $85 billion loan

because they got themselves into trouble over their holdings of credit default swaps.


http://money.cnn.com//2008/09/16/news/companies/AIG/index.htm?cnn=yes

Rocked by the subprime crisis, the company has lost more than $18 billion in the past nine months and has seen its stock price fall more than 91% so far this year. It already raised $20 billion in fresh capital earlier this year.

Its troubles stem from its sales of credit default swaps and from its subprime mortgage-backed securities holdings.

AIG has written down the value of the credit default swaps by $14.7 billion, pretax, in the first two quarters of this year, and has had to write down the value of its mortgage-backed securities as the housing market soured.

The insurer could be forced to immediately come up with $18 billion to support its credit swap business if its ratings fall by as little as one notch, wrote John Hall, an analyst at Wachovia, on Monday.

[gopbuster]

19. Hopefully that was the worst of the worst :) n/t

[mmonk]

3. Paper brought us the first depression, the second one will be brought

about the same.

[Cessna Invesco Palin]

5. The problem with his suggestion is that it destroys *everything.*

It doesn't just destroy the people who've been mucking around with credit default swaps. It destroys the entire financial infrastructure of the country. He himself says that "FDIC is one major collapse from insolvency." What does he think will happen if the run on the banks he suggests occurs? The government will have to pump money into FDIC in order to support the run on the banks he suggests, because every bank will fail. Ergo, the taxpayers will still be footing the bill. If it's even possible to foot the bill for everybody in the country withdrawing all of their money from every bank simultaneiously. And the credit markets will still be broken. Not that it will matter, because there won't be anybody left with money to lend in the first place. This is a terrible, terrible idea.

[magellan]

7. Removing money from banks is just the last suggestion

He also says no bailouts and most important, declare all these CDSes null and void.

[Cessna Invesco Palin]

8. Is there a legal mechanism for doing that?

These are legally binding contracts we're talking about.

[magellan]

9. Who says they're legal?

Maybe we take it to court and find out.

[Cessna Invesco Palin]

10. Oh, they're legal.

You can thank the Republicans for that.

[magellan]

12. Was this one of Phil Gramm's gifts to us? n/t

[Cessna Invesco Palin]

13. The lack of any regulation of them was his gift to us. n/t

[Spike from MN]

20. Well, if they can grant telecomm companies retroactive immunity

they should certainly be able to pull the plug on these and make it retroactive.

[magellan]

24. Good point!

n/t

[Cessna Invesco Palin]

27. Actually, it isn't.

There's a difference between the feds saying "we're not going to prosecute you" (seeing as they're the ones doing the prosecuting and they prosecute at their discretion) and the feds saying "hey, you two parties to this legally binding contract - it's invalid" when the contract is in and of itself not illegal.

[HamdenRice]

11. Pure. Economic. Illiteracy.

I don't blame the OPer who is just citing to an article. Sadly, most of us in the liberal blogosphere have little understanding of finance and our journalists' and bloggers' attempts to explain things often go disastrously wrong.

The OpEd News piece doesn't seem to even realize that credit default swaps are written to ensure securities, not individuals and their mortgages.

I do agree with the OPer on this, though: "It's impossible to make an informed decision about the latest bailout without understanding what caused the problem."

Here is an explanation of a credit default swap I wrote a few days ago:

Credit default swaps are a casualty not a cause.

But they are a big, big problem, especially for AIG.

A credit default swap is an insurance policy that a bondholder buys. Paraphrasing the colorful names used in the Wiki article, let's say that Penion Fund wants to buy bonds from Risky Corp. It buys $10 million in Risky Corp's bonds which are 7% bonds for 5 years.

Risky Corp pays 7% interest or $700,000 each year. If Pension Fund gets scared that Risky Corp will default, Pension Fund can go to AIG and ask to buy a credit default swap.

Let's say the credit default swap costs 300 basis points (that's a fancy way of saying 3%). So Pension Fund pays AID $300,000 per year out of the $700,000 per year it gets from Risky Corp.

That may sound like a lot but it means (or was supposed to mean) that there was no chance that Penion Fund could lose money. If Risky Corp sends out a letter saying, we've run out of money we're not paying interest and may not be able to pay you your $10 million in year five, under the credit default swap, Pension Fund can go to AIG and say, here's Risky Corp's bond, we want our $10 million back and AIG has to give it to them -- even if Risky Corp's bonds are now selling for $2 million on the open market because of the default.

The worst thing about credit default swaps is that the repugs put a clause in the bankruptcy code that says that credit default swaps are basically exempt from waiting in line during bankruptcy if the issuer (AIG) of the credit default swap goes into bankruptcy.

That means that while AIG's bondholders, suppliers, employees, contractors -- everyone who was owed money -- would have had to wait in line if AIG had been allowed to go bankrupt, while the bankruptcy court tried to figure out how to pay off AIG's debts, holders of credit default swaps, like Pension Fund could just go and demand payment and get it.

Credit default swaps were purchased on trillions of dollars worth of mortgage backed securities, which means that the default of mbs means that certain issuers, like Lehman, are on the lines for billions and billions -- supposedly to be paid before bankruptcy even starts.

[magellan]

14. So if I read this right

...holders of CDSes can force financial institutions into bankruptcy by demanding payment, and these are the same institutions we're being forced to bail out?

What does "ensure securities" mean? What exactly is a security?

I'm trying very hard to understand all I can and appreciate you pointing out any flaws in the thinking of others I'm drawing from.

[HamdenRice]

15. Good questions

1. Yes, effectively, holders of credit default swaps can force an insurance company into bankruptcy by "jumping the line" that the bankruptcy code was supposed to create. Corporate, banking and bankruptcy law create an elaborate system of who gets what first in the case of a bankruptcy. The repugs (Gramm?) inexplicably screwed up the entire elaborate hundred year old system by putting cds first and outside of bankruptcy.

2. A security is a stock, bond, or other investment that can be represented by a piece of paper like a stock certificate. Just think, stocks and bonds.

All stocks and bonds have risks. Stocks are supposed to be a little risky, and that's why investing in them is called "playing the stock market."

Bonds are supposed to be super safe. But if the company issuing the bond is a little shakey, an investor could buy an insurance policy on that bond called a credit default swap.

In my example, the insurance company was paid $300,000 per year to insure Risky Corp's bond. If this had been properly regulated like other insurance policies, AIG would have been required to put that $300,000 per year (and all the other money it collected in cds fees) in other super duper safe investments, in order to save up in case they had to pay off on the policy.

Again the repugs exempted cds from insurance regulations and made sure cds were treated as a derivative commodities (go figure, I'm as puzzled as you are on that one) rather than treated as an insurance policies.

So they didn't save up the premiums. Now that institutional investors are presenting failed bonds for payment of the insurance policies, the insurance companies don't have the cash. Hence bankruptcy -- but worse, because the "line" has been screwed up.


On edit: The first line of my block quote says that the cds was the "casualty not cause". In the context of the original discussion we were talking about mortgage backed securities -- so cds bankruptcies are a casualty not cause of the mortgage mess. But cds is a cause of the bankruptcy of issuers of cds.

[Cessna Invesco Palin]

16. I'm assuming the Republicans did this because *somebody* asked for it.

I just can't see how anybody with half a brain would ever believe this was a good idea.

[HamdenRice]

17. Asked with a "pretty please with sugar on top" ...

that no doubt involved campaign contributions or worse.

Yep, it's hard to imagine anyone with half a brain doing this. But then again, Gramm is pretty much brain dead.

[gopbuster]

18. HamdenRice- any thoughts on this which was posted yesterday-

http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=114&topic_id=44082&mesg_id=44082


It sounds like they may have trouble reworking the mortgages




Why The Government Cannot Modify Mortgages If It Purchases $700BN of MBS

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posted by Adam Levitin
I've written a short explanation of the why even if the Treasury buys $700BN of MBS it will be unable to modify the underlying mortgages. The explanation, which is more detailed than any of my previous postings on the subject, is available here.

At core it is a Trust Indenture Act problem, where the bonds cannot be modified absent a specified majority vote and consent of bondholders whose payment rights are affected. And here is no possibility of doing an exchange offer to get around it; there is simply no mechanism for an MBS trust to do an exchange offer. (For the classic discussion of Trust Indenture problems, see Mark Roe's article, The Voting Prohibition in Bond Workouts.) The solution of Trust Indenture Act problems with corporate bonds is...you guessed it, bankruptcy modification!


snip>>>>

Problem 6. REMIC Tax Problems from Modification Would Destroy MBS Resale Value
and Cost Taxpayers Money
Even if the government could somehow modify the underlying mortgages by purchasing
MBS in spite of all the obstacles mentioned thus far, modification would result in serious
negative tax consequences for the MBS that would make them hard for the government to resell
and would penalize MBS holders who could not or did not participate in the bailout.
The value of MBS depends heavily on their tax treatment. MBS are structured to enjoy
REMIC (Real Estate Mortgage Investment Conduit) status under the Internal Revenue Code,
which enables the MBS to avoid double taxation of income. Absent REMIC status, federal
income tax would apply to the SPV as well as to the dividends paid to the MBS holders. REMIC
status gives an SPV pass-thru status, so federal income tax only applies to the MBS holders on
the dividends received from the trust. In order to qualify for tax-advantaged REMIC status, the
pool of loans securitized in a REMIC must generally be treated as a static pool.4 This usually
precludes large scale modification of loans in the pool.5 Thus, significant mortgage modification
by servicers could cost an SPV its REMIC status and result in double taxation of the MBS.
Because of this concern, many PSA place significant constraints on modification of mortgage
loans as well as modification of the PSA itself.6 Once REMIC status is lost, it cannot be
regained, so any government action that would cost an MBS its REMIC status would seriously
impair its resale value.

The Government Will Be Unable to Modify Mortgages Simply By Purchasing Billions of
Dollars of Mortgage-Backed Securities. Bankruptcy Modification Provides the Only
Guaranteed Method of Widescale Mortgage Modification for Distressed Homeowners
Only bankruptcy law changes can require the trust to go along with a loan modification
and deal with the junior lien problem. Already Chapter 11 bankruptcy is used for the same
effect. Because of the Trust Indenture Act, it is very difficult to engage in a consensual
modification of corporate bonds. As a result businesses that need to restructure their bonds often
find it necessary to do in bankruptcy. Amending the Bankruptcy Code to permit modification of
all mortgages would also make voluntary modifications more likely, because a trust could defend
any lawsuit by asserting that the borrower could have gotten the same deal (or one less favorable
to the trust) in bankruptcy. Thus, permitting bankruptcy relief may well cause it to be
unnecessary in many cases.
http://www.creditslips.org/creditslips/2008/09/why-the-...

[HamdenRice]

22. As far as it goes it's correct. I've been reading a Bear Stearns Prospectus; the situation is dire

I'm not so worried about something like the Trust Indenture Act or even the tax consequences. As long as Congress is legislating the bailout, they can slip in special exemptions, say, for any mbs that has been acquired for this special program by Treasury.

That said, we have to keep in mind that there is a difference between helping/fixing the underlying mortgages, and fixing the mortgage backed securities issue against them. As for the former, the "Servicer" under the mbs trust has the power to fix the mortgages, and as some of the comments to that article suggests, the feds could lean heavily on the Servicers to do so. In fact, looking at the Bear documents, it's clear that the investment banks and Servicers have full power to fix the underlying mortgages, so I don't see such a big problem for Uncle Sam.

I was also under the impression that the plan was to acquire ALL the mbs of a particular trust or series, in order to fix the underlying mortgages. That would take care of the Trust Indenture Act, because the feds would have all the bonds that would need to vote.

Unfortunately, as I began reading the Bear Stearns material, I realized that they had fucked up the issuance of the securities far more than any rational person can imagine and would require the feds to purchase not just the potentially triple A mbs, but so much exotic stuff that really is slightly less desireable than used toilet paper.

Even looking inside the guts of a "worst of the worst" morgage backed security series there was tremendous value and huge upside potential for the feds that could be salvaged and reissued. But it's much harder to get to it because of Bear's "creative financial engineering".

It now seems that the plan Congress is focused on has no provision to buy up mbs of a particular series and fix it as an entirety. That makes me very sick and scared, because that means the only plan seems to be to buy whatever shit is offered up by the financials, hold it as a portfolio, and hope the housing market eventually turns around.

I still hope for a more systematic and comprehensive approach, but it doesn't look like it's going to happen.

[gopbuster]

26. "creative financial engineering". layers & layers

Thanks for your thoughts

[magellan]

23. Thanks so much, Hamden

Even though you have problems with the article I linked to, it did give me generally the same understanding as your explanation. But I understand more from you...and have more questions, if you'd be so kind.

AIG: WOW. So Willumstad declines his $22 severance package...but isn't it obvious he was risking the company by not saving the premiums? What did he make behind the scenes? I know you can't answer that, I'm just wondering at the reasoning behind his intentionally reckless behavior.

Also, were the failed banks/financial institutions so far also issuers of CDSes? Or doesn't that matter?

I guess I'm trying to figure out if the bankrupt corps have people high up who knew what was happening and were in on the scheme.

I know you're pretty adamant that a bailout has to happen. But I'm still wondering -- if we don't know the eventual potential scope of these bankruptcies, because these CDSes are hanging out there, isn't it possible that the amount of cash needed to bail them all out will cause such terrible inflation that we're facing economic meltdown anyway?

Thanks for being so patient with me. This is a foreign terrain but I'm very willing to learn.

[Junkdrawer]

28. I think you mischaracterize the author of the article. That being said...

I disagree with his solution. But in his article he points out a real problem:

These monoline insurance companies were writing policies for hundreds or thousands of times their capitalizations. Thus, in the event of a systemic failure, their "insurance" wasn't worth the paper it was written on.

[AZCat]

29. Thanks for this (and subsequent) post, HR.

All this is pretty confusing to those of us who, until recently, had no interest in the nuances of securities. It sucks trying to learn "on the fly" but it becomes much easier when people like you are kind enough to clear up some of the confusion. You have my gratitude.

[willing dwarf]

21. Swindled is exactly the term for it

Krugman the other day on Bill Mahrer's show opined that "China sends us poisoned toys and we send them our worthless securities"

[magellan]

25. Seen in that light, it seems a fair trade

Except we're the ones paying for it while the criminals walk off with pockets full of money.