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Wednesday, January 14, 2009

orders of stupid

As the financial crisis hit, legions of well-meaning people realized they didn't remotely understand the mechanisms behind the meltdown and resolved to seek out balanced, non-ideological explanations to sate their curiosity. Ha, kidding!

For wingtards, the financial crisis was the logical outcome of the Community Reinvestment Act of 1977. You see, the CRA forced banks to lend to poor people, and then, well, uh, you know the rest. Fannie Mae and Freddie Mac also jumped in on the action. This all conveniently blames brown people and the government for everything that's gone wrong ever. Anyway, its not true and, indeed, beyond stupid.

That said, credit default swaps (CDS) are to libtards what the CRA is to the right, though in fairness, CDSs are, you know, relevant to this whole thing. CDSs are, in effect, insurance contracts to insure against a default on pretty much anything its possible to default on. For example, one party agrees to insure against the risk of default on a security held by a second, transferring the risk of holding the security from the holder to the insurer. This market had grown to a nominal $62 trillion at one point, which is why it has attracted so much attention. That a little understood, completely unregulated market could grow to such a size made it seem like the logical source of so much trouble.

All that would make it hard to explain how this happened:

Big investment banks ripped up more than $30,000bn worth of credit derivatives last year, or almost half the record total outstanding at the start of 2008, as they aggressively pursued efforts to tidy up the industry.

Regulators raised the already-strong pressure for reform of the derivatives industry following the rescue of Bear Stearns and the collapse of Lehman Brothers, prompting banks to step up moves to terminate old and superseded contracts.

This gets to what CDSs are and aren't. You might expect that wiping out $30 trillion in contracts from its peak in a single year would be an earth-shattering event. Not exactly. While much has been made of the casino-like aspect of this market, it hints at why the trillion dollar figures are highly misleading: casinos are zero-sum. You lose, house wins and vice-versa. Much of finance is zero-sum. Boring-ass foreign exchange markets are zero sum; highly complex arbitrage trades are zero-sum. Someone's winning what another's losing. This means that, theoretically, the $62 trillion nets to zero, and explains why banks can pretty much say "eh, fuck it" to $30 trillion in contracts without the planet shutting down.

I say 'theoretically' because problems arose not only when people started defaulting and contracts were triggered, but when counterparties to trades themselves, the insurers, started failing. This is the role of CDSs in the crisis. With every bank failing along with systemically important companies like AIG, it was thought that many contracts would simply not be honored at all and the default risk transferred back to the original holder. Moreover, because of the lack of regulation, most CDS deals were structured bilaterally, meaning only the two counterparties themselves knew their own exposure, leaving everyone else to simply guess who was exposed to what. The prospects of actual defaults along with the sheer opacity of the market in CDSs thus resulted in an amplification of counterparty risk, and perhaps just as importantly, the perception of it. They were an important transmission mechanism of financial contagion, much as girls are to cooties.

Still, their importance is exaggerated since there were plenty of other avenues for counterparty risk. Clearly there would have been a big fat financial crisis without them. The solution to the CDS problem after all has been to just not have them anymore. The same approach cannot be applied to collateralized debt obligations (CDO) where the actual, tangible losses from the housing collapse reside. The two are linked, however, to the extent that you can write a CDSs on CDOs, which is, again, relevant since that's where plenty of payouts originated.

But the cause of the crisis, if anything, is the CDOs--shitty mortgages structured into shitty, yet AAA-rated securities, that were then sold to investors and other banks who were making similarly shitty securities. This is called the originate-to-distribute model, as in originating a turd and distributing it to the toilet. Knowing they would sell them to someone else, mortgage lenders had no incentive to maintain lending standards. Banks had the same lack of incentive when structuring CDOs. Moreover, they traded these things off-balance sheet, meaning no capital was held against them, leaving them vulnerable to an investor boycott when people started defaulting on their mortgages, which they did. Shitty securities came back on balance sheet, banks panicked, and everyone with money everywhere collectively peed their pants.

This, in a word, is your financial crisis. And yea, those securities are still fucking there.

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