Return of the Macs

by Eric Martin

Yet another post-mortem of the housing bubble and subsequent bank meltdown that debunks the conservative theory that loans to poor minorities/Fannie and Freddie was the culprit in any meaningful way:

The wave of housing price increases was kicked off by changes in private label securitization. These changes left Fannie and Freddie with a smaller market share and lower absolute level of securitizations. Fannie and Freddie attempted to adjust their basic business practices to stay competitive in bubble markets and among aggressive borrowers.

These adjustment left Fannie and Freddie exposed to a large decline in housing prices. This is exactly what happened and Fannie and Freddie reaped enormous losses because of their exposure.

Had Fannie and Freddie stuck to their traditional role of guaranteeing low value traditional loans rather than trying to stay competitive in bubble areas their losses would have been substantially less.

In short, attempting to subsidize the American dream for low and moderate income families may be a fundamentally bad policy. However, it does not appear to be either the origin of the housing bubble or the source of Fannie and Freddie’s trouble.

Unfortunately, post-mortems don't apply to Zombies.

(via)

Comments

[GoodOleBoy]

If I accept every point you argue, I still end up very unhappy about these two organizations before and after the housing collapse. Any taxpayer who likes to see value for their money should feel the same. Of course, we were always told it would never be a taxpayer issue.

I think it is fine for you to defend a program designed to foster equal treatment for all Americans, but there is no reason to let that support extend to organizations with long-standing corruption and greed in its management ranks (maybe some outright larceny, as well). You aren't supportive of the management approach at these organizations over the last couple of decades (includes Raines and Johnson), are you?

[Eric Martin]

You aren't supportive of the management approach at these organizations over the last couple of decades (includes Raines and Johnson), are you?

Amazingly, Fannie and Freddie have cost taxpayers far less money than the private banks on Wall Street.

Let's just say, I'm not a fan of any of them, and would be fine with either scrapping Fannie and Freddie or significantly paring back their portfolio.

But what really rankles me is the theft, corruption and management approach on Wall Street which has, as I mentioned, cost taxpayers much more directly and, via wrecking the economy, exponentially more indirectly.

If I were to prioritize, I'd say we need to clean up the banking industry first. That's what's costing us the big bucks.

[Tony P.]

Did Fannie and Freddie have private-sector stockholders in recent years, or not? Does any blame attach to THEM for Fannie and Freddie's pursuit of "market share" in the crap-mortgage-securitization scam?

--TP

[Sebastian]

"The wave of housing price increases was kicked off by changes in private label securitization. These changes left Fannie and Freddie with a smaller market share and lower absolute level of securitizations. Fannie and Freddie attempted to adjust their basic business practices to stay competitive in bubble markets and among aggressive borrowers."

Why did they need to stay competitive? Their mission was to get certain types of people into homes because there was allegedly a market failure in allowing them to get homes (or alternatively a need for a subsidy to get them into homes). If at some point it turns out that they are better served by the market, why in the world would the government backed organization need to expand? Shouldn't they celebrate that they had accomplished their mission?

"In short, attempting to subsidize the American dream for low and moderate income families may be a fundamentally bad policy. However, it does not appear to be either the origin of the housing bubble or the source of Fannie and Freddie’s trouble."

This doesn't make sense. Why were they getting into Alt-A and Interest only loans? Karl thinks it was because they were losing market share. That means that the people they normally were serving were able to get into homes without their help. If their response had been to continue on as before, he thinks they wouldn't have been hit as hard. But they didn't.

Also notice this from him "The higher number of Alt-A and Interest Only loans combined with ultimately higher delinquency rates have meant that a plurality of losses have come from these two categories. These loans were vulnerable not because the borrowers were low-credit individuals the government was taking pity upon but because they were predicated on rising housing prices."

Yes, which means that Fannie/Freddie's loans in these categories were directly contributing to the bubble and predicated on its continuation.

And "Areas with the largest collapse in home prices have accounted for most of Fannie and Freddie losses. Refer to the same graph above.

This is further evidence that it was the collapse of the bubble and not betting on people who were poor credit risks that induced major losses at Fannie and Freddie."

But why did they move into the bubble dependent mortgages? Because they were losing market share. Market share of what? Houses to poor and middle class people. Why did they want more market share if these people were getting the houses that they supposedly couldn't get without Fannie/Freddie?

Fannie/Freddie didn't start the fire. They didn't light it but they didn't try to fight it.

They aren't 'responsible' for the bubble in the sense of beginning it. But they certainly contributed to it especially right toward the end.

I'm not sure exactly what you mean by 'the culprit in any meaningful way'. Pretty much there is no 'the culprit'. Toward the end it was doing as much business as pretty much any of the individual private labels. Does that mean that none of them were the culprit?

Strangely the answer is probably yes. The culprit was the bubble mentality held by tens of millions of people. That was enabled by lots of structures, and a medium number of lending institutions. Frannie and Freddie were two large ones. They weren't the largest. But no lender was a majority. There is no 'the culprit'. But plenty of culprits.

I guess this feels like over-debunking. The conservatives who claim that Fannie/Freddie were *the problem* are crazy.

But I'm not at all comfortable with the spin that they weren't part of the problem--they clearly were.

[wj]

The problem with Fannie and Freddie is that they were only partially privatized. They maintained a mandate to support certain kinds of loan business. But they also had shareholders for whom they had a duty to make profits . . . and a government guarantee (which is why it cost the taxpayers money).

What needs to happen there (in addition to whatever else is done in the banking/mortgage industry) is to either
1) make them back into government agencies, or
2) remove the government guarantee and the government mandate on what kinds of business they must do.

Absent that, they remain a problem which will just recur again. And at the most inconvenient time.

[Ugh]

As tax cheat* and Treasury Secretary Geither said recently:

Amid the general race to the bottom in standards across the private sector, Fannie and Freddie lowered their underwriting standards, providing guarantees for increasingly risky types of mortgages without charging nearly enough to cover the risk.

And Fannie and Freddie were allowed to build up substantial portfolios of mortgage-backed securities, which rose to a level of more than $1.6 trillion dollars at their peak, without the financial resources to cover potential losses.

These two strategies were pursued to maximize short-term returns to shareholders and senior management. They were possible only because of the toxic combination of a perceived guarantee by the government and an absence of effective oversight. They were not the sole causes of the crisis, but they made the financial crisis worse. And they resulted in huge losses for the taxpayer.

Fannie and Freddie private stockholders were wiped out in 2008 and they are currently in conservatorship under the FHFA (read its report from which Eric's link draws here). The Federal Government holds a warrant to purchase 79.9% of Fannie (and I think Freddie) common stock for a nominal amount (something like $0.000001 per share).

*I don't really blame him for that screwup, actually.

[Eric Martin]

Fannie/Freddie didn't start the fire. They didn't light it but they didn't try to fight it.

They aren't 'responsible' for the bubble in the sense of beginning it. But they certainly contributed to it especially right toward the end.

Right, which is the point.

I'm not sure exactly what you mean by 'the culprit in any meaningful way'.

Meaning, they got in on it late in the game, and didn't have anything to do with the secondary market in CDOs.

But I'm not at all comfortable with the spin that they weren't part of the problem--they clearly were.

Yes, they were part of the problem in small, secondary ways. They hopped in on the bubble after it was inflated, and didn't have anything to do with the mortgage securities devised by Wall St. that led to the financial meltdown.

The biggest story is the financial meltdown brought on by CDOs. The second part is the housing bubble, brought on by a number of factors, none of which is Fannie/Freddie or the CRA. However, once inflated, Fannie/Freddie hopped in and helped keep it pumped up.

That's the summary.

[John Thullen]

goodoleboy:

"Of course, we were always told it would never be a taxpayer issue."

Yes, I suppose some said that, but Peter Lynch, formerly of Fidelity's Magellan Fund and champion of Fannie and Freddie knew there was an implicit government guarantee underlying the Mae sisters, when he invested in them years ago.

As did Warren Buffet.

I knew it too at the time I owned Fannie Mae common years ago.

Everyone did. Tell me one half-way knowledgeable person who didn't.

Now, the statement "we were always told it would never be a taxpayer issue" applied 100% to Citigroup, Bankamerica, Goldman Sachs, Morgan Stanley, etc, etc, ad nauseum .... until it became one .... under George W. Bush's TARP (Obama was in the room)

Which, at the time, I favored.

(this next is not directed goodoleboy's way)

But now that the cowboys running the latter thieving outfits have turned on the government that barely saved the world (maybe not for long) financial system from their depredations, and now that traitorous hedge-fund managers and their hookers who were served $500 fois gras and white truffle Kobe Beef burgers adorned with edible gold leaf as they traded the pure sh*t paper that nearly brought all of us down are meeting today, as we speak, to defeat Democrats, the latter having been begged on bended knee by Republican Treasury (Goldman Sachs) Secretary Paulson to pass the TARP (one of these hedgefund scum, the sub-human Eric Bolling, now spends his time on FOX peddling the Obama is a Muslim meme, among other of Goebbels' BIG Lies), I have changed my mind.

I wish now the entire banking edifice had collapsed into dust like the WTC without government help. Not a single large bank or investment should have survived and further, the government should have let the toxic paper just lie there.

I suspect the homeless Tea Party zombies and raving lunatics would by now have literally hacked the banker and hedgefund zombies to death --(they are natural enemies, if you examine the rhetoric) .. in the streets.

The rest of the country would be a smoking ruin, because other than a few community banks and credit unions, if even those, there would be no banking system -- zilch.

The market would have won. Purity and death.

I'm dying see what that would look like, since so many recommend it as man's natural order.

Lenny Dykstra for Congress. It could happen.

The perfect symbiosis of Wall Street fraud and Tea Party crank demagogue.

[John Thullen]

"Why did they need to stay competitive?"

"Why did they want more market share...?"

Ah, cripes, Sebastian, I hate it when you play naive. ;)))

Because the shareholders, including hundreds of money managers, pension fund managers, Wall Street analysts and hedge fund managers of these publicly traded corporations, which had implicit government guarantees, demanded it, that's why.

Because the management and the boards of directors were beholden to shareholders, not taxpayers, to our misfortune.

Now, one can argue that this hybrid arrangement was a bad idea, but I'd have liked to have sat in on an investor conference call with Fannie Mae, for example, in which Franklin Raines explained demurely to various sharks that the company would not chase market share and would not further endanger taxpayers by remaining competitive.

The stocks would have gone to $0.63 in a week and then, what, callloo, callay .. the mortgage buble never would have happeded?

No, the purely non-governmenetal players would have taken all market share and inflated that bubble even further than it ultimately went.

This internet thingy with all its info, does it work?

[John Thullen]

One thing about rants ... the spelling always suffers.

Sorry.

[John Thullen]

Ugh:

Geithner said: "These two strategies were pursued to maximize short-term returns to shareholders and senior management. They were possible only because of the toxic combination of a perceived guarantee by the government and an abscence of effective oversight."

Well, O.K.

But other entities WITHOUT a perceived guarantee by the government and with a lack of effective oversight pursued the same suicidal path.

In the 1920s, before there was any effective government guarantee, human nature carried everyone over the cliff too.

[Tony P.]

Lenny Dykstra for Congress. It could happen.

Let it happen, says I.

It's a lead-pipe cinch that 9% of Americans won't have a job to go to on election day. They will be entirely at leisure to turn out at the polls. The ridiculous thing is that half or more of them will vote for Republicans. If not for that ridiculous thing, the GOP would be toast: you can't win the House or Senate if you spot the opposition 9% of the vote.

But what will we get if the Dems manage to hold on? Simple: a Democratic party cowering like a frightened puppy, too scared to bite the hand that just tried to slap it with a rolled-up newspaper. A whimpering, simpering thing, too relieved at having survived a close call to do anything but roll over and beg for a tummy scratch from the GOP.

Sometimes, you have to destroy the hamlet in order to save it.
Vote Republican.

--TP

[GoodOleBoy]

Didn't Fannie and Freddie already enjoy a competitive advantage from their ability to borrow at more favorable rates than their market competitors and from their obvious influential relationship with key congressional banking committee members? They never were chartered to capture market share, but to fill perceived gaps in the market. As Thullen said, we got warnings when they went public. That's when the perception of safety changed. I don't wish financial losses on anyone but shareholders, many of whom went in thinking there was an extra measure of safety, suffered appropriately. I think what really rankles ordinary Americans is to see the great and elite ivy-league educated financial management 'experts' not have a clue when it comes to the assets they have been entrusted and paid to care for, but somehow they don't walk away broke like the rest of us.

I think it really boils down to the fact that their senior executives are cut from the same cloth as the Wall Street guys. And no matter how much expertise is claimed or how much expertise is supposedly bought with compensation, they are in it for what they can take out and if the shareholders, bondholders, and taxpayers are not vigilant at every step, they will be raped and robbed.

[Tony P.]

I think what really rankles ordinary Americans is to see the great and elite ivy-league educated financial management 'experts' not have a clue when it comes to the assets they have been entrusted and paid to care for, but somehow they don't walk away broke like the rest of us.

And they deserve to keep their tax cuts, too!

--TP

[Marty]

I haven't read the comments here but...YOU always link poor and minorities with any discussion of Fannie and Freddie. There are lots of us conservatives that think Fannie and freddie had a lot to do with the housing but that it has nothing to do with poor and minorities. The mortgages that they were handing out eventually included mortgages up to 750k, with little to no down payment. The relaxation of the rules for Fannie and Freddie also had the effect of banks relaxing rules for qualification across the board.

You can quote as many post mortem revisionists that you want, but the impact of the government backed mortgage requirements being relaxed cause a ripple effect that was fundamental to the risks being taken by the non governmental mortgage makers.

Note that not once in that explanation did I comment on the fact that any of them were poor or a minority. In fact, the problems, even at Fannie and Freddie, were the people who simply bought more house than they could afford in an already overpriced market.

[Troy]

The relaxation of the rules for Fannie and Freddie also had the effect of banks relaxing rules for qualification across the board.

This really isn't in evidence.

Conforming limits were chasing the market not setting them. The market peaked in 2006 but the conforming limit was raised from $417K to $730K two years later. It was a palliative not an accelerant.

What WAS propelling the market up was:

1) late 90's wagebase increases / the $500K capital gain change
2) 2001-2003 tax cuts resulted in more purchasing power across the board
3) 2000-2003 rate cuts -- 30 year fixed went from 8% to 5.5%
4) Option-ARM, Negative-Am, NINJA/SISA risk layering
5) mid 2000's wage increases due to bubble-spending (feedback effect #1)
6) the momentum of a bubble (feedback effect #2)

GSE was marginal.

[Sebastian]

"Conforming limits were chasing the market not setting them."

along with the idea of Fannie/Freddie being the culprit....

Both ideas look at markets as static entities. As if there was one thing starting an issue, and that is the whole story.

The market is a large dynamic feedback loop. Most of the time that is its strength, but sometimes the feedback loops get out of control. Certain kinds of out of control feedback loops are called bubbles. Other kinds of out of control feedback loops are called depressions. When F & F were buying sketchy loans in 2004, true they weren't 'orginating' the sketchy loans--they didn't do that until about 2007. But they were providing a large push in the positive feedback loop to aid those who were. And they did that much earlier.

[McKinneyTexas]

Good chat, folks. Not my area at all, but fascinating.

Another smart person I know mentioned derivatives as playing a major role in all of this. Does anyone have a useful, comprehensible definition of a derivative and an executive summary of the role they played in bringing down the house?

Thanks.

[Sebastian]

'Derivatives' are really too general of a concept (an agreement to have a price settled by the underlying price of something else).

What the person you know probably mean is that some derivatives allowed high leveraging (trading while only paying for a portion of the total price) allowing people to make massive bets which caused even more massive debts when the market finally crashed.

[Phil]

There are lots of us conservatives that think Fannie and freddie had a lot to do with the housing but that it has nothing to do with poor and minorities. The mortgages that they were handing out eventually included mortgages up to 750k, with little to no down payment.

And we all know Negroes and Latinos aren't buying any $750k houses, am I right? (wink, wink)

[Eric Martin]

There are lots of us conservatives that think Fannie and freddie had a lot to do with the housing but that it has nothing to do with poor and minorities.

But YOUR not the types of conservatives driving the national messaging on this issue.

For them, it's all about poor and minorities.

Marty, you and McTex and Seb (though he's not really GOP any more) are very reasonable people, and so I'm sure that some of this stuff grates on your nerves because you're above it (as right leaning folks, your critiques are otherwise).

However, due to the ubiquity of these nasty memes, I sometimes feel compelled to smack them down.

If you feel it is unnecessary, I appreciate that for you it is, but in this country, it is actually quite the controversey due to conservative/GOP pundits and pols. Not me.

[Eric Martin]

What the person you know probably mean is that some derivatives allowed high leveraging (trading while only paying for a portion of the total price) allowing people to make massive bets which caused even more massive debts when the market finally crashed.

Adding to what Seb said, the derivatives were often comprised of (or better yet based on) very shaky loan instruments, that would not receive high ratings on their own. However, the big banks combined them into tranches, and the ratings agencies (not wanting to lose the banks' business) gave the tranches triple A ratings (even though the underlying securities were junk rated).

The AAA ratings then allowed pensions and other regulated retirement funds and investment vehicles to purchase these tranches (whereas they would not have been able to with sub-AAA).

This allowed the rot of the derivatives to stretch far and wide, from State pension fund ledgers, to AIG (which sold insurance against default for such loans) and key banks.

The total bill was in the trillions - a higher tally, in fact, than the actual loss of value caused by the bursting of the housing bubble.

[Eric Martin]

Phil, that was really unfair.

It can't both be about poor minorities, and high end housing. Marty was debunking the meme, not expressing a racial judgment.

[Slartibartfast]

Another smart person I know mentioned derivatives as playing a major role in all of this.

A friend of mine explained it this way: with or without the derivatives being involved, the root cause of the crash was speculation, enabled by lending institutions allowing speculators to buy with very little of their own money at stake.

Which is, if you think about it, very similar to what caused the run-up and crash of the stock market back in 1929: not necessarily a HUGE inflation in valuation, but rather over-leveraging by speculative buyers coupled with a slowing in the rate of growth.

All of which is probably arguable and probably has already been argued. The fact that the over-leveraging of debt was hidden in derivatives just compounded the problem.

At some point (and I admit my knowledge in this area is overly thin) regulation was introduced to limit stock purchaser's use of brokerage/bank funds to absorb risk for them. I think we're likely to see some of that, or we'll just see banks require more down payment and pay more attention to getting a valid appraisal. For a while, until it looks like the coast is clear; then it'll be back to making the same old mistakes.

[GoodOleBoy]

'If you feel it is unnecessary, I appreciate that for you it is, but in this country, it is actually quite the controversey due to conservative/GOP pundits and pols. Not me.'

'Phil, that was really unfair.

It can't both be about poor minorities, and high end housing. Marty was debunking the meme, not expressing a racial judgment.'

Eric, I appreciate your having made these two comments, they have been needed for a while. I haven't heard a lot of defense of GOP here even though the more conservative commenters have political opinions that frequently coincide with positions 'stated' to be those of GOP elected officials or candidates. Many individuals hold conservative views without having any of the bigoted positions almost automatically attributed to them because of their conservative political and/or economic views.

I usually try to ignore the personal attacks that result when I comment on a matter that causes someone here to read more into the comment than is there, namely the bigoted viewpoints of someone else who is known to hold conservative views or the fact that the specific topic under discussion is one with a long association with discrimination, such as CRA.

[Marty]

Eric, Thanks and I understand the meme to be addressed but in the last few posts on the subject I have found that even most of the referenced material is just liberal bloggers discussing it among themselves.

The closest thing to a conservative making it a point was this working paper that stresses my point in its opening paragraph, the problem started in the late 90's and it was the systemic lowering of criteria started by the CRA that increased the risk of the mortgage pool overall. Laid out again in this Business Insider piece a year ago.

It really becomes a question of whether the earlier CRA decisions prompted the broader lowering of standards or you just want to count the loans they bought post 2005. I believe the CRA changes prompted the banks to add more risky mortgages to their portfolios. Others think the banks, in the early 2000's, just decided to do this and then Fannie and Freddie jumped in.

Either way, I don't see a bunch of conservatives out pushing this story, so I wonder why, each time it is brought up.

[Sebastian]

"Marty, you and McTex and Seb (though he's not really GOP any more) are very reasonable people, and so I'm sure that some of this stuff grates on your nerves because you're above it (as right leaning folks, your critiques are otherwise).

However, due to the ubiquity of these nasty memes, I sometimes feel compelled to smack them down."

I appreciate this, and while it does grate on my nerves I also see that you are right to feel compelled to smack them down. So thank you for that.

My feeling (in this forum) is that someone also needs to draw attention to the additional danger of over-debunking.

F & F were a part of what let the housing bubble get so big. Especially toward the end, when the big private firms were finally getting worried (though Countrywide was careening crazily and often fraudulently toward disaster) F & F enabled the bubble to keep getting bigger anyway by its entry into the 'complicated' loans market. And even earlier than that, F & F had enabled the bubble to grow by being one of the major ultimate buyers of questionable loans such that the private originators didn't have to worry very much about holding on to them very long. Neither point are particularly well addressed in the article you cite, which is why I wanted to mention it.

The reason I think this is important is because the actions of F & F are well in line with what I expect your average government intervention to look like in bubbles involving things that intersect with government goals.

The goal of creating F & F was something like: the market is not getting loans to all the people who can reasonably buy and hold on to a home. We want to encourage home ownership, so we will create something that can get these people loans.

Instead of realizing that their decline in market share was because their goal had been met (at least for the time being), they decided to try to increase their market share by engaging in loans that were well beyond the social goal of their government mandate.

That is why I'm skeptical that government would have popped the bubble.

(I also think that the housing crisis portion sometimes gets overplayed. AIG and the big banks were doing other highly questionable things which were likely to cause trouble even if the underlying commodity were something other than houses.)

[DecidedFenceSitter]

McKinney,

Thanks to writing up in 2008ish a paper on Derivatives, CDOs, Credit Default swaps, and other items I know more than I ever want to know.

For the housing bubble in a cohesive, basic form, I suggest this video on the Crisis of Credit.

Here's a brief excerpt from my paper to explain the two basic branches of derivatives:

Derivatives, in and of themselves, have no inherent value, they instead derive their value from other items - a tangible commodity such as wheat, oil, or cotton, or the notional accepted value of a packaged financial vehicle like mortgage loans. It is easiest to contemplate there being two types of derivatives, the good derivatives, or derivative securities, and the bad derivatives, or over the counter (OTC) derivatives. The safer derivatives are those quoted on the numerous derivative stock exchanges, and are driven by real world considerations to alleviate risk, such as the purchase of wheat futures, where the farmer has an assurance of selling at least some of his wheat harvest at a set price; and the purchaser has an assurance of purchasing some wheat at a set price, and with a set price both parties can make plans and simulations about the future. Without these sorts of assurances, neither party would be able to create solid business plans and models.

Risky derivatives, on the other hand, derive their value from nothing tangible. Instead, these are sold “over the counter” by banks. Without the basis in real world tangible goods, such as wheat, oil, soybeans, or any sort of other commodity, these OTC derivatives are marketed through trust relationships to corporate customers and hedge funds and are a great gamble. With no easily discernable value to back them, bad derivatives can collapse far more quickly and thoroughly, taking the economy with them. Until recently, with the implosion of hedge fund companies and banks world wide, few people understood the risks involved; however, risk awareness is growing as items come to light such as the fact that “At least a portion of the $30bn (GBP15bn) soft loan given by the US Treasury to support Bear Stearns's "less liquid positions" related to the mountain of derivatives it had written” (Blair, 2008).

[wj]

Does anyone have a useful, comprehensible definition of a derivative

To summarize what FenceSitter said, there are two kinds of derivatives:
1) insurance (against the price of something changing in a direction that hurts the buyer),
2) a bet (against that price changing that way).

As may be obvious, they are mirror images of each other. To give a more familiar example, when you buy life insurance, you are insuring against dying earlier than expected. And the insurance company is betting that you will live longer than that. It's just that, instead of a derivative on the price of corn or oil, they are a derivative on length of life.

[LongHairedWeirdo]

Re: derivatives, it's not *specifically* derivatives. The biggest issue (as I understand it) was a particular derivative, the Credit Default Swap.

But first, a digression.

Imagine you offer me a contract. In 20 days, you want the right to buy my Microsoft stock for $30 a share. What's a good market value for that?

Well, right now, it's trading at under $25. Still, I assume you know something. I'm going to charge you some nominal fee. The contract is almost valueless (assuming you don't have insider knowledge).

Now, what if you offer a contract for the right to buy my Microsoft stock at $20 a share? Well, the value of that contract is at least $3.93 a share - it's trading at 23.93, per a quick quote from the web.

This contract is a derivative - its value rises or falls based upon the price of Microsoft stock. If Microsoft stock were to zoom up to $50 a share, a contract for the right to buy it at $30 is worth at least $20 a share. If it were to fall below $30, it would be worthless.

So, that's a derivative. The contract to buy stock at a price derives its value from something else - the stock price.

So: what caused the big meltdown? Credit Default Swaps.

Let's say you think that a certain bond at 7% is a *damn* good value. But you realize that you can't afford to lose your principle if the company goes bankrupt. A Credit Default Swap is where you go to an investor and say "I'll pay you a fee and, if this bond defaults, you give me its face value."

The value of a CDS depends on two things: the fee that gets paid, and the creditworthiness of the bond issuer. As long as the underlying bonds don't default, it's free money (less administrative costs). If they do default, well, CDS issuer takes a major bath. So, they have to charge enough to take into account the risk of a default. Issue enough CDSes and it's just like life insurance - sure, some bonds default, but others don't, and the CDS issuer make a nice, steady profit.

Here's the problem: there was little to no regulation. If you were issuing life insurance, you had to keep reserves on hand to pay out in case of some natural disaster, based upon assumptions. And you might have to provide some reason for taking out an insurance policy on someone - insurers are a bit funny about you using life insurance as a lottery.

With CDSes, there was no such regulation.

So, insurers didn't need to keep reserves based upon the likelihood of defaults - they could hold so many CDSes that they could be on the hook for more assets than they could cover.

And, people didn't just insure bonds that they owned. They did use CDSes as lottery tickets.

Here's one hilarious thing. Why were CDSes so horrible? Because the fee was too low. People should have charged a lot more for them.

Why didn't they?

Because the bonds had AAA ratings - these were *prime* bonds, they weren't going to default!

Why were they AAA rated?

(I need to assure you - I'm *not* kidding here!)

Because the rating companies had no idea how to rate them, so they based their rating on the price of a credit default swap. It was low, so they got a AAA rating. Surely the insurers knew how to determine the risk of these things!

CDSes are what killed AIG. They issued too many CDSes at too low a price.

[John Thullen]

Too big of an elephant, not enough hands on the blind men.

I'm going to do some reading on all of this, so I hope we have further posts on the subject. I've recently finished Randall Lane's "The Zeros", which explains nothing of the underlying catastrophe, but rather parades the cast of larcenous pond scum who floated to the top near the end to act as pilot fish, feeding on the sharks as they consumed the world. (Really, it's a story: I've mentioned Lenny Dyskstra, but the artist Peter Max, Henry Hill (yeah, the Goodfella himself, out from witness protection, nursing drug addiction, dodging the mob), Steve Cohen (Google what he was doing this week), John McCain (high-stakes craps player), and a cast of hundreds of absolute f*ckers.

Randall Lane is to The Zeros what Henry Hill was to Goodfellas -- their self-serving but vastly entertaining Boswell -- but, I don't trust him either.

But two things: first, wj's explanation of insurance and bets as two types of derivatives: there were derivatives (bets) on underlying assets, which then were insured via insurance derivatives, and then the insurance derivatives were traded and bet on via another layer of derivatives. Am I wrong?

Second: Drawing a line between the Community Reinvestment Act and the housing catastrophe and all of the intervening chicanery seems to me to be like saying the Red Cross shouldn't stockpile blood plasma because it might produce an infestation of vampires. I don't think the link even deserves the title of "unintended consequence", as if having vampires around should prevent us from provideding blood transfusions.

Marty: "Either way, I don't see a bunch of conservatives out pushing this story, so I wonder why each time it is brought up."

Really? An entire political movement (I'm holding my tongue) is born under our very eyes, the Tea Party, hatched from a comment by CNBC commentator and bond trader Rick Santelli (YouTubed ad nauseum) regarding the your neighbors defaulting and stealing from you, and astroturfed by Republican Party TARP-hater Dick Armey and you wonder why it's brought up.

Does Obsidian Wing's exist outside of Funk and Wagnell's hermetically-sealed mayonnaise jar?

You have hedge-fund traders, like the monied elitist Steve Cohen mentioned above and Eric Bolling, hedge-fund trader now FOX business commentator lying the big Lies about Barack Obama and making common cause with the scum rabble, the Tea Party.

It's like the sick in need of a blood transfusion (the Tea Party) handing over their Red-Cross procured blood to the vampires.

It's like the fictional Madame Defarge (the Tea Party) being offered a job as King Louis XIV's court courtesan for a crust of bread. The King gets to keep his head and receive a free blow job as well.

Just today, you have tens of thousands of veterans in fatigues at an anti-government rally on the Washington (let's leave aside for a moment Glenn Beck's and Sarah Palin's disgusting (again, I hold my tongue) attempted hijacking of the civil rights movement) protesting among all of their other effing grievances, taxes and government spending.

Nest Tuesday, of course, these same scum have an appointment at their local VA hospital to steal my money.

[John Thullen]

Re Fannie and Freddie: Google modeledbehavior.com/2010/08/27/fannie-freddie-acquitted

On the Washington gathering of the self-righteous today: let me add that the fact that Al Sharpton led the counter rally is a disgrace.

We're in the hands of lethal crazy people.

It will end very, very badly.

[a]

That's just spin. The report you linked to demonstrated that F&F indeed were involved in creating and expanding the housing bubble.

[Snarki, child of Loki]

I'm not at all surprised that F&F lowered their standards as their market share started to slip. That's classic shortsighted behavior, with a classically-bad result. That doesn't mean that the mess was F&F's "fault", but they did some enabling of it.

Another example: hurricane insurance. One company cuts rates to get more market share, and the others either have to follow suit or get out of the business. Rationally, they should get out if the rates don't cover their risk, but that's their business line, dammit, and besides there hasn't been a big hurricane in the last few years. And down the insurance rates drift, until WHAM and suddenly there's a huge crisis.

F&F *should* have kept their standards up; I'm not sure whether that would have triggered a housing crisis earlier (milder?). But they followed a well-trodden path to the edge of the cliff.

[John Thullen]

a: Make of it what you will. The extent to which Fannie Mae and Freddie Mac lowered their standards, as Snarki points out, was a response to the ever-touted "incentives" of the market.

IMO, had Congress and the Boards of Mae and Mac decided to forgo market share and adhere to their public functions, those public functions would have been under no less attack from the usual suspects.

But, hey, for the next big scam from the world-destroyers, go to International Economy.com and read (hat tip to Alan Abelson, columnist for Barron's) Harold Malmgren's and Mark Stys' "The Marginalizing of the Individual Investor".

High Frequency Trading -- natch, the gummint is way behind the curve on this grift, but no doubt will be blamed by the usual suspects when HFT takes what's left of your money from the mortgage debacle.

Read Abelson's column this week, too.

I suspect the big hedge fund managers and institutions who are marginalizing individual investors (commie liberal ones and Tea Party types alike) are lining up against the Democratic Party this Fall because they foresee that this new gigantic grift will be in Progressive regulatory sights next year.

I wouldn't be surprised either if we get a real good ginned-up Black Swan event up our market wazoos this Fall -- with the blame pointed right at Obama by the trading institutions and hedge fund folks for threatening to regulate and from the Tea Party types for not saving them from the banks and the hedge fund operators.

Either way, Madame Defarge and King Louis XIV will work together to take down the President and the Democratic Congress.

[John Thullen]

... and, remember, as Glenn Beck has said, "there will have rivers of blood" if we don't follow his 9 values and 12 principles, which I suspect include NOT regulating high-frequency trading (if you read the small-print 712 footnotes to the 9 values and 12 principles).

[Lewis Carroll]

There WERE attempts to limit F and F's exposure to dodgy RE paper, but they were not exactly received enthusiastically by those in power at the time:

http://www.ft.com/cms/s/0/8780c35e-7e91-11dd-b1af-000077b07658.html

[Lewis Carroll]

I should add that, setting aside the larger question of whether and to what extent the gov should be involved in the housing market at all, anyone can take a look at the summary of the proposed legislation and decide whether it would have protected F and F from meltdown.

That summary is here: http://thomas.loc.gov/cgi-bin/bdquery/z?d109:HR01461:@@@D&summ2=m&

I should say that right now I'm reading Yves Smith's book, and I'm skeptical that the legislation would have prevented the financial collapse, and skeptical that F and F were a major cause of the collapse anyway.

[Marty]

Black Swan is almost assured so cash it is until after the election.
It's hard to imagine that the leadership of the financial sector wouldn't go out of their way to make this administration look bad.

[Phil]

Off -topic, but I'd like to see one of our resident "It's too close to Ground Zero and that's the only reason people are protesting it" folks comment on this:

Federal officials are investigating a fire that started overnight at the site of a new Islamic center in a Nashville suburb.

Ben Goodwin of the Rutherford County Sheriff's Department confirmed to CBS Affiliate WTVF that the fire, which burned construction equipment at the future site of the Islamic Center of Murfreesboro, is being ruled as arson.

Special Agent Andy Anderson of the federal Bureau of Alcohol, Tobacco, Firearms and Explosives told CBS News that the fire destroyed one piece of construction equipment and damaged three others. Gas was poured over the equipment to start the fire, Anderson said.

Lots more at the article, which closes with this charming quote that makes me want to buy a shotgun posthaste: At one such prayer vigil, WTVF reported opponents speaking out against construction.

"No mosque in Murfreesboro. I don't want it. I don't want them here," Evy Summers said to WTVF. "Go start their own country overseas somewhere. This is a Christian country. It was based on Christianity."

[bobbyp]

"Black Swan is almost assured..."

Come on, Marty. Just WTF does this mean...that you assign a high probability to a future event that is more than 3 standard deviations off the mean? I mean really, what does your strategy have to do with black swans?

And why cash? Cash is a creation of the Fed, backed by nothing but a promise to pay, well, more of it. Are you predicting a general asset value collapse?

And the financial sector has a political agenda? Who the f*** would have ever posited such a thing?

You communist.

[Jeff Blanks]

@Tony P:

The Democrats did almost nothing in '93 and '94 except get the ball rolling budget-wise, and they paid for it by losing both houses of Congress in '94, because the GOP had at least something that looked like a platform. The Dems at least did something this time, and if they hold onto at least one house of Congress this time, they need to have the difference impressed upon them. They're running scared because they don't know why they lost in '94.

[McKinneyTexas]

Thanks for the very useful and informative background info. I read it over the weekend on my BB but can only just now thank everyone for their help. This thread will make a useful background source for future discussions.

[John Thullen]

It should be Louis the XVI, as in Sixteenth.

Louis Louis.

[John Thullen]

More on the toxic, fascist nexus of the Tea Party and the hedge fund "community", from Newsweek:

'President Obama and the business community have been at odds for months. But in July the chairman and cofounder of the Blackstone Group, one of the world’s largest private-equity firms, amped up the rhetoric. Stephen Schwarzman—the leading John McCain supporter in a firm that, in 2008, gave more money to Obama—was addressing board members of a nonprofit organization when he let loose. “It’s a war,” Schwarzman said of the struggle with the administration over increasing taxes on private-equity firms. “It’s like when Hitler invaded Poland in 1939.” '

Meanwhile, over at RedMurder, the violence-prone Kenny Solomon spreads rumors (to call them baseless would be like petting Error Irksomely's goat) that the Social Security Administration is holding a meeting this week at which they will lay out their plan to confiscate all 401ks.

In comments, Solomon and the usual suspects lay out their plans to murder liberals and everyone in the Federal government.

Moe Lane wades in and chastizes everyone regarding the posting rules, pointing out that he has an aunt who is liberal, and if they don't spare her during the coming pogrom, he's going to sulk about the attention taken away from killing Muslims.

No, he doesn't. He's trolling another thread on the lookout for actionable grammatical errors.

Error Irksomely, meanwhile, whispers into his goat's ear and takes it by the by the horns at one end and holds it still while David Vitter, pants in a puddle at his feet, administers a free rogering to the poor animal.

Hide the children.

Murder is afoot in America.`

[ral]

It should be Louis the XVI, as in Sixteenth.

He has had a long journey and miscounted.

[hairshirthedonist]

McKinney, here's an interesting article I read a while back. Someone here may have even linked to it at the time. I don't remember. In any case, it's a good read and will give you some additional insight into the mess now under discussion.

http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all

[hairshirthedonist]

Here's an excerpt, which I should have provided with the link. (Why do I think someone will find something interesting just because I say it is?)

For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

[wj]

bobby, what actually backs the currency is this: There is a line printed on each bill: "This note is legal tender for all debts, public and private."

What that means IIRC is, if you want to buy anything, and you offer the seller a piece of US currency he can either accept it or not. But, having "tendered" it, you get the item regardless. Plus, when you owe taxes, you get to pay them in the currency as well.

So, while the currency may not be "backed by something," it does have a defined and specific utility.

[Bernard Yomtov]

DFS,

The potential problems with OTC derivatives do not stem from the fact that they are not based on actual commodities. Lots of OTC derivatives are in fact based on the same sorts of underlying assets that exchange-traded derivatives are based on.

The big advantages of exchange-traded derivatives are that they reduce what is called counterparty risk, and they are "transparent," - the prices are public knowledge.

Counterparty risk is what it sounds like - the risk that the party on the other side of your bet won't pay. This is reduced because the exchange members form what is called a "clearing corporation," which takes the other side of all trades.

Suppose you agree, today, to buy a carload of wheat from someone in December for $1000 (made-up price). Obviously, there is a seller somewhere. What happens is that at the end of the day the clearing corporation steps in and takes the other side of both trades. Instead of having a contract with a seller you don't know and never heard of you now have a contract with the corporation, which is backed by exchange members, and so does the seller. You don't have to worry about the seller reneging.

Price transparency is what it sounds like. It's that ticker that shows every price, so you know what the market is doing before you trade.

Unfortunately, this has a cost. The contracts need to be highly standardized, in terms of the underlying asset, quantities, delivery dates, etc. That means they don't necessarily match the hedge you want. Enter OTC derivatives, which have lots more flexibility. You deal with a big solid bank, like Lehman or Bear Stearns, and they find someone to take the other side of your propsition (or they take it themselves, sometimes) and charge a spread.

[Rob in CT]

Can someone explain to me why we have these hybrid private/public entities? Why can't they simply be government agencies (given their mission, full privitization doesn't make sense).

[John Thullen]

Rob in CT:

Fannie Mae was started as a fully governmental entity in 1938. LBJ converted Fannie Mae to a private/public (implicit government guarantee) entity to get it off the government's books because he had blown the budget out of the water (mildly, compared to now) with the costs of the Vietnam War.

Freddie Mac came along just a few years later ostensibly to compete with Fannie Mae.

www.newyorker.com/talk/financial/.../080728ta_talk_surowiecki

Also, see Wikipedia.

That's the skeletal story supplied by the internet -- there's got to be some books about the history of these enterprises.

[Marty]

Bobbyp,

Because I say so, yes things will be worth less, well I would and of course I am a life long left winger.

[John Thullen]

This comment today from a MarketWatch news article after the market close (down another 140 points) from one of the commie pinko money managers on Wall Street.

And you guys though Marty was bad.

"The market is having a bit of a temper tantrum, saying businesses should step up and start hiring people or we need one more shot of stimulus," said Burt White, chief investment officer at LPL Financial."

[Ugh]

I think the market needs a time-out and should go stand in the corner to think about what it has done, otherwise it's going to get the invisible hand.

[Ugh]

DJIA on 9/6/2005: 10,679
DJIA on 8/30/2010: 10,010.
Total five year return: -6.265%

DJIA on 9/5/2000: 11,221
Total ten year return: -10.8%

My money market is currently paying 0.03%. A one-year, "high-yield" CD from BofA will net you...0.7%. 30 year t-bill is 3.84%.

Wheeeeee!

[Tony P.]

If we were not all wimps, those of us who are getting 0.5% on our money would team up with those of us paying 25% on our credit cards and split the banksters' vigorish between us. Just a thought.

Now a question: why is Alan Simpson bulletproof, but Elizabeth Warren too controversial? I am particularly interested in the conservatives' answer to the second half of that question.

--TP

[John Thullen]

I don't think the conservatives who need to answer the question frequent Obsidian Wings.

As for the answer, I suspect it has something to do with tits.

Simpson has always shot his mouth off like a cantankerous Mr Magoo in the early stages of dementia and folks find it charming in a countrified sort of way, like stepping in a cowpie and wiping it off on the drapes in the parlour, while the little lady has her back turned.

If they filmed a remake of "Dr. Strangelove", he'd be cast in the Slim Pickens role.

The President should fire him, but then I was looking at the other truly crazy Republicans appointed to the SS Commission --Paul Ryan, Jeb Hensarling, etc, and it makes you wonder what the game is.

Howard Baker wasn't available? Heck, James Baker would have been better than most of the conservative Democrats sitting on the panel.

It's a little bit funny, this feeling inside, to hear Obama accused of Stalinism by the same cracker types he named to the Commission.

Speaking of the 310 million tits Simpson referenced, if you total up his Federal pension, health care benefits and Medicare coverage, his sucking alone is responsible for most of the mastitus infections in America.

[Savana]

It is important to serve the families with low income as, they are fighting for the resources that will be beneficial for them to get better rights.

[bobbyp]

wj,

I was being sarcastic.

marty,

You're a lefty? Outrageous. Tell me, why have we not imprisoned James K. Glassman and Lawrence Yun?

:)