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The biggest lie of the financial collapse

by Eric Ferguson on April 5, 2009 · 3 comments

Cross-posted at Ravensblog

The biggest lie of the collapse of the financial industry is we can’t understand it. It’s supposedly so complex, only the Wall Street high rollers can figure it out, and they can’t be bothered with the anger of the wee folk in the hinterlands, by which I mean those of us more than a couple blocks from Merrill Lynch HQ. Can we understand this stuff? Can I get a “Yes We Can!”, because we can understand this stuff. It’s not intuitive certainly, and a bit of homework is required, but please don’t think for a second you have to take some CNBC pundit’s word for anything.

So fellow wee folk, I hardly propose to explain everything about the banking crisis in a blog post, but I do propose to explain a couple terms you’ve have probably heard but not heard explained, just to prove that you can understand what’s going on.  
A collateralized debt obligation (CDO) is basically of bunch of debts bundled together. Instead of buying one mortgage, paying off the lender in exchange for the right to collect the balance, some companies bought a bunch of mortgages, stuck them together, and sold them as a CDO. Supposedly this reduced risk because whereas buying one mortgage meant losing the whole investment if the borrower couldn’t pay and the house couldn’t be sold, buying a CDO meant losing only a little of the investment if one mortgage went bad. Buyers could even buy pieces of CDOs, so they owned a fraction of many different debts. Great idea, provided almost all those mortgages were low risk, which is what buyers of CDOs assumed. However, the demand for CDOs meant lenders lent to riskier and riskier borrowers in order to generate the mortgages they resold, so the CDOs were full of bad debts.

A credit default swap (CDS) is an insurance policy on a debt. Let’s say you grant a mortgage but you have doubts the borrower will pay it off, or you buy corporate bonds but you have doubts the corporation will pay them off. You buy a CDS, and pay the insurer a premium, which obligates the insurer to pay back the debt if the debtor defaults. So when the corporation goes into bankruptcy and doesn’t pay its bondholders, the bondholders go to the insurance company and ask for their money. This is great for the insurance company if almost all the debtors are good for it, and great for the CDS buyer if the debtor defaults. Of course, if lots of debtors default, as happened, and the insurer assumed it wouldn’t have to pay off on many policies and didn’t keep any cash on hand, as happened, there is a crisis.

One more concept if I may, but again you’ll see you can understand this. You may have heard the term “naked” like in “naked CDS”. It means basically making a bet without putting up any money. A naked CDS was purchased by someone who did not own that which they insured, so they would not lose their investment if a debt went bad, but they did hope to get paid off by the insurer. It would be as if we could buy fire insurance on someone else’s house, perhaps thinking it was a firetrap that was likely to burn, so if it burns we get paid the value of the house, but if it doesn’t, we lose our premiums. So we go to an insurance company to buy a policy on someone else’s house, and they think it won’t ever burn, and sell us the policy. Thinking this is easy money, they sell insurance on that house to ten people, even though, if it burns, they can pay off only one or two, which means they’re insolvent, and all their policy holders suddenly have no insurance on their houses. You can see why this shouldn’t be legal. It is legal with CDSs however.

So CDOs have gone bad in huge numbers, AIG can’t pay off more than a tiny fraction of the CDSs they sold on those CDOs, so CDS buyers can’t get paid when their CDOs go bad, so their risk is suddenly much higher, and the greater risk makes their CDOs worth much less. Those counting the former value of their CDOs among their assets find they may not have enough assets to stay in business.

And yes, there’s more to it than that. Much more; this was just the start. I never said it was easy, just comprehensible. So now comes the homework.

The best explanation of how the subprime mortgage market grew and blew up was broadcast on This American Life, The Giant Pool of Money. In fact, this American Life has been the single best source for understanding how the mortgage industry devolved into such a crisis. They followed that first program with Another Frightening Show About the Economy and Bad Bank. They have transcripts for those just not into audio, and MPR carries the program at 3 PM Saturday and 8 PM Sunday.

To understand just what AIG did to bring so much anger upon itself, read Matt Taibi’s article at Rolling Stone, The Big Takeover. You’ll get angry at what the people at the top of Wall Street were pulling and are pulling, but more important, you’ll understand it. Then reward yourself with a treat: you knew something was wrong about AIG exec Jake DeSantis complaining of his bad treatment over his bonus, but it was hard to put your finger on it. Taibbi put his whole fist on it.

Feel free to add more useful explanations for laymen in the comments.

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