Wall St., Credit Default Swaps, Glass-Steagall, The Subprime Crisis . . . & Black Tuesday

"September 30 is the day when positions unwind and this is when the pain on Main Street will really start."

That dire prediction comes from Dinah Lord. Ms. Lord is a blogging friend who spent her formative years as a trader on Wall St. She has been kind enough to do a post explaining the role of deregulation of the finanicial industry with the repeal of the Glass-Steagall Act in 1998 as well as the credit default swaps that are at the crux of the subprime crisis. It fills in an informational gap that I have not seen anywhere else. This is mandatory reading for all taxpayers.

This from Ms. Lord:

. . . Starting back in 1995, the masters of the bond and credit market universe got too cute by half and structured a new and exciting financial instrument, the credit default swap and it's these credit default swaps that are the crux of the problem. The magnitude of the fallout from this hairy piece of "financial engineering" is staggering. Believe me, when I tell you that these things are so wrapped around the axle I don't think anyone knows who's got what.

Under a CDS, a bank originates loan to a company. A second bank (or other financial institution) can agree to cover the credit risk for the loan, by agreeing to make payment to originating bank if the company defaults on the original loan. The originating bank pays a small insurance premium to the second bank for assuming the risk of the loan.

Typically, payments under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong (CDS being a new market, it is by no means "recession-proof").

Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.

But they didn't work out that way...the real estate bubble burst and the mortgage market melted down, factors of life their models didn't take into account. Which brings us to another Gods of the Copybook Heading meets Gordon Gecko Greed is Good moment...the moment when "Wall Street" took over and expanded the volume far beyond what was required for hedging risk. The traders at commercial banks and insurance companies, freed from the constraints of Glass-Steagall by Bill Clinton era deregulation, jumped in with both feet.

After all, bonuses depend on the volume of business. Therefore, bank traders sold the credit risk of a loan not just once, but as many as 10 times. And they sold it not to solid banks and insurance companies, but to three solid banks, one solid insurance company, three dodgy brokers and three hedge funds. Then the traders went out and sold other CDS products that were not even related to actual loans on the books, but to imaginary indices of credit quality in the "widget" industry.

The credit risk of the system was hugely multiplied.

Instead of one $10 million credit risk loan, there are now ten $10 million credit risks on just one loan.

See what I mean about being wrapped around the axle?

Because of this axle, banks around the world are under tremendous pressure. They've even stopped loaning to each other which tells you how bad it is. Bond traders have been standing around with their hands in their pockets - no one is making trades. LIBOR is quaking under the weight of the stress and the short term paper market has pretty much seized up. Commercial paper is how companies finance their day to day operations and make payroll. September 30 is the day when positions unwind and this is where the pain on Main Street will really start. A flood of redemptions is preparing to swamp Hedge Funds. The US Mint has stopped production of gold coins due to soaring demand. Tonight's Asian market open will indeed be interesting. . . .

This isn't over by a long shot. Unless this can get things moving quickly (and have you ever known anything to happen quickly when the US govt is involved?) havoc will continue to wreak the credit markets, the relief rally in the stock market will be brief. Will smart money continue to stay on the sidelines? Will there be any smart money left? At heart, financial markets are about confidence in the system and confidence has been gravely shaken.

In other words, the jig is up.

How bad it will be is anybody's guess. . . . I believe we will all muddle through somehow.

I'm also a free market trader and believe that the market has to work this out. These type of bailout programs just tend to delay the pain and there is going to be some pain, my friends. I oppose the structure of this bailout on principle, so watching these government types preening and posturing in front of the cameras this weekend was like watching a train wreck in slow motion. They are beyond clueless. And infuriating. For Nancy Pelosi to call the House Republicans for not attending negotiations that they weren't invited to attend is an outrage. To see these Democrats stand up in front of the cameras and outright lie their a$$e$ off just shows you what we're dealing with.

. . . If you are interested in learning more, this piece . . . is a good place to start and this will provide you a window into what's been going on with the banking side of the equation. If you want to laugh and learn as you get up to speed on these magillas go here and check out this horse race analogy.) . . . Some of Dinah's other Wall Street [blog posts] can be found here.

And please be reminded that the fasten seat belt sign is still illuminated. It's gonna be a bumpy one.

The full post contains much more in the way of musings, and I highly recommend her blog to all readers.

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The History Of The Left's Subprime Crisis

Roger Kimball, writing at PJM, gives a very good thumbnail history of the subprime crisis and how it is a creation of Democratic identity politics and interference in the market. This story cannot be repeated often enough, particularly when Nancy Pelosi and company, aided and abetted by the MSM, are baldly lying, loudly and repetetively in an effort to hide their responsiblity for the subprime swamp.
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This from Roger Kimball:

. . . ”The Community Reinvestment Act” (see here for more).

* The original Community Reinvestment Act was signed into law in 1977 by Jimmy Carter. Its purpose, in a nutshell, was to require banks to provide credit to “under-served populations,” i.e., those with poor credit. The buzz word was “affordable mortgages,” e.g., mortgages with low teaser-rates, which required the borrower to put no money down, which required the borrower to pay only the interest for a set number of years, etc.

* In 1995, Bill Clinton’s administration made various changes to the CRA, increasing “access to mortgage credit for inner city and distressed rural communities,” i.e., it provided for the securitization, i.e. public underwriting, of what everyone now calls “sub-prime mortgages.”

Bottom line? It forced banks to issue $1 trillion in sub-prime mortgages.
$1 trillion, i.e., a thousand billion dollars in sub-prime,i.e., risky, mortgages, in order to push this latest example of social engineering.

But wait: how did it force banks to do this? Easy. Introduce a federal requirement that banks make the loans or face penalties. As Howard Husock, writing in City Journal way back in 2000 observed: “Bank examiners would use federal home-loan data, broken down by neighborhood, income group, and race, to rate banks on performance. There would be no more A’s for effort. Only results—specific loans, specific levels of service—would count.” Way back in 1994, for example, Barack Obama sued Citibank on behalf of a client who charged that the bank “systematically denied mortgages to African-American applicants and others from minority neighborhoods.”

* In 1997, Bear Stearns–O firm of blessed memory–was the first to get onto the sub-prime gravy train.

* Fannie Mae & Freddy Mac–were there near the beginning, too.

Anatomy of a bubble

Step 1. The intoxication: “My house is worth millions!” From 1995 - 2005, the number of sub-prime mortgages skyrocket. So did the house prices.

Step 2. The hangover: “Oh my God, my house isn’t selling. What went wrong?”
Why didn’t someone try to stop it?

Someone did: “The Bush administration today recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago,” The New York Times, September 11, 2003.

But someone intervened to stymie the Bush administration. Who? The New York Times reports:

Supporters of the companies said efforts to regulate the lenders tightly under those agencies might diminish their ability to finance loans for lower-income families. . . . “These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. “The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”

Why didn’t someone else ring the alarm?

Someone else did. In 2005, John McCain co-sponsored the “Federal Housing Enterprise Regulatory Reform Act,” which among other things provided for more oversight of Freddie & Fannie. The bill didn’t pass. Guess who blocked it?
The bill was reintroduced in 2007. But again, no luck. Fannie Mae and Freddie Mac had friends in the Senate:

* Chris Dodd, a recipient of “sweetheart” loans from a Freddie and Fannie backed company.

* The junior senator from Illinois, i.e., Barack Obama, who turned to Jim Johnson, former head (1991-1998) of Fannie Mae, to help advise him on whom to pick for the vice-presidential slot on his ticket. From 1985 to 1990, incidentally, Johnson was managing director of Lehman Brothers. Remember them?

* You might also want to check out one of Barack Obama’s other advisors: Franklin Raines, former CEO of Freddie Mac: see here , for example, or here , or here.

Towards the end of the video, we read this salutary observation: “Everyone deserves a home, not a house of cards.”

Who gave us the house of cards? Watch the whole thing here (original link was here). And then pass it along to everyone you know.

There are at least two other actions at work here. Of course if someone smells a dollar on Wall St., they'll try and latch onto it. That is what they get paid to do. But they don't get paid to purchase assets worth $1 for $10. The risk assessment associated with subprime lending got completely skewed. No one yet has even attempted to explain why that I can find, let alone do so with clarity. The other action are the recently introduced Mark to Market accounting rules that require accounting for assets at fair market value today. This accounting rule has the advantage of exposing bad assets. But subprime loans are secured. They are not valueless, though in today's market, under the Mark to Market rule, securities relating to these loans have to be counted as $0 because no one will offer any value for them. That, according to many in the know, seems to be a large part of the current implosion.

Other posts related to Subprime Crisis (from oldest to newest):

1. McCain, The Fannie and Freddie Crisis, and Obamafuscation - Obama and the entire Democratic Party are trying to blame Republicans for the subprime crisis. But this crisis was created by Bill Clinton and protected against Republican efforts to reign it in over a decade – until it failed, nearly pulling out entire economic system into a depression.

2. Dodging a Depression - The NYT and WSJ document just how serious is the subprime crisis. Quite literally it brought us to the point of a complete and catastrophic stoppage of our financial systems. This was not a stock market crash, it was a lending and credit crash. The WSJ describes the events of the week leading up to the crisis point.

3. Obama & The "Family" Of Fannie Mae - Documenting Obama’s relationship to Fannie Mae.

4. The Origins – And Foreseeability – Of the Subprime Crisis - A 1999 article in the NYT describes the Clinton Administration forcing subprime loans onto America and also forecasts that this will create a house of cards that will fall apart in a down market.

5. The Left’s Subprime Meltdown - A post by the Anchoress discusses this subprime crisis as a creation of the left and a system that was protected to the end by the left. She adds additional sites, quotes and links to explain the mosaic.

6. Fannie & Freddie, McCain & Obama, Subprime & Wall St.The WSJ discusses both how the subprime loan market came about and how Democrats, including Obama, were both the cause of the problem and the roadblock to a solution that would have averted this catastrophe. Dafydd at Big Lizard's explains how Mortgage Backed Securities worked on Wall Street.

7. A Doddering Fool & Charlatan - Chris Dodd is up to his ears in the subprime crisis. With our economy teetering on an actual depression due to the Fannie/Freddie/subprime loan crisis, it was not merely surreal to watch Senator Chris Dodd chair an emergency hearing of the Senate Banking Committee to evaluate the Treasury's proposed rescue plan, it was obscene.

8. Finally – Oversight - The FBI has finally announced criminal investigations at Fannie and Freddie.

10. The President Addresses The Nation - Bush explains the stakes involved for America with the subprime crisis.

11. McCain The Chessmaster Part II - McCain was responding to a 3 a.m. phone call in returning to Washington. He is given political cover and support by Bill Clinton.

12. A Spotlight On The Left's Subprime Crisis - A video summary of the origins of the subprime crisis with lots of footage of Rep. Barney Frank and others protecting Fannie Mae from regulation by the Bush Administration and McCain.

13. WaMu Swallowed Up In The Left's Subprime Swamp - Washington Mutual goes under because of toxic mortgage debt.

14. Dodd, ACORN, and the Penultimate Screwing of the Taxpayers - The left, the people responsible for the subprime crisis, proposed a deal that would have used the return on rehabilitated investments not for the benefit of taxpayers but to fund progressive advocacy organizations that are fundamentally corrupt.

15. Krauthammer On The Subprime Crisis: Time For A Return To Public Executions - America is livid over this fiscal crisis and wants a pound of flesh to satiate its cravings before beginning the job of putting our financial house back in order. Krauthammer things we should give it to them and suggests a return to the auto de fe, this time as a reality show.

16. The Subprime Crisis, Dems, Obama & McCain - a great video giving the history of the subprime crisis.

17. Subprime Crisis: Spin versus C-Span - a video of 2004 hearings in which the House Democrats heaped scorn on the idea that Fannie Mae and Freddie Mac were a disaster waiting to happen and fighting tooth and nail to preven any further regulation of Fannie and Freddie.

18. Thomas Sowell On The Subprime Crisis & Proposed Bailout - Economist Thomas Sowell weighs in on the need for the proposed bailout to stabilize the market and the politics at the root of this fiscal crisis.

19. Resolution of the Initial Subprime Crisis - Time For Investigation - A first look at the draft legislation and an outline of what else needs to happen to resolve this crisis.

20. The Treasury Dept. - Anerica's Newest Subprime Lender - The legislation to solve the subprime crisis is only aimed at part in shoring up financial markets. A large part of the bill requires that the Treasury Dept. act as the subprime lender of last resort.

21. The Subprime Crisis, ACORN & Obama, The Community Organizer - Obama's time as a community organizer was very much involved with ACORN's efforts to force subprime lending upon the financial institutions in Chicago.

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