Reward without risk

Instead of holding on the mortgages they wrote, their banks began selling the mortgages in pre-packaged bundles to a variety of investors, and disseminating the risk out into the general economy.

The idea was simple. The loan originator could make the initial commissions for writing the mortgage, and then sell the mortgage off to other investors, thus making money AND relieving themselves of any responsibility should the borrowers default on their loan. Think of it as reward without risk.

In this system, the banks that originated the loans were best served to write mortgages as fast as they could, and with little regard for whether or not the borrower could make the payments.

Why would investors buy a security backed by shaky home loans, you ask?  Given the exploding real estate market, investors thought that there was very little risk that the mortgages would go bad. Their reasoning was simple: by the time these mortgages re-set to higher interest rates after the teaser period, the consensus was that the real estate market would continue increasing in value and allow the borrower to cover the loan out of the increased equity.

But this was not comforting enough to many companies creating and purchasing these mortgage-backed securities. They wanted further assurance that their downside risk was limited. In short, they wanted to buy insurance on their investments. And since most insurance is subject to state regulation, banks formed private risk-transfer agreements called OTC derivatives and credit default swaps.

One way to think of derivatives is to compare them to bets. If there is cash on the line then there is a value to be assigned to a given event - say, the chance that the Dolphins will either win or lose. Derivative markets in the most basic sense are the buying and selling of risk, or in other words, bets on whether or not the mortgages they buy and sell will go into default. 

OTC or “over-the-counter” derivatives, otherwise known as “swaps”, are private contracts based on the value and risk associated with the underlying asset. Just like “over-the-counter” medications, these private contracts are subject to minimal-if-any regulation or scrutiny by any governmental agency. In fact, the scrutiny is so non-existent that there is some disagreement about how big these markets actually are. Some recent estimates place the number somewhere north of 500 trillion dollars.

For reference, that is somewhere between 35 and 40 times the entire GDP of the United States. Most experts agree that the world's derivative markets are larger in total value than all of the real estate, securities and bonds on the planet combined. These markets are the largest, most volatile, and least transparent financial instruments on the planet, and every major Wall Street firm is at least knee deep in them. 

As the process of bundling and selling mortgages and related credit derivatives became more and more streamlined earlier this decade it was not uncommon for mortgages to be sold within hours of their origination. In 2006 and 2007, which most people consider to be the worst years for the origination of disturbingly shitty home loans, the securities and financial instruments containing these sub-prime loans were blasted out into the general economy faster than the Dolphins could rack up a losing record.

Bringing Down the Bear

Warren Buffet famously called credit derivatives “financial weapons of mass destruction”. If there was any doubt as to what kind of destruction these mysterious instruments could cause it was put to rest earlier this year. When it collapsed, Bear Sterns was the fifth largest investment bank in the country. What took 85 years to build was destroyed in about 48 hours by a series of bad bets in the form of credit derivatives. So the people who made the bets are left holding the bag, right? Well, not really.

The reality of the interconnectedness of our economy is such that a bankruptcy on this scale could have tossed the whole world into a catastrophic financial meltdown.  Recognizing this, the Federal Reserve had no option other than intervening to rescue the toppling giant. With 30 billion dollars of taxpayers' money, the Fed orchestrated a rather brilliant intervention, which saved the massive bank with a degenerate gambling problem from complete implosion. So now who owns the bad mortgages? Well….we do. Cheers!

Where to go from here

So is this the beginning or the end? Well, that is the 500 trillion dollar question. The truth of it is that no one can really answer it, because no one can determine the extent to which these major financial institutions are involved with these “over-the-counter” transactions. Because these derivative instruments are entirely unregulated and invisible, banks can decide on a case-to-case basis whether or not they want to list them on their balance sheets as assets, as liabilities, or even leave them off altogether. So without further transparency there is no way to know if the Bear Sterns collapse is the worst of the storm behind us, or if it is simply the first drop of rain.

However, a few uncomfortable facts remain. The largest quantity or risky mortgages were originated in 2006 and 2007. These mortgages have yet to reset to their higher interest rates, which means that the worst mortgage fallout is probably yet to come. Since no one has a clear idea of exactly who owns these loans and the associated derivatives, there is almost no predicting where or when that fallout will hit.

Furthermore, the same template used in the bundling and selling of mortgaged backed securities has been used in all credit markets. Credit cards, student loans, auto loans, and business loans are all exposed to this same type of meltdown as they have been originated and disseminated into the general economy in the same way. So if I were a betting man, I would bet that there is more to come, which means more meltdowns, and more bailouts, and more intervention.

So did the Fed do the right thing?  Should it have used taxpayer dollars to bail out Bear Sterns? Absolutely. The truth is that none of us could predict the extent to which Bear’s bankruptcy would have destroyed confidence in world markets. Will the Fed have to do the same thing in the future when faced with similar crisis? Probably yes. But should the Fed have allowed the lack of transparency that caused this to happen in the first place? Absolutely not.

A truly free market requires not only freedom from regulation, but also freedom of information. The whole idea of a marketplace is changed when the purchaser does not have the ability to make decisions based on realistic information about what she is purchasing. In other words, by removing all scrutiny from the massive markets in which these banks buy or sell their most valuable assets, it makes it impossible for their stockholders to know what exactly it is that they own.

As we have seen, these complex derivative markets have not been able to effectively regulate themselves. Or, another way to put it would be that due to the interconnectedness of the modern day economy, leaving these markets to regulate themselves exposes us all to a possible financial meltdown which is a risk that is far beyond acceptable market fluctuations.

So should the government carefully regulate these markets? A better question is could the government effectively regulate these markets? And the answer is probably not very well. What it could do is force greater transparency when it comes to these derivative markets and credit default swaps which we now know can cause such extensive damage to the global economy.

It seems that the lack of scrutiny and transparency in these markets is exactly what has led to the need for drastic intervention on the part of the federal government. A functional free market is dependent on all the players knowing the rules of the game, so that the collective economy has the tools it needs to regulate itself.

While it shouldn’t be the Fed’s job to govern the direction of the derivative markets, it should be responsible for ensuring that the market understands itself, and that buyers understand the nature of the products they are purchasing. Greater transparency regarding the nature of these OTC transactions may well have averted the need for the kind of market intervention that will likely characterize the economic landscape of the next several years.

So what about my investments, you ask?  Well, I don’t pretend to be an expert on mutual funds and securities. In fact, I run a small precious metals company that sells gold coins and bullion to private investors like you and me. Since the Fed’s interest rate cuts and investment bank bailouts have been very bearish for the US dollar (which usually trades opposite gold), gold has been steadily on the rise for years now. So I think I’ll stick to what I know best, and buy a couple more gold coins for my safety deposit box.  Most importantly for me, I’ll know exactly what it is that I own. I’ll also know exactly what it is I stand to lose.

TrackBack URI for this entry

Name

Email

Website

Comment smaller | bigger

Write the displayed characters

Add Comment