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CREDIT DEFAULT SWAPS AND COLLATERAL DEBT OBLIGATIONS

December 6, 2016

CREDIT DEFAULT SWAPS AND COLLATERAL DEBT OBLIGATIONS

Don’t let the title throw you; I will define these phrases in this essay, and when defined they will be easily understood in the world you and I inhabit apart from their Wall Street legalize. Though I briefly considered going for a PHD in economics rather than going to law school, I didn’t, and thus am only armed with a B.A. in the discipline which I earned before going to law school and becoming a lawyer. In this essay I intend to define a couple of the hi-falutin’ terms ordinary citizens encounter when reading the business pages and other apologia for the rich and corporate class, jargon that should not be solely owned by that class in impeding communication but rather known to the rest of us so we can establish a level playing field and argue with those who try to muddy the water with big words to further their greedy designs, designs proven to be not in our best interests, as the following will demonstrate.

Credit default swaps and collateral debt obligations have not always been with us. The big banks on Wall Street have a history of bringing whiz kids from the business schools at Harvard and Wharton and have them dream up new ways to securitize debt or insure against certain “credit events” in attempts to make a lot of money and simultaneously manage risk (exposure to loss).

In the case of collateral debt obligations (CDOs), just what exactly are they?  A CDO is a relatively new security bankers put together consisting of low-rated (BBB or A) mortgages which served as collateral for the CDO to be sold to investors. The banks were having trouble selling such low-rated mortgages so, as one Wall Street banker put it, (we) “created the investor.” Here’s how they did it.

They repackaged such low-rated mortgages into the new CDO security, hired and paid such rating firms  as Moody’s to abandon their traditional roles of independent rating and (in 80 percent of the cases) rate such combinations (CDOs) as AAA, the highest rating available for any security,  and all even though the underlying mortgage collateral was composed of BBB and A ratings. The bankers and their raters effectively made a silk purse out of a sow’s ear in changing the name of the product as though this effectively transformed subpar collateral into riskless AAA-rated securities. (Both bankers and raters, of course, deny that the banks’ payment to the raters had anything to do with this scheme lest raters as well as bankers be sued for collusion and fraud.)

Bankers then sold their top-rated CDOs to investors such as police and fire and nurses’ pension funds who were led to believe by their AAA rating that such securities were without risk. They, of course, were not without risk. Between 2003 and 2007 during the Bush years of deregulation of banks’ activities and as house prices rose 27% nationally and $4 trillion in mortgage-backed securities were created, Wall Street banks issued nearly $700 billion in CDOs that included mortgage-backed securities as collateral.

The predictable defaults started to happen. One example reported by Standard & Poor’s is that of Citigroup’s $772 million in a CDO deal the bank concocted which defaulted within ten months of its founding and which cost investors and Citigroup almost all their money. This example is a drop in the bucket but underscores how inflated grading of securities and their sale to gullible investors contributed to more than $2.1 trillion dollars in losses to the world’s financial institutions after home-loan defaults soared and residential prices plummeted, all as noted in a February 5, 2013, piece by Jody Shenn in Bloomberg and reported by Elizabeth Warren in a note in her 2014 book, A Fighting Chance, an effort which has provided me with research for this essay.

So now you perhaps know more than you did about collateral debt obligations as new kids on the securities block and how Wall Street banks profited greatly in their sale to trusting investors before the market crashed and you and I were told we must bail out these banks that “were too big to fail” or risk international depression. We bailed them out along with AIG insurers, bank stockholders and the automobile industry who were on the verge of failure due to frozen credit which resulted from the greedy shenanigans of banks that had already at least technically failed but were brought back from dead by our largesse.

We (but not the big banks) are still suffering from remnants of Bush’s Great Recession today with underemployment and wage inequality and their effects on our underperforming economy via tepid demand, and as I will point out in Part II when discussing the second item of this essay – credit default swaps – it was underregulation of banking, Wall Street greed and the impact of the repeal of the Glass-Steagall that prompted the twin disasters of Bear Stearns and The Lehman Brothers which led to the panic and frozen credit spawned by the big banks as their overrated mortgage-backed securities went to pot with the results of millions of foreclosed homes, massive unemployment and other human tragedies which we suffered and are still suffering. Stay tuned.     GERALD        E

 

 

 

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