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CREDIT DEFAULT SWAPS AND COLLATERAL DEBT OBLIGATIONS (PART II)

December 7, 2016

CREDIT DEFAULT SWAPS AND COLLATERAL DEBT OBLIGATIONS (PART II)

We saw in part one what collateral debt obligations are and how underregulated Wall Street banks recklessly repackaged subpar mortgages into such a new security,  paid for AAA ratings to give the new security a much higher rating than the underlying mortgages would have had if sold individually, and peddled the results to trusting investors both here and elsewhere. Such collateral, predictably, bombed, investors were faced with enormous losses, the housing bubble burst, and we quickly proceeded into what I call Bush’s Great Recession, a downturn from which we have still not fully recovered.

For my money this was a deceptive practice amounting to fraud, but when the executives of the big banks who orchestrated such frauds were finally brought to account they were only fined, not jailed – and that’s after you and I bailed out their technically insolvent institutions and saved them their shareholders, vendors and even insurers from going down the drain.

As I have often blogged, we will not see reform in big bank practices until there is the jingle of handcuffs in their boardrooms. (Incidentally, I understand that Jamie Dimon, CEO of the biggest bank on Wall Street, JP Morgan Chase (a big bailout recipient), and a CEO who admitted to paying bribes to Chinese politicians in return for lucrative banking contracts in criminal violation of the Foreign Corrupt Practices Act but didn’t go to jail, is currently under consideration for an appointment in the upcoming Trump administration. (Why am I not surprised? It figures; just another fox in the henhouse in Trumpworld.)

But I digress; let’s get to credit default swaps and how they figured in our near brush with depression brought about by the big banks’ greedy crapshoots leading to the crash in 2008-2009. A credit default swap was at that time a new insurance product not subject to federal regulation. It was designed to protect investors from defaults or declines in the value of mortgage-backed securities, a sort of insuring agreement where the insurer would pay the buyer the face value of the mortgage debt in the event of default or other specified “credit event.”

Buyers of such mortgage debt securities paid a premium to the insurer for such coverage, and the terms of such agreement were, as noted above, not subject to federal regulation; they were treated as over-the-counter derivatives. As new insuring products with no underwriting history, those who offered them for sale to investors were quickly dealing with insolvency when the repackaged mortgage securities held by such insured investors crashed and burned. Such “derivatives” gave the illusion of security to the mortgage-backed securities sold by the big banks and thus contributed greatly to the coming crash since buyers thought their face values were guaranteed, but what happens when the insurers go broke?

AIG, for instance, a large international insurer, sold more than $79 billion worth of credit default swaps in the run up to the crash and bailout. Obviously a combination of credit default swaps and collateral debt obligations whose face value the swaps guaranteed to pay in the event of default created (as the Financial Crisis Inquiry Commission Report at the time noted) “a dangerous environment in which there were multiple opposing bets on the same securities spread across different sectors of the financial system.” That’s putting it mildly; the illusion of safety through insurance greatly contributed to the purchase of such rotten collateral the banks were peddling under disguise of AAA ratings.

It was not just the Wall Street big banks that were technically insolvent with the crash. Investment banks such as Bear Stearns and Lehman Brothers went down the drain as well. Bear Stearns failed as a result of excessive exposure to subprime mortgages and was bought by JP Morgan Chase in a negotiated sale orchestrated by the Federal Reserve Bank of New York, a deal in which the government loaned Jamie Dimon’s bank $30 billion dollars to salvage the company. That’s a lot of “salvaging,” and I suspect there was a lot of chicanery involved since Dimon, the unindicted CEO, was in on the deal.

Another investment bank, Lehman Brothers, filed for bankruptcy protection after suffering major stock losses and devaluation of its assets by credit-rating agencies, which sent a shock wave throughout the markets. There are those of us who are still wondering why Bear Stearns was bailed out and Lehman Brothers was not but rather left dangling in the wind. In any event, such uncertainty of asset valuation and other market disruptions led to suspicion of market players that assets of all banks and investment houses might be overvalued. Thus Merrill Lynch and Citigroup started having problems assessing credit even from other financial institutions as the firestorm of fear spread. Merrill Lynch was swallowed by the Bank of America as a result of (per the B of A) “pressure from the U.S. government to follow through on the transaction.” Bear Stearns was already gone, so fear morphed into panic, and readers know the rest of the story with bailouts of banks and insurers and loans to auto companies as features of that chaotic time.

What readers may not know is that AIG was bailed out and that a story broke in the New York Times on March 14, 2008, to the effect that “AIG was planning on paying huge bonuses to their executives after their $170 Billion Bailout,” and that the reaction was swift and intense, including death threats against some of the AIG executives. The House quickly passed a bill that called for a 90 percent tax on bonuses for certain bailout recipients, apparently to quell civil commotion. The then Special Inspector General of bailouts noted at the time that “Had Treasury officials been more effectively monitoring the government’s investment in AIG and more concerned with accountability and basic fairness, they might have helped prevent the blowup,” further noting that “that the argument of AIG that the bonuses should be paid because “the bonus recipients were essential personnel necessary to wind down AIG’s complex transactions – doesn’t quite wash.”

The Special Inspector General was and is right. His complaint that Treasury didn’t effectively monitor this specific mess with AIG can be expanded to their lack of monitoring the entire mess, the mess caused by lack of regulation of the big banks and their greedy crapshoots into uncharted territory. Had regulators kept a wary eye out on what the big banks were doing and questioned such fraudulent conduct as repackaging subpar mortgages into AAA rating status by rating agencies who were paid by the banks for such services, perhaps the Great Recession would not have happened.

Think about such lack of regulation and where it can lead us and the world when Trump ascends the throne as he has already told us that banks are over-regulated when the fact is that they are clearly underregulated. Great Depression, anyone?   GERALD      E

 

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