Another notch in Taibbi’s belt, as he just shreds yet another Cornerite:
M.T.: What a surprise that you mention Franklin Raines. Do you even know how a CDS works? Can you explain your conception of how these derivatives work? Because I get the feeling you don’t understand. Or do you actually think that it was a few tiny homeowner defaults that sank gigantic companies like AIG and Lehman and Bear Stearns? Explain to me how these default swaps work, I’m interested to hear.
Because what we’re talking about here is the difference between one homeowner defaulting and forty, four hundred, four thousand traders betting back and forth on the viability of his loan. Which do you think has a bigger effect on the economy?
B.Y.: Are you suggesting that critics of Fannie and Freddie are talking about the default of a single homeowner?
M.T.: No. That is what you call a figure of speech. I’m saying that you’re talking about individual homeowners defaulting. But these massive companies aren’t going under because of individual homeowner defaults. They’re going under because of the myriad derivatives trades that go on in connection with each piece of debt, whether it be a homeowner loan or a corporate bond. I’m still waiting to hear what your idea is of how these trades work. I’m guessing you’ve never even heard of them.
I mean really. You honestly think a company like AIG tanks because a bunch of minorities couldn’t pay off their mortgages?
B.Y.: When you refer to “Phil Gramm’s Commodities Future Modernization Act,” are you referring to S.3283, co-sponsored by Gramm, along with Senators Tom Harkin and Tim Johnson?
M.T.: In point of fact I’m talking about the 262-page amendment Gramm tacked on to that bill that deregulated the trade of credit default swaps.
Tick tick tick. Hilarious sitting here while you frantically search the Internet to learn about the cause of the financial crisis — in the middle of a live chat interview.
B.Y.: Look, you can keep trying to make this a specifically partisan and specifically Gramm-McCain thing, but it simply isn’t. We’ve gone on for fifteen minutes longer than scheduled, and that’s enough. Thanks.
M.T.: Thanks. Note, folks, that the esteemed representative of the New Republic has no idea what the hell a credit default swap is. But he sure knows what a minority homeowner looks like.
B.Y.: It’s National Review.
I bet Rich Lowry wishes York had not corrected him at the end and had let people think York actually wrote for the New Republic. This has to have been the worst year for the National Review, ever.
At any rate, this just gets back to what everyone across the country is beginning to figure out- the bullshit artists who have been running this country and propping up the Republicans have no idea what they are talking about- ever. They have relied on invective and personal attacks and fear appeals and personal narratives for so long, we are to the point that they can not even debate coherently anymore. When pressed and pushed away from the talking points and the convenient scapegoating, they whiff. Reciting “fight them over there rather than over here” or yelling “no surrender” or babbling incoherently about American exceptionalism really doesn’t work when you are asked a specific question.
And for the record, I have only the fuzziest idea of how Credit Default Swaps work. It seems to me they are a ridiculously complex instrument whipped up by folks who in previous generations would be using their mathematical models to study theoretical physics. From what I have read, Ponzi scheme really does seem to sum up what they are.
(via)
Keith
I wish I had the email in front of me from a friend of mine -who is a financial broker – so I could quote it directly. He basically chastised me for supporting Obama ("Disappointing, dude.") and proceeded to claim that Obama’s policies – as explained by Rupert Murdoch’s Wall Street Journal, no less – will lead the country into another depression.
There’s irony, ignorance, and lack of credibility all succinctly contained in 2 sentences. It’s as if the last 8 years didn’t happen, and somehow Clinton has still been running the country, and salvation lies in this upstart party of idealists called the GOP. Laughable.
Sammy
Credit default swaps are actually the easy part. They are really just bets or insurance between two sides on whether a third company will default on their loans or not. The more difficult things are the CDOs which are "securities" of sliced up debt instruments.
Lee (not the one who posts regularly)
That. Was. Awesome. Between this and Rachel Maddow’s interview with Frum, I really am having a great week. :)
NonyNony
And for the record, I have only the fuzziest idea of how Credit Default Swaps work.
From what I’ve been hearing, most of this financial meltdown has its roots in the fact that the guys who buy and sell these things only have a slightly better idea of how they work than you do.
Doctor Gonzo
A CDS is like unregulated insurance. You buy one from a company, and you get money if a third party goes bankrupt. So, for example, let’s say you have $10 million in bonds from GM. But GM isn’t doing so hot these days. So you could buy a CDS on GM from some financial institution such that if GM goes under, you will get your $10 million (either the financial institution will take the bonds off of your hands and give you $10 million, or they will let you keep the bonds and give you the difference between their new, post GM-bankruptcy value and $10 million. Same net result either way).
This use of CDSes is all well and good for managing risk and so on. But what happens when you buy lots of CDSes on GM? Now you could get lots of money, far more money than the $10 million in bonds that you have now. It’s like buying a million dollars of insurance on a $100,000 house. Burn, baby, burn!
When the CDS market got to be $60 TRILLION dollars, people probably should have realized that they are "insuring" several times the value of the U.S. economy, and if even a substantial fraction had to be paid off, there isn’t enough cash on the planet to do so.
Zifnab
The average wingnut will blame mortgage meltdowns on minorities. They’ll blame the meltdowns on Fannie and Freddie. They’ll even blame the meltdowns on Democratic-sponsored deregulation. But Phil Graham is off limits. If Clinton signed a bill, it’s Clinton’s fault that the bill soured. But if Graham wrote it… well… that’s everyone’s fault (but his).
This is assuming you can even make a GOoPer acknowledge that the Glass-Steagel and Graham-Leech Acts existed in the first place.
Dave
It’s amazing to see how far the National Review has fallen. I remember when guys like Jeffrey Hart wrote for them. Even if you didn’t agree with them, at least they knew what the Hell they were talking about. Watching Byron York try to comprehend a CDS or CDO is like watching a toddler try to open a combination lock.
Montysano (All Hail Marx & Lennon)
If you take out fire insurance on your own home, you are acting prudently. If you take out fire insurance on my home, you are now gambling, betting that my house may or may not burn down. Even worse: many people besides you are betting on my house burning, and the casino with which you all placed your bets cannot pay off if they lose.
You can’t get your head around it because it makes no sense, it flies in the face of how responsible people conduct their affairs.
And good on Taibbi for smacking down this ridiculous notion that poor brown people brought down AIG. It’s the dumbest, most desperate ploy yet.
Nylund
The "This American Life"/NPR radio show explained CDS’s in a decent way for lay people. Episode 365.
I lived with a Wall St. guy in 2005 and he explained the whole CDS, CDO, MBS thing to me and immediately it struck me as a ponzi scheme and I went around trying to convince people that it was bound to come crashing down. Everyone laughed at me then, but since then a lot of them have emailed me back saying, "I framed your email from 2005".
But, the one memory of my old Wall St. roommate that stuck with me was this speech he gave me:
"The basic idea behind making a profit on anything is to sell something for more than you paid for it. When everyone knows the value of what you’re trying to sell, it becomes really hard to make much profit, so sometimes in finance it seems like people are purposely making up really complex things because the harder they are to value, the easier it is to convince someone to pay too much for it."
dmbeaster
CDS — not a Ponzi scheme, but the ultimate example of leverage, which MT points out so well in his comment. "Because what we’re talking about here is the difference between one homeowner defaulting and forty, four hundred, four thousand traders betting back and forth on the viability of his loan."
Nothing like literally betting trillions (literally) on whether or not a much smaller amount of debt may or may not go bad. Because when they rolled snake eyes (on debt made bad because of the greed to pump more of it, no matter how ill conceived, into the system), the bet was far larger than the debt they were betting on.
It really is not that much of a mystery — like the Great Depression, leverage gone wild to support a crazed speculative bubble. What you get is a much louder pop.
Nylund
Note, episode 365 is the second big one about the economy they’ve done. Episode 355 is the first one that many people linked to earlier in the year. 355 goes through the mortgage chain from a borrower to wall street. 365 gets into CDS, leveraging, and bailout plans.
Both are recommended. follow the link in the previous comment for ep. 365. for episode 355, just change the number in the url.
Perry Como
Can I have a chat with Byron York? Tabbai rightfully eviscerated the hack, but my language would be a bit more colorful. Tabbai didn’t touch on the larger OTC derivatives market that is somewhere between $600 trillion and $1 quadrillion that is floating out there thanks to the CFMA. The CDS market is only 10% of the larger problem.
joel hanes
As nearly as I can make out, they depend on antigravity.
Two leveraged companies express their mutual money-force quantum attraction in an exchange of imaginary insurons;, virtual trustons are copiously produced in the reaction, and they in turn give off a shower of money. We have just seen the first experimental measurement of the half-life of these virtual trustons when they are exposed to a 1 milli-Krugman reality field, and it turns out to be something on the order of 3 x 10^5 seconds.
pooh
short answer is that I make 100 subprime loans, which I then combine and slice into 100 shares. It gets more complex when I divide the pool into "tranches" with differing ror’s. Basically, it’s a scheme to obscure the true risks of each loan in such a way that the cdo purchaser will systemically overvalue them as assets by not properly discounting for risk.
Libby
I’ve been calling it a Ponzi for the better part of two years and it seems to me to fit the basic criteria. Or would Three Card Monte be a better analogy?
Meanwhile, to make up for my many pathetic blogwhores in the last week, here’s a link to a very funny chart from Angry Bear proving that McCain is responsible for the Dow tanking.
SpotWeld
Just ym guess.
CDS: A well crafted and prepackaged bit of highly luminous "dazzle" that has been designed specifically to let seller and buyer be mutually destracted from the foundation of b*llsh!t?
Elvis Elvisberg
this just gets back to what everyone across the country is beginning to figure out- the bullshit artists who have been running this country and propping up the Republicans have no idea what they are talking about- ever.
True enough, but there’ll always be a market for blaming all our problems on minorities and people who have pointed out that we have problems.
Funny that Christopher Buckley quoted his father yesterday, saying that it was his life’s work trying to separate conservatives from kooks. I don’t know, maybe there’s just too many stupid white people in this country for that to work.
brent
Credit Default Swaps are actually pretty easy to understand in the abstract. A couple people have already offered a decent summary and you can listen to the This American Life podcast which analyzes the situation with those instruments quite well. What I don’t understand is how people like York can opine so strongly on these matters without apparently having an even passing knowledge of the collapse of a multi-trillion dollar market right at the center of it. Its really unconscionable and Taibbi, as caustic as he tends to be, I think strikes the right tone here. If one can’t be bothered to form even a basic understanding of the fundamental issues underlying a crisis, they should really just STFU about it.
Doctor Gonzo
I don’t know if the whole CDO thing could be described as a Ponzi scheme, more like deliberate obfuscation.
The whole point of a CDO is to take a bunch of debts (like mortgages), then package them together in such a way as to be able to resell products with different risk/return ratios from them. And even that is just fine in certain situations. However, the real issue is that somehow, both the creators and the ratings agencies thought that the aggregate risk of all of the tranches of the CDO could be lower than the risk of its underlying parts. It can’t be. That’s simply impossible. If anything, bundling and reselling should raise the risk.
Which is why the ratings agencies are the ones who really screwed things up here. They rated CDO tranches as AAA without really understanding how they worked. Why? Because ratings agencies have a vested interest in ratings things highly. THAT definitely needs to change if we are to avoid this in the future. Otherwise, the next obfuscated financial product will do the exact same thing.
bleh
FWIW, and better-informed readers definitely should correct this, I think a credit-default swap is at root a form of mutual insurance between two securities-issuers. Each guarantees the other’s security 9e.g., a bond) against default. As long as the two businesses are not so closely related that one of them defaulting would make the other more likely to do, it works out in both companies’ interests; each gets insurance — and thus gets a better rating and so enjoys lower rates — but neither has to pay the full costs of insurance (e.g., to an insurance company).
It’s sort of like a VFD: I’ll help to put your house fire out if you’ll do the same for me, and that way neither of us has to pay for a full-time fire department.
Of course, it’s not exactly that simple. If one company is riskier than the other (which usually one is), then the less-risky company is taking on more risk that it’s trading away. So, indexes were developed to measure the risk of each company’s securities, and those were used to calculate what riskier companies had to pay less-risky ones, in addition to the swap. But the amount of money was still trivial compared to the total they both would have had to pay to an insurance company, so everyone was happy.
Now, how did this go wrong? Two ways.
First, the same thing happened here as happened in many other markets: correlation. If BOTH companies get in trouble, then mutual insurance doesn’t do any good. By analogy, if one or two houses catch fire, the VFD works, but if there’s a general conflagration, then it doesn’t. (This is very similar to what sank the mortgage-based securities market: a few mortgage-holders defaulting didn’t matter — in fact, it was assumed — but when a LOT of houses started losing value, and a LOT of mortgages started going bad, then the risk-spreading didn’t do any good any more.)
Second, once there were "prices" on the credit-default swaps, they became — surprise! — securitized, and sold, and bundled and chopped up, and re-securitized and re-sold, and pretty soon nobody knew what was behind any one instrument, so there was no way to value it except via market price. And when the credit markets started seizing up, nobody knew what any of the (credit-related) CDS instruments were worth, so THAT market threatened to seize up too, and … well, you know the rest.
EarBucket
Taibbi makes me feel better about getting the New Republic and National Review mixed up all the time.
Cris v.3.1
Jesus. I was at first taken aback by Taibbi’s rudeness, but he was saying exactly what needed to be said to exactly the right person.
Zifnab
The scary thing was that they weren’t just rolling dice with even odds. They were rolling dice on a sure lose. The mortgages that these insurance policies were set to cover had been written to people who did not have a job and may or may not have had a double digit credit rating. It’s like playing Russian Roulette with a fully loaded gun. What did they think was going to happen?
The only reason these insurance policies existed was because the industry giants knew they were playing with fire. The only reason the policies – like their mortgage counterparts – were written hinged on their ability to make bets without putting down nearly enough collateral. They gambled with IOUs on the assumption that if the bill ever came due, they could flee the casino. That’s what wholesale deregulation got us.
ksmiami
A few years ago, I helped put together an auto loan securitization for a captive finance group. Everyone was there, Standard and Poors, First Union, BofA and yet the whole idea of building a cottage industry out of financing non-income producing assets and seeing how long it could go on seemed like a strange exercise to me. I mean how did this build anything and how did these investment "vehicles" really pass muster under scrutiny? Now I understood corporate bond issuences and traditional securities, but the idea that slicing up mortgages and auto loans was going to power the global economy was just bunk and grew out of hand until people couldn’t pay the bills anymore.
Joshua
CDS instruments are just part of the scam that let these companies make billions of dollars on a bunch of bullshit. Remember, companies collect fees every time derivatives are bought and sold (which are often used to buy other derivatives). There was a lot more to it – CDS are just one piece. I would go far as to say that CDS weren’t even the most brazen, or most insanely idiotic part of it.
Hell just simple common sense says you don’t give a $500,000 loan to someone without verifying their income. But that is just what was going on in this country, thousands of times a day. Someone had to loan that money, and someone else had to then make $15 million of bets on that loan.
The idea that the problem is solely the cause of the person that asked for that $500,000 loan is simply too crazy to refute. These companies were full of cheats, phonies, frauds, liars, and incompetents – and it’s their fault.
Montysano (All Hail Marx & Lennon)
A couple of commenters have made an excellent observation: the bond rating agencies failed at their job, which is to be the most conservative and disinterested party, the final FailSafe in the system. When this toxic crap was given AAA and BBB ratings, we were well and truly screwed.
I made this point to a wingnut colleague, and like Byron York, he blurted out some gibberish about ACORN. I laughed and pointed……. then I drank.
Perry Como
@Doctor Gonzo: While CDOs don’t fit the exact definition of a Ponzi scheme, they are damn close. Both collapse when you can’t find enough people to pay in to them. The entire market was a house of cards.
Sinister eyebrow
One of the reasons CDS makes for a confusing thing for many people to understand is because the name itself is meant to obscure the nature of the animal. It is, funamentally, Credit Default Insurance. I.e., insurance purchased against the potential default/devaluation of an investment you made. However, if the people selling these things called them "Insurance" then they would be regulated as insurance so whoever sold them would have to have the assets to back up a significant portion of the stuff they insured. Calling it a "Swap" keeps it from falling under the purview of insurance commissioners in the 50 states, and the various regulations of the insurance markets.
As a "Swap," it remains governed by contract law alone and contract law places very few restrictions on what can be bargained for (i.e., nothing criminal is about the only real prohibition).
It is sleight of hand. Anytime you see someone playing games with the names of things you should immediately become concerned with what’s going on. Semantics do count in some things–ask any lawyer.
Shinobi
In the process of trying to convince me that the CRA was to blame for the recent financial crisis (and failing miserably to contradict the statistics and other information I laid at his feet) a family member claimed that "He knew all about CDS, they are just like shorting a stock."
As I don’t actually understand the concept of stock shorting, can someone just clarify for me, are they really like shorting a stock?
(Just prove me right, that’s all I really want. ;-) )
Comrade Stuck
Bingo
Math Eggheads really are behind WS crash
Gus
That’s what they do. They lack knowledge about anything but their rigid ideology. Every issue that comes up must be shaped to fit into that ideology.
Ronnie P
However, if the people selling these things called them "Insurance" then they would be regulated as insurance
This is pretty much all the average person needs to know about them.
Brachiator
It’s funny. A host on a local sports talk radio station here in Southern California (AM 570) gave a pretty good explanation of Credit Default Swaps, and how these instruments and Commercial Paper are key to the financial crisis. When credit markets freeze up, companies — big and small — can’t get promissory notes to meet short term obligations like payroll.
But the Big Lie is that evil Democrats forced lenders to make loans to poor illegal aliens and black folk who could not pay the loans, making hard working white working class Americans suffer when the credit market collapsed. Note here that the solution to the problem is more cowbell, uh, I mean, more de-regulation. This nice bit of denial lets the wingnut fringe demonize the poor and cling to their belief that de-regulation is the answer to every economic problem. These morons also can’t explain how supposed Fannie and Freddie problems magically resulted in a global financial meltdown.
Also note that even though Bush started out by saying that the Congress had to act right away to pass his $700 billion rescue plan which would have blindly funneled money to lenders, the most recent plan looks a lot like the British approach to stabilizing banks. Once again, shoot-from-the-hip unilateralism gets pushed aside for a more deliberative approach. One difference, though, is that the Brits are exacting a little more punishment in exchange for pumping billions into the banking system:
Meanwhile, the US approach is more like "We will give you money, but you have to promise to behave in the future." Even key Democrats still are floundering. Barney Frank seems to be happier that he may be able to limit the "excessive compensation" of execs who accept bailout money than he is about making sure that any bailout plan is workable in the long term.
Ronnie P
As I don’t actually understand the concept of stock shorting, can someone just clarify for me, are they really like shorting a stock?
If they are, then I’ve been misunderstanding both short-selling and CDS’s the whole time.
Short sell = sell a stock (high) before you buy it (low); you think it’s going down
CDS: I have a risky bond in my portfolio. I pay you money, and in return, if the bond tanks, you assume the loss (if it doesn’t tank, you make a buck)
Right?
libarbarian
Awesome Vids from Marketplace:
Crisis explainer: Uncorking CDOs
Untangling credit default swaps
The credit crisis as Antarctic expedition
Tim in SF
John, to learn about how this mess started, listen to this This American Life episode #355, The Giant Pool of Money:
http://www.thislife.org/Radio_Episode.aspx?episode=355
Then, listen to the follow up episode, 365: Another Frightening Show About the Economy
http://thisamericanlife.org/Radio_Episode.aspx?episode=365
(this one explains all about credit default swaps. I listened to it twice to understand and I think I got it)
I also recommend episode 363: Enforcers
http://www.thislife.org/Radio_Episode.aspx?sched=1260
…but only Act Two, titled "Now You SEC Me, Now You Don’t."
I also recommend this blog post on DK.
http://www.dailykos.com/storyonly/2008/9/21/9322/74248/245/602838
More resources (from TAL):
Alex Blumberg and Adam Davidson (the guys who did that program) have a new daily, free podcast and blog applying that same explanatory power to each day’s breaking news on the financial crisis—Planet Money.
Podcast: http://www.npr.org/rss/podcast/podcast_detail.php?siteId=94411890
Blog: http://www.npr.org/blogs/money/
A great episode of Fresh Air, in which Terry Gross interviews Michael Greenberger, a former director at the U.S. Commodity Futures Trading Commission. He gives a very helpful, lucid primer on the current financial picture.
http://www.npr.org/templates/story/story.php?storyId=89338743
A follow-up Terry did with Greenberger, just as good, when the government bailed out AIG in mid-September.
http://www.npr.org/templates/story/story.php?storyId=94686428
…..
And next up, the cure will be worse than the disease:
http://timmy.vox.com/library/post/progressive-shock-doctrine.html
Simp
CDS and other specifics about the meltdown explained VERY WELL a couple of weeks ago on This American Life
The show is called: #365: Another Frightening Show About the Economy
Can’t recommend it enough.
Though when he said:
what we’re talking about here is the difference between one homeowner defaulting and forty, four hundred, four thousand traders betting back and forth on the viability of his loan.
sums it up pretty succinctly.
Joshua
These guys get their math degree from MIT with a 3.9 GPA then go on and make $200,000 on Wall Street… to start. It’s hard to turn down cash like that. Hell when I was looking for jobs after I got my math degree from UCLA I looked longingly at them… my GPA wasn’t good enough.
The point is, these guys designing these contracts are pretty close to geniuses. The dude down the hall with a BS in Finance or an MBA at best isn’t going to understand what the hell these things are. All the MBA is gonna see is that these math geniuses designed a money tree. And that goes right up to the CEO.
JimPortlandOR
I can’t decide whether the more modern/appropriate name for NR would be the National Batshit Crazy Review or the National Review of the Batshit Crazies. It is some of both.
If NR were my dog, I’d have it put down to spare it the agony and pain of a lingering death from brain deterioration. It’s the humane thing to do.
Bill H
Derivitaves are not even new. Orange County went bankrupt more than twenty years ago and the main issue that drove them under was derivitaves. There was a
bigsmall push to regulate that market, but Phill Gramm (mostly) killed it. John McCain helped.The S&L crisis revolved around commercial real estate. The perps sold a piece of property back and forth, inflating the "value" with each sale, until the lender was holding a $5million mortgage "secured" by piece of desert worth $10. Everything was fine until some regulator actually went to look at one of the pieces of property and said "Oh shit."
So now we have these instruments "secured" by mortgages and everything was fine until homeowners started defaulting. That caused regulators to look at what was in the packages. What they saw caused them to crap in their pants, not because of the defaulting mortgages, but because they realized that there was a whole load of "resale" in those instruments.
Shinobi
Joshua, you are right about the MBA’s not getting it.
I think they key assumption that got screwed up in these models, and in financiers minds is the idea that property values always increase. They always HAVE increased, that doesn’t mean they always will. But y’know, my GPA wasn’t high enough either. And I have like… Common sense…. and stuff.
All I can say is THANK the FSM I did not get any of those hedge fund jobs!!!
burnspbesq
There is nothing intrinsically evil about securitization. In the relatively simple case of securitization of home mortgages, it allows banks to originate more loans, because they are able to replace the loans they write with cash from the securitization vehicle on the asset side of the balance sheet and use that new money to make more loans. For potential investors in the securitization vehicle, if the loans in the pool are appropriately diversified (e.g., by geography), in theory buying into the pool is less risky than buying every mortgage that your local bank originated over the last three months.
All of the problems are behavioral, and they crop up everywhere in the distribution chain. The simplest and most obvious problem (albeit perhaps not the biggest) is the moral hazard problem at the level of the originators. If you know you’re not going to have that new loan on your books for more than 90 days (vs. 30 years pre-securitization), why would you bother to follow traditional underwriting criteria? After all, any defaults are going to be somebody else’s problem. And that’s the logical fallacy behind the whole setup: risk can be transferred endlessly, but it cannot be made to magically disappear, and far too many people behaved as though risk could be made to magically disappear.
This really is a case of "hate the playa, don’t hate the game." Or it might be more accurate to hate that a game that needed referees was played without them.
Jon H
" However, the real issue is that somehow, both the creators and the ratings agencies thought that the aggregate risk of all of the tranches of the CDO could be lower than the risk of its underlying parts. It can’t be. That’s simply impossible."
My understanding is that this would have worked had defaults remained at historical low levels.
The problem is that defaults jumped *way* up. This model doesn’t account for mortgage originators using crazy lending standards and setting lots of people up with loans that are bound to quickly go into default.
The originators were only on the hook for loans that defaulted in the first six months (or sometimes less). If the mortgage resets and becomes unaffordable after a year, and the borrower defaults, it’s the problem of whoever the originator sold it to.
liberal
Shinobi wrote,
I’m not an expert, but in a particular context there’s a resemblence:
A CDS is a hedge against a particular entity defaulting.
A short could be viewed as a hedge against a particular stock going down.
The BIG BIG difference is that CDS’s are private contracts, so there’s huge counterparty risk: what if the guy who sold you the CDS can’t pay up?
In contrast, that kind of thing isn’t an issue with stock shorts AFAICT (again, I’m not an expert).
While I think the biggest part of the financial mess is due to deregulation, there’s something to the claim that things would be a lot better if these things were sold on open exchanges and were not private contracts.
Tim in SF
I wrote this post about credit default swaps and other resources but WordPress wouldn’t let it go through. I guess it had too many links. So I put it here. Please give it a look.
Perry Como
That family member is an idiot and should STFU about the current crisis. CDSs are insurance. They are nothing like shorting a stock.
Comrade Stuck
For all fellow comrade eggheads out there, some forsooth splainning.
I’m kind of life science egghead myself. So the word egghead is used lovingly and without malice. No eggheads were harmed in this or earlier comments by moi’.
burnspbesq
Sinister Eyebrow:
Exactly right. And Republicans have always understood the power of controlling the framing of issues through the use of semantic tools much better than Democrats. Another example of this phenomenon is how a handful of really rich people and their lobbyists were able to convince millions of small business owners and family farmers who themselves were almost certainly never going to pay a penny of estate tax that the "death tax" was the evilest thing ever.
libarbarian
The point is, these guys designing these contracts are pretty close to geniuses. The dude down the hall with a BS in Finance or an MBA at best isn’t going to understand what the hell these things are. All the MBA is gonna see is that these math geniuses designed a money tree. And that goes right up to the CEO.
Joshuas right.
The problem is that there is an intellectual chasm between your average Mathematician/Physicist and an Average MBA – aka. 99% of Mathematicians and Physicists could get an MBA with no problem. 99% of MBAs simply could never get an undergraduate degree in Math or Physics, let alone a PhD.
Dont blame it on the smart guys. Blame it on the retarded monkeys with oversized egos who, for some reason, get put in charge of people who dwarf them in intellect.
Barbara
Shorting a stock entails borrowing shares from someone else and agreeing to return them sometime later, selling them, and then, after the stock has tanked, buying the shares back and netting the difference between the original sales price (high) and the price at which you were required to buy them back.
You short when you think something is overpriced. You sell high and buy low, in that order, rather than the reverse, which is the usual way of doing things.
If the shares go up instead of down, things can get really ugly.
CDS can be like shorting in the sense that you get paid on the obligation only if the party that is the subject of the swap fails to meet its debt obligations. If you are the person, say, who actually owns the mortgage, it makes sense to hedge by buying insurance — or swaps — that allows you to collect even if the mortgagor can’t make the payments.
But what happened is that most people owning these instruments didn’t actually hold the underlying debt, and used them as a way of betting on companies, so in that sense, they were like shorting, because the possibility of making money was closely related to the failure of another party to meet its obligations. As others have noted, the sheer volume of "bets" on the debt vastly exceeded the value of the underlying debt. It should have been regulated to some extent, certainly, because companies were essentially acting as unregulated insurers, on the theory that everyone involved knew how to protect their own interests.
As much as I love Matt Taibbi, I do sometimes wonder what his home life was like when he was a child.
liberal
Joshua wrote,
I didn’t go to Wall Street myself, but…
It’s not that hard to turn down the cash; the hours really suck. Also, my impression from talking to people is that there’s a huge amount of BS going on, so if you don’t like putting up with that…
One interesting point: a common claim is that some occupations are paid more partly because there’s a high risk of failure. One very good physicist I know from high school (he never went to Wall Street, but thought about it—he did create at least one successful tech startup) pointed out that not a single one of the physicists he knows who went to Wall Street failed.
Jon H
Brachiator wrote: "Meanwhile, the US approach is more like "We will give you money, but you have to promise to behave in the future.""
I hypothesize that this is because Britain retains the culture of WW2, getting through the Blitz, etc, whereas America really doesn’t retain that mindset in our culture.
It probably helps in Britain that the obituaries these days are full of WW2 vets with freaking amazing stories.
Perry Como
Ugh. Folks, CDS != shorts. They are different instruments. They can be used to hedge and speculate, but their structures are completely different. Don’t let the wingnuts run with this. It’s like saying a hammer and a gun are the same thing because both of them can kill a person and drive in a nail.
liberal
burnspbesq wrote,
Yes, though it’s helped by the fact that, on average, small businessmen are, as a historical rule, very right-wing. (Not trying to be nasty here; it seems to me however that this is true across many decades and in many countries.)
liberal
@burnspbesq:
I don’t disagree with anything there, or in your full comment.
But what I don’t understand about securitization is that, in so many cases, the originator did not pass on the credit risk. Either by offering the buyer a CDS or something, or by something written in the contract of the security itself. IIRC that was true of a lot of Fannie/Freddie stuff.
So…if you’re not passing on the credit risk, what the hell is the point? Yes, you’re getting liquidity to make more loans, etc, but you’re manifestly not distributing credit risk, which sounds like a bug not a feature.
Jon H
Perry Como wrote: "That family member is an idiot and should STFU about the current crisis. CDSs are insurance. They are nothing like shorting a stock."
Yes and no.
Shorting a stock is, essentially, a bet that the stock will go down – a bet against the company.
When an uninvolved party buys a CDS on someone’s debt, they are essentially betting against the issuer of that debt. Maybe that’s not the original intention behind Credit Default Swaps, but that’s how they are often used.
If there’s a lot of interest in Credit Default Swaps against a particular issuer’s debt, that indicates a lot of people think that issuer is in trouble, much like a high level of short interest in a stock indicates that a lot of people think that stock is in trouble.
demimondian
Look, CDS’s are, in theory, quite simple, and they have nothing to do with ponzi schemes.
Suppose you and I are in different businesses — say, you lend to people who farm in Indiana, and I lend to homeowners. Now, there are conditions which might lead you to be insufficiently capitalized to pay all your debts in a timely fashion, and there are conditions which might lead me to in sufficiently capitalized to pay all my debts in a timely fashion, but those conditions are rare by themselves, and are even rarer in conjunction. Now, be aware, both of us will have assets which can be sold to cover those debts *in time*, but not necessarily as fast as need be.
If those three conditions all obtain: joint failure is far less likely than individual failure, overall net positive value, and availability of both of us, then you and I can enter into an agreement that you’ll insure me if I can’t pay, and I’ll insure you if you can’t pay. It means each of us doesn’t need to keep as much cash on hand, and provides each of us with extra security, thus making capital cheaper to obtain for loans.
That’s a "credit default swap" (CDS), a straightforward derivative instrument, in this case a mutual insurance policy which two parties offer to each other.
But, wait! A third party could take that instrument, and offer it to several parties simultaneously in return for an income stream. That third party could go into business as a broker for that kind of insurance, collecting premiums, and taking a vig from the bets. If they’re not going to all default, that’s an income producing asset.
Cool, and then it could be used as collateral for another loan, which would make those policies cheaper to insure — and maybe the third party, which we can call the Amazing Insurance Generator, could even generate a second-order derivative to insure against its own default. And sell that. And then sell a derivative against that…ad infinitum.
Insofar as that goes, actually, that’s not as bizarre as it sounds. In principle, the necessary conditions for a sound CDS could be satisfied: multiple parties (check), joint default rare (at least, if the Amazing Insurance Generator is well managed _and is not so large that its own default would trigger other defaults_), and net positive value (thanks to the Black-Sholes formula and a bunch of rocket scientists in the back room being both clever and honest.)
But did you see the phrase in _italics_? That’s what went wrong with this castle in the air. The real AIG and its counterparties became large enough that a single failure could, and, in fact, did, trigger another failure. That critical independence assumption about joint failure being rare? Yeah, suddenly, not so much.
And that opened the doors to the abyss.
Tony J
Far from an expert, but I think I’m right to say that short-selling is when you, believing that a certain stock is going to go down in value, temporarily borrow some of that stock from someone else who has a lot of it, on the promise to give it back to them + some percentage of interest at a definate future date.
You then sell on that stock to your mark, for the same price you paid for it + carrying fee, wait for it to tank, and then buy it back from your panicking mark for a lesser amount.
You then return it to your original source, and pocket whatever is the difference between the price you sold it at and the price you originally paid.
That this may lead to problems is one of the reasons the people who coined the term (I believe it was the Dutch) also banned it and got all medieval on the ass of anyone caught doing it.
Jon H
"But what I don’t understand about securitization is that, in so many cases, the originator did not pass on the credit risk."
I think this was not so much the originator (fly-by-night mortgage broker shops don’t do CDS) but at some level up the chain whose customers are sovereign wealth funds and other large institutional investors.
Sean
I love it when so-called ‘intellectuals’ of the right get brutally pwn3d.
ksmiami
I know there is nothing evil about it, but it was never supposed to become a cornerstone of our economy. And left unregulated THAT is what happened as the risk got sliced and sold to investors in small towns in Norway, etc. No one knew what crap was in each package and as long as Moody’s and S&P had their signatures on it, nobody cared, but the people who could have made a difference like the originators had no skin in the game and they became less and less incentivized to ensure that there were any standards being applied.
So now, will these brilliant math people go back to engineering or something?
Barbara
Shorting and CDS are different — and in this respect, they are very different: every shorting arrangement involves actual shares in an actual company. CDS are disconnected from an underlying asset such as debt or shares in a company. A company being shorted could start repurchasing its own shares, for instance (though a strategic short involves companies that are usually too weak to do this). The point is, there is an outer bound to the loss, which would never be more than 100% of the outstanding shares of the company. CDS have triggered liability many times the value of the assets to which they are pegged so that if those assets fail, the liability is astronomical and that’s why it could have such a domino effect in the economy.
libarbarian
Obama vs. the GOP – a preview
JenJen
Can Matt Taibbi be my boyfriend? Please?
I’ll never forget watching him on Bill Maher earlier in the primary season, where he talked about how John McCain can just run any old shit up a flagpole and the tire-swinging media will dutifully salute it.
demimondian
@burnspbesq:
What the man said.
Part of the problem is that the rocket scientists in the back room weren’t innocent. They were making money, and, in the process, making ever more ludicrous bets. There wasn’t anybody out there who was being payed to really weigh those bets — and you can be sure that the financial folks will always make sure that any such person can be offered a f*ck of a lot more money to ride through the revolving door and work for the other side.
And you can also bet long odds that the corporate press would call the few honest souls who chose to stay in the regulatory world either communists or incompetents.
Perry Como
Jon H: The "CDSs are like shorting stock" is a meme I’ve heard in the wingnutosphere. I’m not sure where it started and I have no idea where it’s going, but I’m pretty sure it will end up with laying blame on the Democrats. The only way the two instruments are the same is that they can both be used to do similar things. My most charitable concession would be to say speculative CDSs are similar to naked shorts. But even that may give enough wiggle room for wingtards to spin whatever tale they are trying to tell.
demimondian:
The CDO market was a Ponzi scheme. The CDS market is John McCain in Vegas with an American Express Black card and trunk full of cocaine.
r€nato
oh man total pwnage! thank you for posting that, I am still wiping the tears of laughter from my eyes.
I’m not gay but man, if I wanted to gay marry, Matt Taibbi would be my guy.
bluebayou2
I want both Matt and John to be my new BFF’s, but I know I am too old for them. Recently discovered this site, somehow, when linked by Atrios. It always makes me feel better.
Re the financial mess, a couple of observations from one who worked in it and took a package (retirement) after the events of 9/11 from one of the firms that went away a few weeks ago.
A former co-worker, still a broker at same firm, but who has listened to Limbaugh and Boortz for years, sent me a diatribe last week that (1) Obama was the cause of the market panic (2) that Dem Congress persons, mostly AA ones along with Barney Frank, were a major cause by preventing Republicans (when they were in the majority a couple of years ago) from instituting more stringent oversight of Fannie and Freddie. Sent a selectively edited You Tube video. Franklin Raines is the star of the video, along with Maxine Waters, and Barney Frank. Just a few minutes ago on CNBC, one of their reporters explained how the short sellers drove up the spread on CDS and then went and said to the CRS how weak a particular bank was. The CNBC reporter used the expression that "Wall Street ate itself".
Republicans are absolutely unhinged vis-a-vis their total inability to accept any responsibility for anything. They are idealogues and not pragmatists.
r€nato
what I understand about CDS, is that they are basically like buying insurance but without having any ownership of the underlying asset.
In other words, they are a bet. Pure and simple. I’m sure the details are a bit more complicated but that is what they amount to.
At least Vegas bookies have the common sense to keep enough cash on hand to pay off bettors. AIG and the other Ponzi schemers didn’t even keep reserves for the CDS. They just pocketed the money as if they found it on the ground and there was no potential liability associated with it.
demimondian
Actually, they don’t; you’re thinking of Parimutuel. In Vegas, or any casino, the house never has enough cash on hand to immediately cover all bets. The house counts on winning and using the cash from the shlubs to pay off the occasional lucky bettor.
Brachiator
@demimondian:
The big problem here is that it is not really a mutual insurance policy. More traditional banks and insurance companies have to have some amount of reserves from which losses can be paid. With CDSs, after a point people were essentially bluffing. They had neither the means nor the intention of paying off a loss.
In addition, the "foundational loan" was often made to people who were not capable of keeping up the payments, and were extremely unlikely to be able to make the payments in the future.
The odds that the whole scheme would collapse was close to an absolute certainty.
r€nato
The analogy I always think of when it comes to CDOs and tranches, is it’s like, say you’ve got a tank of water with a toxic carcinogen in it – enough to give fatal tumors to a lot of people.
Now let’s say you also have a huge well full of clean, unpolluted water. There’s a lot of thirsty people who are willing to pay good money for your water.
You could just sell them the clean, unpolluted water… but if you are a sharp businessman, to maximize your profit and sell the most water possible you can dilute the polluted water with a sufficient quantity of the clean water, and the parts-per-million of the carcinogen drops so low as to produce a negligible to no risk of cancer to anyone who drinks it.
But what really happened is, they didn’t ‘dilute’ the water enough and now everyone has cancer, even the people who were told they were buying the safest, most-diluted water.
Shinobi
Thank you for proving me right about stock shorting(which I think I now understand) and CDS (which I already understood.)
I don’t actually think my relative is an idiot, I think he just desperately wants to believe that 1. He is smarter than me and 2. the republicans are right. Unfortunately he is being a total dick in the process of trying to prove these things and confusing the hell out of me!
I hope that having the democrats in power for a while will cause the republicans to return to the realm of rationality. It is very hard to argue with people when they are exsisting in a HTW where yes is no.
Ondine Breck
@joel hanes:
I want to have your baby.
Perry Como
I’d like to buy Derangement Default Swap protection on that.
burnspbesq
Perry Como:
Tee hee. Don’t think you’re likely to find a counterparty willing to write it for any amount you’d be willing to pay.
Joshua
@Brachiator:
Well, thats because a lot of times, they would then buy other swaps to hedge the CDS.
Yes, that’s right, these companies were taking out bets on the bets. And I am sure they were taking out bets on the bets on the bets. And so forth. Nobody really knows how deep this goes.
Tony J
Not really.
You’ve got to remember that the last 30+ years in the UK have been the story of successive governments indulging in one long crush on whatever the US happens to be doing because America=Cool and Popular. Brown and Blair brought New Labour to power in 1997 by more or less copying the Republican-lite handbook of Clinton’s Democrats, and after 2000 they jumped ship to the Republicans, with everything that entails.
The difference in Britain is that, while Brown bears a ton of responsibility for getting Britain into the same economic fuck-up that’s hitting America, he’s first and foremost an economist with a politician’s job, and a month ago he was sitting on record low poll-numbers and the certainty that, whatever he said or did, he was going to lose the next election to the ‘New Conservatives’ because the British public are basically sick and tired of the New Labour brand after 10 years of lies and betrayal and want to punish them by voting for the only other party with a wide enough base to unseat them, which means the Conservatives.
Then the economy went tits-up, which could have been the final nail in his coffin, but as an economist he could see what the Swedes had done in part-nationalising the banks was the only way to go, while following the White House’s policy would just cede that option to the Conservatives, who could then run as the anti-Bush party in the assurance that the White House would have a different occupant by the time they came to power. And if he did it with a big enough PR effort, he could spin the whole thing into a story about SuperGordon the Economic Genius leading the world to safety by knowing what the fuck he’s doing, unlike those feckless Conservatives.
Which he has, and it seems to be working. He’s gone up in the polls, and the Conservatives are stuck without anything to say. It remains to be seen if the economic side of the calculation will be anything like as succesful as the political one.
Jon H
Tony J wrote: "Not really."
I meant the bank executives taking it in the shorts with a stiff upper lip, old bean.
American executives would pitch a kicking and screaming tantrum, and the Feds aren’t about to push the issue. British executives, I think, or at least some of them, still have a notion of taking one for the team in a time of crisis, for the good of the nation. Especially since they’re already wealthy.
Don
I think the CDS = Stock Shorting confusion started out with someone pointing out the VERY LIMITED PARALLEL between CDSes and naked short selling, which is a very different (and illegal) beast. The slender similarity is that you don’t have to be the owner of the debt being insured by a CDS, just as a naked shorter has not procured the share from anywhere.
That’s the real problem in both cases. If CDSes were limited to one per security such that the payout on them was contingent on the
insurerissuer took control of the bad security then (a) the CDS market could never be bigger than the security market rather than the 10x+ it is now and (2) the organization paying out on the CDS could recoup some of their payout through foreclosure (in the case of mortgage securities).Similarly a naked short sale results in no limit on how many people can be making these negative bets. If the stock has to be borrowed from a legitimate owner then there’s a total capitalization limit. Not so if I can just make a (potentially empty) promise that I’ll come up with it later.
However that’s just a loose parallel that obviously has caused more confusion in the long run.
LongHairedWeirdo
Re: Credit Default Swaps, here’s the thing.
Let’s say you buy a bunch of bonds… say, a thousand $1000 bonds. That’s a million bucks, and they’re paying a decent rate. They have a five year term, so you’ll get interest for five years, and then get your million bucks back.
But you’re worried. What if something goes wrong? You can’t afford to lose your million. So, you pay me insurance to pay you back $1000 for each of those bonds that defaults. (Or, possibly, to pay you the difference between what you can sell them for – sell them for $650, and I pay you $350).
Let’s say you pay me 1% of the bonds – 10,000 bucks a year – for this. (Remember, you’re getting interest on these bonds, so, really, all you’re doing is cutting the interest rate to yourself in order to provide security for your principle.)
That’s the easy part.
Here’s the hard part. You probably are insisting that I have at least a million dollars in assets to cover the possibility of default. Or, say I’m a bank, and I can loan out X dollars for every Y dollars I have in assets.
How much is that contract we have worth?
If we knew that the bonds were perfect, it would be worth the present value of $10,000 a year, for five years.
If we knew the bonds were all going to default tomorrow, it’d be worth -$1,000,000 (that’s a minus sign, just so it’s clear).
But we don’t know how much that contract is worth. So, how do we value it?
Two ways. One, our actuaries do some horrendously complicated math, and say "it’s worth X% of the present value of $10k a year for five years, based upon these assumptions regarding default rates, which have served us well in these circumstances".
The other way is "Hey, everyone! I have a CDS, paying 100 basis points on a million in bonds! Who wants it, for how much?" and take the high bid.
The problem is, no one is buying. I mean, seriously, if you offered to buy that CDS, you just *know* I’d be giving you the ultimate booby prize, a CDS where I was already sure that the bonds were going to tank. And you know this because you know you’d do the same to me, if I was stupid enough to buy from you.
Now, here’s the fun part.
Look at these possible outcomes. Remember that bit about assets?
That CDS is an asset until there’s a default. But no one knows the value. That’s problem one.
Second, some of those bonds will default, and I’ll need to sell assets – assets that no one is buying! – to pay you.
Third, your bonds used to be a million in assets, but with no one knowing if I can actually cover your losses, they’re not a safe million any more, are they?
So your assets aren’t as good as they were. No one wants to buy from you to give you any cash because no one trusts the bonds.
So it keeps rippling out.
It’s really fascinating, or it would be, if it was just a computer simulation.
HyperIon
If this stricture were applied to the web, there would be about 5 posts on this thread.
And wrt demi’s mention of violating the
this is another great reminder that NATURE CANNOT BE FOOLED. if you violate the assumptions your scheme is based on, you will NOT get the results implied by that assumption.
brent
If this stricture were applied to the web, there would be about 5 posts on this thread.
Perhaps, but
1) I don’t think its reasonable that comments on a blog post be held to the same standard as the opinions of professional public intellectuals that hold themselves out as having, at the very least, informed opinions on the topics at hand.
2) The alarming bit is that, contrary to your aspersion, most people here do seem to have a basic understanding of a lot of the structural financial issues underlying the current crisis that York clearly demonstrates in that exchange that he does not. We can argue about whether the knowledge demonstrated here is comprehensive or even sufficient for the purposes of intelligent conversation but the point is that York does not even seem to be aware that things like CDOs and CDSs exist. That, I submit, is unconscionable for a person expressing such a strong opinion in this circumstance.
RememberNovember
The NR needs to Fire Kristol and his goose-turd stepping lackeys and hire WFB Jr. back to achieve any semblance of gravitas and integrity.
eyelessgame
Of course some loans are riskier than others. That’s the nature of making loans. There is nothing wrong with making risky loans; all you have to do is evaluate the risk accurately, and discount the expected value of the loan by the cost of the risk. The basic problem here is that the deregulation crap that Gramm peddled has resulted in the deliberate and fraudulent misvaluation of these risks.
The slightly more sophisticated racist claim is that they understand all that but that banks were forced to make risky loans and not allowed to charge higher interest to cover the cost. But that’s still not a problem — basically the argument becomes "banks do not know how to make a profit." Bullshit. A bank can raise rates across the board by a fraction, which is enough to cover the cost of the riskier loans.
Banks know how to balance their books. They have been doing this for hundreds of years and I think it’s fair to say they know what they’re doing. But for those same hundreds of years, if the government didn’t keep them from selling pigs in pokes, they naturally will attempt to sell off risk without telling the buyers about it. It was exactly the requirement for that sort of accurate disclosure that Gramm’s amendment repealed.
demimondian
Problem is, Hyperion, if you understand this business, then…you really can’t express a strong opinion. It’s *complicated*, and we’re going to spend a long, long time figuring out what went wrong, and how to keep it from happening again. Remember, derivatives are nothing more than *useful* tools — and we need to figure out how to make sure that they aren’t thrown out, just because Phil Gramm and the UBS Grammy Boys made a really bad hit with them.
Brachiator
@RememberNovember:
I suppose that a dead WFB Jr is more erudite than a living Bill Kristol, and not nearly as malodorous, but still….
I think you meant to say, Christopher Buckley, son of WFB Jr.
eyelessgame
I should point out that my post above is not an attempt to explain CDS (others before me have done an excellent job) but only a refutation of the racist idea that banks went bust because they had to loan money to brown people.
Douche Baggins
When I graduated from MIT in 1988, fully half of my class went on to Wall Street. And not just the math majors, either, who tended to smell funny and laugh at inappropriate things; the physics majors were a hot commodity.
Twenty years later I’m still an engineer, and while I don’t make nor ever have made 200 large in a year, I get some small satisfaction knowing that the fruits of my labor have come from the reality-based world of molecules, and not the bullshit world of electrons.
Rob in Columbus
It’s shaping up to be quite the annus horribilis for National Review. Has it still never made a profit? Here’s hoping it finally goes under.
http://www.nytimes.com/2004/06/29/politics/29buckley.html?ei=5088&en=ac98a00aa26dd50e&ex=1246248000&partner=rssnyt&pagewanted=print&position=
Adam
So Ocean’s Eleven lied to me? :(
Comrade grumpy realist
Heh, feel I have to weight in on this as a card-carrying MIT physicist….
Almost got hired by Moody’s back in 2002 to create CDOs, so I can guess at a pretty good sketch of how the whole thing blew up: the quants would put together a CDO based off mortgages, bonds, whatever, and tack on to it the 10 pages of caveats and assumptions under what conditions the probabilities will hold. Can be rated "AAA" under conditions X (20% of the time), "AA" under conditions Y (25% of the time), and so forth. Said CDO gets handed to the front office guys, who immediately junk all the caveats and conditions, stamp "AAA" on it, and whisk it out to the sales people.
As I keep saying, molecules never scream and run into one corner of the box; humans often do.
The other problem is that everyone was working off "historical estimations" of default rates which had been established when banks were being stodgy and careful and keeping their noses clean and making sure they could be paid back. CDOs come along, the banks/mortgage critters think they’ve found a great new shiny way of taking no matter what type of dodgy debt and turning it into gold so they slack off on the standards….what did anyone EXPECT would happen?
comrade pseudonymous in nc
To quote dsquared: