Sunday, March 22, 2009

Thirty Dollars of Debt...

If I am holding a mortgage on your house and I go to an insurance agent and buy a policy that pays me the money you owe me if you default on your loan, that is a good deal for me, the mortgage holder, and it’s legal.

If the insurance agent, knowing that he does not have enough cash reserves to pay off policies that statistically are going to go into default, continues to sell policies such as the one I just described, he is breaking existing laws. The way around that is to not call them insurance policies, but rather call them “credit default swaps.”

If I am not, repeat not, holding a mortgage on your house and I go to buy a policy that pays me the money you owe me if you default on your loan (to the person who is holding the mortgage), that is illegal. The way around that is to not call it an insurance policy, but rather call it a (wait for it) “credit default swap.” In this case a “naked” credit default swap.

If I’m at all nervous about all of the CDS instruments that I own, I can buy an insurance policy that pays me if they go bad, but such an insurance policy would be illegal and the person I’m buying them from doesn’t have the cash reserves that insurance companies must carry (although he doesn’t tell me that), so these instruments are called “derivatives.” There are other forms of derivatives as well, some of them based on factors as abstruse as the weather on a given future date in East Tonga.

There is also debt secured by your mortgage, the opposite of the CDS's.

If I hold the mortgage on your house and I don't want to hold it any more I can sell it to another financial firm. It happens all of the time. Our credit union sold our mortgage to Citibank.

But suppose that, rather than selling your mortgage, I bought a financial instrument (a derivative) on credit and said that I would put your mortgage up as security against that loan, while still holding the mortgage? That's legal enough, so long as I only do it once. What happens if I do it ten times, or thirty times?

Or I can sell a derivitave which contains assets itself, one of those assets being your mortgage. Again, legal enough if I only do it once, but when I do it many times over I am selling a fraud.
(People also bought "credit default swaps" on the instruments which contain your mortgage, often when they didn't even own any such instruments. It's enough to make your head hurt.)

There is insurance on your mortgage, there are God knows how many “naked credit default swaps” based on your mortgage, there are derivatives based on that insurance and on those “naked credit default swaps,” and there are more derivatives based on those derivatives. If you pay off your mortgage (oddly), all of those financial instruments become worthless. There are other instruments secured by your mortgage, or containing it, worth many times the value of your mortgage, which become worthless if you default on your mortgage.

That is the basis of the pyramid that President Obama let slip on Jay Leno the other night with his little remark about how, when they started looking into finances when home mortgages started going into default, “they found thirty dollars of debt for every dollar of mortgage."

This financial crisis is not about defaults on home mortgages, good ones or bad ones. It's about financial manipulation of amounts many, many times that amount which are based on those mortgages. Whether those mortgages succeed or fail, those instruments have now been revealed as a massive pyramid scheme.

What happens when the true nature of the Ponzi scheme can no longer be denied? If there is “thirty dollars of debt for every dollar of mortgage,” what happens when you do pay off that mortgage? How do the other twenty-nine dollars of debt get unwound? If you default, how does it get paid?

That is the nature of the “toxic assets” sitting on the books of the banks and that the Geithner Plan will buy from them as a price yet to be determined. That will presumably be below face value but high enough to satisfy the banks. The government will hold these “assets” until it can sell them, we are told, hopefully at a profit.

The Geithner Plan says the purchase of these assets will be made by a mix of private investment and government, but if you read the fine print you will discover that the government puts up 97% of the money. Private investors put up 3% and receive 20% of the equity which benefits the taxpayers in some magical way not explained by Geithner.

Probably the same magical way that the “assets” regain their value.

The end result is that banks get rid of worthless paper at a profit, which benefits the stockholders and management of the banks. The management which ran the banks into the ditch get to keep their jobs and their salaries. Investors get equity in something that they essentially did not pay for. And the taxpayers get one trillion dollars added to their eventual tax bill.

As usual, everybody wins except the taxpayer.

There was outrage, appropriate but distracting, when Wall Street looted $165 million from taxpayers in the form of unearned bonuses. Just wait and see what happens when America at large is asked to stand by while Wall Street loots another $1 trillion.

1 comment:

  1. Anonymous12:57 AM

    It stands to reason that there is fraud going on here.. esp if you go by your description. And yes, it makes your head hurt.

    1) Can these perps be prosecuted for fraud? Would a punishment include restitution?

    2) What happens if the financial institutions that did it were allowed to fail? IE, no bailout for them.

    3) The much ballyhooed bonuses (which I think just stink in the first place) are really just the tip of the iceberg. Some people keep talking about Obama being the next FDR, but how many people remember that 1/3 of the banks back then just failed of themselves or were allowed to fail?

    4) The financial mess is bad, sure. But that doesn;t take away from the forclosure mess, which is bad as well. Is there or will there be or should there be a viable plan for that as well?