Tfgray’s Weblog

Let’s start with a comment from Polixian to a previous post:

 This should give responsible media outlets a greater opportunity to point out the history of how it is our economy got to where we are…beginning with the Community Reinvestment Act of 1977 (President Jimmy Carter); the push by the Clinton Administration to force sub-prime mortgage lenders to expand their offerings into under-qualified, high-risk groups; the money trail of industry lobbyists (esp. Freddie Mac, Fannie Mae) and their political allies (esp. Frank, Dodd, Obama, and other republicans as well); and, the efforts by the aforementioned, as well as Maxine Waters and Pelosi, to protect such industry practices via outspoken congressional opposition to reform measures.

Ok, I admit I started it, by thinking that the Bushies had pushed this to bring the maximum amount of sheep in to be fleeced by predatory lenders. It was the Liberals that started this. However, here are a couple of details that have come to my attention:

Polixian echoes the Right Wing charge that Liberal policies have forced banks to make loans to people who could not afford the payments. It is soundly rebutted here:

http://www.snopes.com/politics/obama/loans.asp

The landmark case, Buycks-Roberson v. Citibank Fed. Sav. Bank was about the bank’s refusal to make a loan to a Black woman while granting loans to whites with similar income profiles. The lawsuit sought to end redlining, the practice of refusing credit to individuals based upon their neighborhood, regardless of their ability to repay.

I spoke with Michael, my go-to-guy at work, a second-generation bank consultant, who told me he ran the math and figured out that the $700 billion figure for the bailout was based upon 7% of the $10 trillion mortgage market going south, of which $0.5 billion represents those nasty, evil, ACORN-inspired subprime loans. Po’ folks taking down the global economic system? Not hardly.

Then I ran across this, at http://www.webofdebt.com/articles/its_the_derivatives.php 

What had to be saved at all costs was not housing or the dollar but the financial derivatives industry; and the precipice from which it had to be saved was an “event of default” that could have collapsed a quadrillion dollar derivatives bubble, a collapse that could take the entire global banking system down with it.

Michael puts the total US derivatives market at $180 trillion, or about 18% of the global total, and notes that the entire GDP (Gross Domestic Product) of the entire world is a measly $70 trillion. Yeah, you read that right: the derivatives market is about 14 times the entire annual income of the entire world. OK, so what’s a derivative?

Essentially, it’s a bet. Again, from Ellen Brown, who explains this stuff so clearly:

Derivatives are financial instruments that have no intrinsic value but derive their value from something else.  Basically, they are just bets.  You can “hedge your bet” that something you own will go up by placing a side bet that it will go down.  “Hedge funds” hedge bets in the derivatives market.  Bets can be placed on anything, from the price of tea in China to the movements of specific markets. 

“The point everyone misses,” wrote economist Robert Chapman a decade ago, “is that buying derivatives is not investing.  It is gambling, insurance, and high stakes bookmaking.  Derivatives create nothing.”¹  They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services.  In congressional hearings in the early 1990s, derivatives trading was challenged as being an illegal form of gambling.  But the practice was legitimized by Fed Chairman Alan Greenspan, who not only lent legal and regulatory support to the trade but actively promoted derivatives as a way to improve “risk management.”  Partly, this was to boost the flagging profits of the banks; and at the larger banks and dealers, it worked.  But the cost was an increase in risk to the financial system as a whole….²

Credit default swaps (CDS) are the most widely traded form of credit derivative.  CDS are bets between two parties on whether or not a company will default on its bonds.  In a typical default swap, the “protection buyer” gets a large payoff from the “protection seller” if the company defaults within a certain period of time, while the “protection seller” collects periodic payments from the “protection buyer” for assuming the risk of default.  CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to increase profits by gambling on market changes.  In one blogger’s example, a hedge fund could sit back and collect $320,000 a year in premiums just for selling “protection” on a risky BBB junk bond. The premiums are “free” money – free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims. 

And there’s the catch: what if the hedge fund doesn’t have the $100 million?  The fund’s corporate shell or limited partnership is put into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down.  Players who have “hedged their bets” by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets. 

The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme.  The potential for this sort of nuclear reaction was what prompted billionaire investor Warren Buffett to call derivatives “weapons of financial mass destruction.”

[This might be the time to mention that W's brother Marvin runs a hedge fund, Winston Capital Management, but I digress.]

So, what did that $700 billion buy us? Damned if I know. The credit market is still seized up, since the dominoes are still a-tumblin’ and $700 billion, as impressive as that string of zeros is after the 7 looks, is only .00000004 of the value of the total derivatives market.

And the most interesting part, as Brown points out, is that “Derivatives create nothing. They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services.”

So essentially, derivatives are fluff, wispy critters of air, the foam on the economic beer, so to speak. with as much intrinsic value as the average casino chip. And yes, there are people who have profited most handsomely from them. What to do? Soak the Rich? That would be nice, but the problem is that down the line the real money underlying the cotton candy is your IRA, my 401-K, and Mrs. McGillicutty’s annuity.

Exactly how do we untangle this?  How do we blow the foam off without spilling the beer? Nothing jumps off the top of my head, but I’m putting on my thinking cap, and I hope you will, too.