Another poster requested that I start a thread on this subject. For those of you who need a little primer on this subject:
Derivative (finance - Wikipedia, the free encyclopedia)
and
Mortgage-Backed Securities
Long ago and far away, when someone wanted a mortgage to buy a house, he or she would visit the friendly neighborhood banker. If they qualified, the banker would lend them the money (less 20% down) to buy the house. The funds came from the bank's deposits, and the banker had a great deal of authority to allocate investments on behalf of his depositors. If something unfortunate happened - a job loss, large medical bills - a visit to the banker would usually result in a satisfactory arrangement. Foreclosures were rare but not unknown. In such a case, the banker could just write off the bad debt and continue on.
In the past decade, bankers have become more innovative, and very much more greedy. If they could lend money to home buyers, sell the mortgages off, and re-lend again and again, taking their cut as they serviced these mortgages - why, they could get rich beyond their wildest dreams. All that stood in the way was a pesky little law called Glass-Steagall, which required that commercial (retail) banks be separate from investment banks. This law, enacted during the Great Depression specifically to prevent such shenanigans, proved to be easily gotten rid of, once everybody understood just how much money was at stake.
So the bankers and mortgage originators got very, very busy. Interest rates were low, the country was swimming in prosperity, and the boomer generation could afford to move up to greater luxury. A tremendous variety of new mortgage products became available. As soon as money was lent to a buyer, the loan was sliced and diced into tranches of risk, depending on the buyer's credit score, assembled into pools, and then securitized (turned into securities) for investment. Once bundled into mortgage-backed securities (MBS's) and sold to investors such as pension funds, institutions, international buyers and hedge funds, banks then took the investment money and re-loaned it to new home buyers who needed a mortgage.
It was a Ponzi scheme if ever there was one. Each successive buyer of this debt took on more and more counterparty risk, until it became necessary to make "bets" on the rise of home prices and interest rates. Bond insurers such as Ambac and MBIA got into the act, making big bucks insuring what was a "sure thing". No one could foresee that property prices could go down, that properties could become "underwater", or that the homebuyers would ever default. The bankers became giddy with greed, and created a monster.
A derivative is a bet or gamble that something will or won't happen. There are various types of derivatives, but the OTC (over-the-counter) type is what will be discussed here, specifically the Credit Default Swap (CDS). This type of instrument is off-balance sheet, privately negotiated, and the trading is handled manually; there is no central exchange for "swaps". They are also not regulated. They are marked to model (the price of the underlying security, or mortgage), not to market (the price of that they would fetch if sold).
Swaps are subject to counter-party risk (counter-party insolvency), or the inability to honor the obligation. Derivatives can lead to fabulous wealth in good times, but large losses and ruination when the tide turns, due to the use of massive leverage. Billions were made on small price rises; trillions are being lost on large price declines. There is no floor under home prices, and these assets are now under stress.
The BIS keeps track of the credit default swap market; as of December 2007, this market was $596 Trillion, up 826% over 10 years. This explosive growth in derivatives since 1998 has created a concentration of risk unsurpassed in the history of finance.
Marty Weiss identifies 5 major US banks that control 97% of all bank-held derivatives in the US - Citibank, Bank of America, Wachovia, HSBC, and JPMorgan. Four of them have more credit exposure than capital! Any or all of the 5 could be bankrupted by the default of just a few major counterparties like Bear Stearns (bigger than LTCM).
If you think that we have seen it all, there is much more to this thing. The banks named above are still operating, but are functionally insolvent. No wonder Warren Buffet called these derivatives "weapons of mass financial destruction"!
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OTC Derivatives: The Cause of It All
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