Who is to blame for financial armageddon?
October 19th 2008 08:06
Here's the lineup, I'll leave the judgment to you.
Suspect 1: Credit Default Swaps.
This is my prime suspect. Basically, CDS is insurance against a default on a loan. Company A pays company B an amount upfront and then premiums on top, and company B provides insurance against one of company A's loans defaulting. So basically, if company A lends out money and there is a loan default, company B reimburses company A.
So how does this simple sounding contract threaten the whole financial world? Well, for one it's called a swap instead of insurance (which it is), so frighteningly it isn't regulated by the government. Why is this frightening? The CDS market is worth an estimated $62 trillion US. Just to put that in context, the American GDP is roughly 14 Trillion. So in other words, if you take every single dollar generated by the US for the next 4 years, that is still less than the amount of unregulated money floating around in the form of CDS trading.
Furthermore, you don't have to own the underlying asset to take out a CDS contract. If you think company A will default, you can go ahead and make a CDS contract.... it's straight out gambling, with scores of trillions of dollars at stake. THAT is where this all went horribly wrong. Furthermore, CDS is subject to counterparty risk, so if one party goes bankrupt (such as Bear Stearns for example), then all the premiums you paid to them as well as your insurance, all gone.
That's why the US bailed out Bear Stearns, because it had trillions of CDS on its books, and had they gone under, these trillions = gone. Just like that, a large part of your GDP, up in smoke, and that's something Mr. Bush couldn't allow to happen.
That's it in a nutshell, but you can get a better understanding of the CDS angle here.
p.s. I'm not exaggerating this at all. Warren Buffet called financial derivatives 'financial weapons of mass destruction'... oh Warren, if only we'd listened.
Suspect 2: Lack of Regulation
Now, this sort of links in with the whole CDS issue, because they aren't governed by regulation. However, there's a bit more to it than that. Another widely-cited cause of the widespread economic pandemonium is the sub-prime mortgage crisis. What caused this?
Well, basically, the mortgage lenders were flush with money, and started pumping out sub-prime mortgages (mortgages with clients that had a history of bankruptcy, troubles with finance, etc). Anyway, these lenders fraudulently over-estimated property values and incomes, to push out more money. It was all about getting the fees off the loans, and no one cared about the ability of the borrower to repay the loan. Well, that came back to bite them when all of these borrowers started defaulting, but that's where the lack of regulation came into it. Had this market been better regulated, people would not have received mortgages far beyond their ability to repay, and that whole mess could have been avoided.
Source: here.
Suspect 3: The Housing Bubble and America's Hedonistic Society.
Living in the now. Instant gratification. Hedonism.
How does that link to our current predicament? Well, listen closely. Americans love spending. Americans spend $800 billion a year more than they earn, resulting in a debt ratio of 130%, up from 100% earlier in the decade (Source). What does this have to do with housing? Well, to quote the wiki page again, "ome homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending."
So what happened? As happens to all bubbles, the housing bubble burst. Suddenly, these second mortgages were on houses that weren't worth quite so much at all anymore. End result? Everyone loses. And because the extra cash had been spent on consumer spending instead of investment (see? Hedonism), these people were left floundering, and so was the financial system that enabled them.
There are other causes, but from what I can tell these are the big 3. I am, however, by no means an expert on this topic, so any input or debate over these points is welcome.
Suspect 1: Credit Default Swaps.
This is my prime suspect. Basically, CDS is insurance against a default on a loan. Company A pays company B an amount upfront and then premiums on top, and company B provides insurance against one of company A's loans defaulting. So basically, if company A lends out money and there is a loan default, company B reimburses company A.
So how does this simple sounding contract threaten the whole financial world? Well, for one it's called a swap instead of insurance (which it is), so frighteningly it isn't regulated by the government. Why is this frightening? The CDS market is worth an estimated $62 trillion US. Just to put that in context, the American GDP is roughly 14 Trillion. So in other words, if you take every single dollar generated by the US for the next 4 years, that is still less than the amount of unregulated money floating around in the form of CDS trading.
Furthermore, you don't have to own the underlying asset to take out a CDS contract. If you think company A will default, you can go ahead and make a CDS contract.... it's straight out gambling, with scores of trillions of dollars at stake. THAT is where this all went horribly wrong. Furthermore, CDS is subject to counterparty risk, so if one party goes bankrupt (such as Bear Stearns for example), then all the premiums you paid to them as well as your insurance, all gone.
That's why the US bailed out Bear Stearns, because it had trillions of CDS on its books, and had they gone under, these trillions = gone. Just like that, a large part of your GDP, up in smoke, and that's something Mr. Bush couldn't allow to happen.
That's it in a nutshell, but you can get a better understanding of the CDS angle here.
p.s. I'm not exaggerating this at all. Warren Buffet called financial derivatives 'financial weapons of mass destruction'... oh Warren, if only we'd listened.
Suspect 2: Lack of Regulation
Now, this sort of links in with the whole CDS issue, because they aren't governed by regulation. However, there's a bit more to it than that. Another widely-cited cause of the widespread economic pandemonium is the sub-prime mortgage crisis. What caused this?
Well, basically, the mortgage lenders were flush with money, and started pumping out sub-prime mortgages (mortgages with clients that had a history of bankruptcy, troubles with finance, etc). Anyway, these lenders fraudulently over-estimated property values and incomes, to push out more money. It was all about getting the fees off the loans, and no one cared about the ability of the borrower to repay the loan. Well, that came back to bite them when all of these borrowers started defaulting, but that's where the lack of regulation came into it. Had this market been better regulated, people would not have received mortgages far beyond their ability to repay, and that whole mess could have been avoided.
Source: here.
Suspect 3: The Housing Bubble and America's Hedonistic Society.
Living in the now. Instant gratification. Hedonism.
How does that link to our current predicament? Well, listen closely. Americans love spending. Americans spend $800 billion a year more than they earn, resulting in a debt ratio of 130%, up from 100% earlier in the decade (Source). What does this have to do with housing? Well, to quote the wiki page again, "ome homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending."
So what happened? As happens to all bubbles, the housing bubble burst. Suddenly, these second mortgages were on houses that weren't worth quite so much at all anymore. End result? Everyone loses. And because the extra cash had been spent on consumer spending instead of investment (see? Hedonism), these people were left floundering, and so was the financial system that enabled them.
There are other causes, but from what I can tell these are the big 3. I am, however, by no means an expert on this topic, so any input or debate over these points is welcome.
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