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How We Got In This Basket III

October 5, 2008

Part III – How This All Ties Together (Into the Now)

Now that we’re all up to date on our current system of regulations (at least in a very simplified form), we can begin to examine the current fallout. For most of us, Wall Street means the Stock Market. It is the place where shares of companies are bought and sold, and investors make a profit or take losses depending on the companies performance. The stock market is our most visible indicator of the day to day economy. Especially since the crash of 1929, it has never left the public mind as such.

But the problems we now experience do not stem from the direct trading of stock in companies. It comes from markets that trade in values that are far greater than individual companies. They are the markets that trade in the mortgages of all of our places of work, our homes, our cars, and our student loans.  This is how the securities market problem may have such far reaching effects.

The securities market is nothing new, and certainly not an inherently evil exchange. For a long time, the securities market was a very nice place to be. Buyers knew what they were purchasing, and lenders were fairly ethical and stringent on who they would give loans to. Part of the reason may have been that the commercial banks were the ones underwriting most home loans, but were not allowed to trade in the securities market. As such, lenders had no reason I can find to attempt to overly inflate the market. To do so, for the lender, would require taking on large amounts of undue risk, as it would require loosening underwriting standards and issuing loans to people who were much more likely default on them.

The deregulations of the 1990s allowed banks to enter the security markets. And they did. In fact, as an example of how much they did, in August of 2007 the Fed gave a temporary pass to Bank of America in Charlotte. They granted a one time exemption, allowing B of A Charlotte to drop an additional $25 billion into their subsidiaries in the securities market. However, before blaming the banks, remember that if they didn’t enter the securities markets, investors were going to take their money to other places that could. 

As the housing bubble began to build, large profits were being made in the securities market. These profits got even larger when the market began to trade in Collateralized Debt Obligations, or CDOs. Essentially, CDOs allow lots of mortgages, together with other debt and assets, to be grouped under one large umbrella. These groupings are then traded on the securities market.

It is interesting to note – the first CDO was issued by a bank in 1987. In 1990, that institution was deemed insolvent, and taken over by the Resolution Trust Corporation in the S&L Bailout. After the S&L crisis, things tightened up a bit. Lenders reigned in their underwriting standards and, while CDOs were still traded, they weren’t a huge part of the market.

But with the new deregulation allowing more players in the market, and after a new method of rapidly assessing CDOs was introduced in 2001, the market began to grow. How much? Quoted from WikiPedia:According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totaled US$ 157 billion in 2004, US$ 272 billion in 2005, US$ 552 billion in 2006 and US$ 503 billion in 2007.[6] Research firm Celent estimated the size of the CDO global market to close to $2 trillion by the end of 2006.[7]

Contributing to this growth, these CDOs and Mortgage Backed Securities were increasingly being “insured” through the unregulated credit swap market. Since the language of these credit swap contracts specifically avoided calling it “insurance”, the powers that state and other governmental agencies have to regulate insurers did not apply. And, thanks to the passing of the CFMA, the credit swaps being used to back CDOs and MBSs were themselves unregulated.

But wait, I thought, anything traded on the financial markets gets a rating. Surely the people who were buying CDOs that contained riskier loans would have seen a lower rating, and known their was more inherent risk. Even if they were being backed by credit swaps, the credit swap market is based upon speculation. All speculative markets contain inherently higher levels of risk. No one, I thought, would rate these things in the highest grade of investment.

But when we look a little further into that, it appears that even CDOs that were backed primarily by subprime loans were given AAA ratings right up until the second quarter of this year. How, I wondered, could this possibly be? Anyone with half a brain who was looking around their block noticed home values falling LONG before March 2008! Why would anyone rate these interests so highly?

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