Financial Weapons of Mass Destruction

Last evening, 60 Minutes aired a segment on the "Shadow Market" of Credit Default Swaps".

Bear with me for a minute with this, but the technical definition of a credit default swap (CDS) is a contract in which a buyer pays a series of payments to a seller, and in exchange receives the right to a payoff if an associated credit instrument goes into default or on the occurence of a specific credit event named in the contract (such as bankruptcy or restructuring). The associated instrument does not need to be associated with the buyer or the seller of this contract.
Originally used as a form of insurance against bad debts, these instruments became a tool for financial speculation when the Commodity Futures Modernization Act of 2000 , signed by president Bill Clinton, specifically barred regulation of these trades.

What the heck does this mean and why is it important in light of the financial crisis? I am not an economist and have never worked in the financial industry, but I will attempt to explain as I understand it, in simple terms.

With a global flush of cash looking for a home, Wall Street financial institutions bought up mortages, chopped them up into tiny chunks and sold them as mortgage backed securities to gobs of willing investors. As more and more sub-prime mortgages came into the market, the math geniuses at rating agencies came up with complex algorithms which were supposed to assess the risk of each security so they could be sold off in rated tiers and spread the risk around. To offset risk, particularly with the lower rated securities, credit default swaps were sold along with the securities. These CDSs are basically a form of insurance against a security should it defaut or should the seller go into bankruptcy. Because they are termed "swaps", they are not subject to insurance regulations, which would require that the insurer actually have capital to back up the insured product. Prices for the CDSs varied based on the degree of risk, and Wall Street made a fortune selling these so-called "derivatives", valued at $60 TRILLION, without having to put aside the funds to back them up. CDSs became the most widely traded derivatives on the market, and investors all over the globe bought them. When people began to default on their mortgages, the financial institutions such as Bear Stearns and Lehmen Brothers did not have the capital to fund these liabilities, and went bust. This doesn't make the unfunded liabilties of $60 trillion go away. Someone has to pay for them, and it's one of the many reasons why the crisis continues to spiral out of control globally despite Congress' intervention with the $700 bailout.

Warren Buffet famously called these CDSs "Financial weapons of mass destruction", and has warned against them for years. So my question is "Why didn't the members of Congress see this train wreck coming?" Anyone with half a brain knows that you can't guarantee to insure something if you don't have the funds to back it up. What were all of the members of the banking, financial and insurance sub-committees in Congress doing? Were Senators Dodd, Shumer, Frank, Reed, and others asleep at the wheel, or did they intentionally turn their heads the other way, so as not to upset their big money donors who made gazillions with this Ponzi scheme? At best, it's criminal negligence; at worst, it's conspiracy to commit fraud, ultimately at the taxpayers expense. And what about Phil Gramm, godfather of CDS's? Why aren't they going to jail?

Covering Their Fannies

While Senators Chuck Dodd (D-CT) and Barney Frank (D-MA) play the part of "avenging angels" as stated below in the UK-based Independent, and lay all blame for the financial crisis square on the Bush administration, many Americans are unaware that their fingerprints are all over the root cause of the mess.

Meanwhile, Charles Shumer (D-NY) and Jack Reed (D-RI) have made lots of noise recently decrying the executive severence pay for Mr. Raines and Mr. Mudd, CEO's of Fannie and Freddie. Guess who blocked reform of these very institutions back in 2005 as members of the Senate Banking Sub Committee in a party line vote? Senators Shumer and Reed. As a consequence, the reform bill never even made it to the full Senate for a vote.

From The Independent, Friday, October 3rd, http://www.independent.co.uk.opinion/, is this piece by Dominic Lawson outlining the real story behind Fannie and Freddie's implosion.

"Dominic Lawson: Democrat fingerprints are all over the financial crisis";
The least well off are going to face the most stringent terms for mortgages
Friday, 3 October 2008

Of all the characteristics of a successful politician, none is more essential than bare-faced cheek. Never has this been more evident than in the past fortnight, as senior Democrat members of the US legislature have sought to lay all the blame for the country's financial crisis on the executive arm of Government and Wall Street.
Neither of these two institutions is blameless – far from it. Yet when I see such senior Democrats as Barney Frank, Chairman of the House Financial Services Committee, and Christopher Dodd, Chairman of the Senate's Banking Committee, play the part of avenging angels – well, I can only stand in silent awe at the sheer tight-bottomed nerve of it. These are men with sphincters of steel.
What is the proximate cause of the collapse of confidence in the world's banks? Millions of improvident loans to American housebuyers. Which organisations were on their own responsible for guaranteeing half of this $12 trillion market? Freddie Mac and Fannie Mae, the so-called Government Sponsored Enterprises which last month were formally nationalised to prevent their immediate and catastrophic collapse. Now, who do you think were among the leading figures blocking all the earlier attempts by President Bush – and other Republicans – to bring these lending behemoths under greater regulatory control? Step forward, Barney Frank and Chris Dodd.
In September 2003 the Bush administration launched a measure to bring Fannie Mae and Freddie Mac under stricter regulatory control, after a report by outside investigators established that they were not adequately hedging against risks and that Fannie Mae in particular had scandalously mis-stated its accounts. In 2006, it was revealed that Fannie Mae had overstated its earnings – to which its senior executives' bonuses were linked – by a stunning $9.3billion. Between 1998 and 2003, Fannie Mae's executive chairman, Franklin Raines, picked up over $90m in bonuses and stock options.
Yet Barney Frank and his chums blocked all Bush's attempts to put a rein on Raines. During the House Financial Services Committee hearing following Bush's initiative, Frank declared: "The more people exaggerate a threat of safety and soundness [at Freddie Mac and Fannie Mae], the more people conjure up the possibility of serious financial losses to the Treasury which I do not see. I think we see entities that are fundamentally sound financially." His colleague on the committee, the California Democrat Maxine Walters, said: "There were nearly a dozen hearings where we were trying to fix something that wasn't broke. Mr Chairman, we do not have a crisis at Freddie Mac and particularly at Fannie Mae under the outstanding leadership of Mr Franklin Raines."
When Mr Raines himself was challenged by the Republican Christopher Shays, to the effect that his ratio of capital to assets (that is, mortgages) of 3 per cent was dangerously low, the Fannie Mae boss retorted that "our assets are so riskless, we could have a capital ratio of under 2 per cent".
Maxine Walters' complaint about previous attempts to bring the great state-sponsored housing finance bodies under stricter control was partly a reference to Bill Clinton's efforts. Last week the former President acknowledged that "responsibility" for the absence of proper regulation rested "with Democrats who were resisting any efforts of Republicans in Congress, and earlier when I was President and tried to impose tighter standards on Fannie Mae and Freddie Mac". Then, as now, members of his own party saw all such initiatives as unwonted attacks on the chances for low-earners, and particularly African-Americans, to own their own homes.
From its inception in 1938 Fannie Mae (and later Freddie Mac) was designed to make housing finance available to "ordinary Americans". This was a noble aim. In the 1970s another Democrat President, Jimmy Carter, introduced legislation which demanded that such bodies enhance their lending to minorities. Again, this was based on a noble idea: to stamp out racism in the mortgage market. Thus by 1998 you had the Federal Reserve Bank of Boston producing a document entitled "Closing the Gap: a Guide to Equal Opportunities Lending", which instructed banks that an applicant's "lack of credit history should not be seen as a negative factor" in obtaining a mortgage. As Stephen Malanga of the Manhatta *Institute notes: "Of course the new federal standards couldn't just apply to minorities. If they could pay back loans under these terms, then so could the majority of loan applicants. Quickly, these became the new standards in the industry. As the housing market boomed, banks embraced these new standards with a vengeance. Between 2004 and 2007, Fannie Mae and Freddie Mac became the biggest purchasers of subprime mortgages from all kinds of applicants, white and minority, and most of these loans were based on lending standards promoted by the Government."
One of the few journalists to see where this would lead was Jeff Jacoby, of the Boston Globe. Last week he reminded his readers what he had written in 1995: "Our banks are knowingly approving risky loans to get the feds and the activists off their backs... When the coming wave of foreclosures rolls through the inner city, which of today's self-congratulating bankers, politicians and regulators plans to take the credit?". Jacoby adds now: "Barney Frank doesn't. But his fingerprints are all over this fiasco."
It's true that the improvident lending was not initiated by Fannie and Freddie: their role in this was to buy these loans and sell them on – but then the music stopped. Cynical students of the American political system will note that the biggest recipient of campaign contributions from the munificent duo of Fannie and Freddie over the past 20 years was one Christopher Dodd, Democrat Chairman of the Senate's Banking Committee.
Rather surprisingly, given that he has only been in the Senate for four of those years, the second biggest beneficiary was Barack Obama. In August the Washington Post reported that Obama's presidential campaign team had sought the advice of Franklin Raines "on mortgage and housing policy matters". Perhaps Mr Obama's team just wanted to know where all the bodies are buried – there are rather a lot of them.
The saddest outcome of all this within America – apart from the crippling cost to the nation's taxpayers – is that the very people the Democrats had intended to help will be the biggest victims: for many years to come banks will demand the most stringent terms for mortgages to the least well off.
In the meantime, let us praise Congressman Artur Davis of Alabama, who confessed this week: "Like a lot of my Democrat colleagues I was too slow to appreciate the recklessness of Fannie and Freddie when in retrospect I should have heeded the concerns raised. I wish my Democrat colleagues would admit that we were wrong." I fear Congressman Davis will not go far with this attitude – but at least he will be able to look at himself in the mirror.