On October 3, the majority of our elected officials agreed that taxpayers should pick up the tab on Wall Street's bad investments. So Bush got what he wanted, and before anybody really understood the whole picture, a staggering $700 billion bail out package had been signed into law.
A week later, we were still standing on the sidelines, watching helplessly as our 401Ks vaporized and asking, “What just happened?”
We understand that greed and incompetence played a major role, but most of us don’t understand much about the complex securities or the exotic tricks being played behind the scenes. We’re referring to what some call an unregulated shadow market worth nearly $60 trillion, a market with hidden risks that didn’t surface until it was too late.
First there was the mortgage crisis that began 16 months ago. Wall Street laid nearly a trillion dollars of borrowed money on the gaming table and placed a bet that the shakiest mortgages in the U.S. would be passed off as solid investments.
Looking back now, that doesn’t seem like such a good play considering that they were betting that people with the lowest credit scores and questionable incomes would somehow be able to pay off their mortgages—mortgages with adjustable interest rates that ... well, adjusted.
But the idea seemed reasonable enough to the Wall Street guys who were earning $10 million a year. They were the high-flyers that bought up millions of these bad mortgages, sliced and diced them, and wrapped it up into exotic investments and sold them as mortgage-backed securities, or MBS. These were investments that few people could understand, mainly because of the hundreds and hundreds of pages of fine print.
Enter the Math Science Guys
It’s now known that these complex securities were actually designed by mathematicians and physicists using computer models and algorithms to create products that had the look and feel of relatively low risk.
Mortgage-backed securities are, according to Jim Grant, the editor of Grant's Interest Rate Observer, " ... in effect, mortgage science projects devised by these Nobel-tracked physicists who came to work on Wall Street for the very purpose of creating complex instruments with all manner of detailed protocols, and who gets paid when and how much. And the complexity of the structures is at the very center of the crisis of credit today."
Wall Street made billions selling these to banks, pension funds, and other financial institutions around the globe. And prior to the eventual fallout, rating agencies like Standard & Poor's and Moody's, were actually certifying these securities as investment grade.
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Credit Default Swaps
But if they’d looked beneath the surface, they would have discovered an even bigger problem. A lot of the financial institutions who bought these risky securities also purchased something even more opaque than the MBS—they’re called "credit default swaps," and unless you’re part of the Wall Street in-crowd, you might not be familiar with them.
Credit default swaps are private and murky contracts that mortgage investors buy into as a means to protect themselves against losses, just in case the underlying investments go bad. In other words, it’s marketed like any other standard insurance policy. The tricky part is, they can’t actually call it “insurance” because the insurance industry is tightly regulated. So, Wall Street came up with the term “swap,” allowing it to fly under the federal regulator’s radar.
Offering the swaps softened the edge for those buying mortgage-backed securities, because they were being sold as a risk-saving device for an already risky investment. If these swaps actually did provide insurance, those selling them would have been required to have enough capital reserves to pay in case things went south. But because they were structured and sold as swaps, no back up capital reserves were necessary.
House of Cards
These swap contracts play a significant role in a huge stealth and unregulated market. In fact, they contributed to the problems that hit three of the largest firms on Wall Street—Bear Sterns, Lehman Brothers, and AIG. Basically these investment banks were not only selling toxic securities, they were selling bogus insurance to cover them.
As we now know, when homeowners began defaulting on their mortgages, Wall Street's high-risk mortgage backed securities also began to fail. And since the big investment houses and insurance companies who sold the credit default swaps hadn't set aside the money they needed to pay off their obligations, the house of cards began to fall.
Bear Stearns was the first to fail—J.P. Morgan snatched them up for pennies on the dollar. Next came the Lehman Brothers’ bankruptcy. Then when AIG, the nation's largest insurer, couldn't even cover its own bad debts, the Feds stepped in with $85 billion to rescue them.
How Big is the Market?
There’s no way to know how large the credit default swap market is. A voluntary survey claimed that it ranges from 50 to 60 or so trillion dollars. In other words, it’s so huge you can’t even estimate the actual size within a $10 trillion range. And it’s worth noting that a sixty trillion dollar unregulated market is four times the size of the U.S. debt.
It amounts to a huge shadow market that could conceivably hold the reins to our financial future, and yet no one in the public or government sector is privy to the details—not stockholders and not the federal regulators. Who owns what? Who owes what? Who’ll pay for it all? Nobody knows.
The International Swaps and Derivatives Association (ISDA) may hold the key to details. But getting information from them is a long shot at best. They’re a trade organization for the largest financial institutions in the world, many of which not only helped create the shadow market, they lobbied to keep it unregulated. Now they’re in the middle of the mess they created themselves, not to mention the one they created for the rest of the world.
The end is still not in sight, but at least one thing has become clear. When you’re dealing with a shadow market, there are plenty of surprises yet to be uncovered. You can bet the bank on that.
