CT Blue

Last year I wrote a post about credit default swaps. A few days later I was on a cable access television show and I was asked to explain them. I wonder if what I said made sense. From what I read then, it seemed clear that these instruments were a potential economic land mine:

… There are outstanding policies on debt that far exceeds the actual amount of the debt. So in fact, this is not insurance, it’s actually a sophisticated form of gambling in which, of course, you and I will be the biggest losers. There are $45 trillion, that’s right trillion dollars, or credit default swaps out there. That exceeds the value of all the stock in the stock market.

For reasons explained in the linked article, which I fear I can not accurately summarize, this is a potentially big problem. If the losses could be restricted to the schemers that dealt in these instruments it would be a good thing actually, but of course, it never works out that way.

If nothing else, the prediction at the end of that quote is coming true. Over at Firedoglake, we learn that we are possibly at the beginning of a massive bailout of these gamblers:

The last round of financing to Bank of America, that last $100bn, was in large part due to problems with Merrill Lynch CDSs, according to Gretchen Morgenson in the NYT. If this is like what happened to AIG, Merrill Lynch had to post collateral for a huge amount of CDSs, and wasn’t able to without taxpayer assistance. So, for the second time we have been forced to save this worthless excuse for a market. There is no reason to believe it won’t get worse, and that Citi and BoA will have to put up more collateral, and we have no idea whether they can post it.

By the way, to put that 100 billion in perspective, I learned today that the $15 billion Wall Street gave, by way of recent bonuses, to the folks who brought us credit defaults swaps, is more than the stimulus package has set aside for mass transit. On the other hand, the 100 billion we gave to Merrill Lynch is, if my math is right, less than .1% of the credit default swaps out there. Now, some of them may not go belly up, but a substantial amount will do so. They were never grounded in reality in the first place, but now that they’ve gone south, we may need to come up with real money to bail out this “industry”.

I cruised around and found this still mind-numbing explication of these instruments. The Eisman mentioned in the quote is Steve Eisman, a fellow who recognized that the subprime market was a fraud, and who apparently loaded up on credit default swaps so he could cash in when the market collapsed.

More interesting is Eisman’s realization that he was actually providing the liquidity necessary to keep the market going. But I’ll let Lewis describe it:

…Here he’d been making these side bets [buying Credit Default Swaps to short mortgage backed securities and CDOs] with Goldman Sachs and Deutsche Bank…without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for [high yield fixed income product]. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans.

The question is: why do these gamblers deserve to collect their “winnings”. Or, not to put too fine a point on it, why should we pay them? They are and were merely speculators. Whether we nationalize or bail these banks out, is there a reason why we can’t do it without paying these speculators. The subprime mortgage scam at least had the limited up-side of putting people in homes, and those homes, whatever their present value, have a real existence. I’d like to see a lucid explanation from someone with expertise spelling out precisely why we should not just cut these people loose and let them take their lumps. Maybe there’s a reason, but it escapes me. How are they any different than folks who lose their shirt at the casino? And, by the way, how is this whole house of cards any different, functionally, from a Ponzi scheme. Didn’t the whole thing, ultimately require a constant in-flow of new money, whether real or fantasy?