It is refreshing to hear people taking Conservatives to task on this. There is so much BS going around now about minority homeowners being at fault for the economic crisis, that it is really impossible to dig yourself out. But Matt Talabi states the most important point very clearly in a conversation today with Byron York:
The CDS market, this market for credit default swaps that was created in 2000 by Phil Gramm’s Commodities Future Modernization Act, this is now a $62 trillion market, up from $900 billion in 2000. That’s like five times the size of the holdings in the NYSE. And it’s all speculation by Wall Street traders. It’s a classic bubble/Ponzi scheme.
Read that again: a $62 trillion market
CDS are basically unregulated gambling on the market, and with the market moving down, they need top be paid out. AIG didn’t fail because it held bad mortgages, AIG failed because it had to pay the insurance on those mortgages. Matt takes Byron to task again:
Do you even know how a CDS works? Can you explain your conception of how these derivatives work? Because I get the feeling you don’t understand. Or do you actually think that it was a few tiny homeowner defaults that sank gigantic companies like AIG and Lehman and Bear Stearns? Explain to me how these default swaps work, I’m interested to hear.
Because what we’re talking about here is the difference between one homeowner defaulting and forty, four hundred, four thousand traders betting back and forth on the viability of his loan. Which do you think has a bigger effect on the economy?
And the creation of this entire market does, in fact, fall on the shoulders of Phil Gramm (my emphasis below):
B.Y.: When you refer to "Phil Gramm’s Commodities Future Modernization Act," are you referring to S.3283, co-sponsored by Gramm, along with Senators Tom Harkin and Tim Johnson?
M.T.: In point of fact I’m talking about the 262-page amendment Gramm tacked on to that bill that deregulated the trade of credit default swaps.
Now, the home mortage crisis is bad, but in any normal market a few companies would fail, smarter companies would buy out their assets, and the market would go on. But the CDS market basically tied the entire banking/insurance industry together, like a team of climbers on a cliff face. But in this case, none of the climbers had a safety rope attached to a rock, so once one started to slip, down they all went.
This happened not because Banks used CDS’s to insure their own loans, which is what they are good for, But because of speculation. As noted in Wikipedia (my Emphasis):
[C]redit default swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults — a buyer doesn’t necessarily have to own a bond to buy the credit default swap that insures it.
This last bit is why the CDS market grew to this insane level, and it is also why once these assets started to fail, massive payouts had to occur, to parties with no actual interest in the mortgage in the first place. And with the market in decline, companies like AIG had reduced capital to pay these back. From there it was just a rolling, growing snowball. Paul Roberts points out what made this lack of liquidity even worse:
The greatest mistake was made in 2004, the year that Reagan died. That year the current Secretary of the Treasury, Henry M. Paulson Jr, was head of the investment bank Goldman Sachs. In the spring of 2004, the investment banks, led by Paulson, met with the Securities and Exchange Commission. At this meeting with the New Deal regulatory agency tasked with regulating the US financial system, Paulson convinced the SEC Commissioners to exempt the investment banks from maintaining reserves to cover losses on investments. The exemption granted by the SEC allowed the investment banks to leverage financial instruments beyond any bounds of prudence.
In place of time-proven standards of prudence, computer models engineered by hot shots determined acceptable risk. As one result Bear Stearns, for example, pushed its leverage ratio to 33 to 1. For every one dollar in equity, the investment bank had $33 of debt!
It is important to understand this, because it didn’t need to be a housing value failure to trigger this. Anything could have done it, we have been experiencing all kinds of asset bubbles in our economy, but this one was just big enough to start all the dominoes falling.
Updated with Paul Roberts Quote