Sunday, November 16, 2008

What caused the mess

I have been noticing on the housefrau blogosphere, the growing meme that the economic mess was caused by the holy trifecta of ACORN, Democrats, and poor brown people. To wit, the Community Reinvestment Act, which required that banks treat poor brown people as badly as they treated poor white people, and not worse, forced banks to lower their standards, make all these subprime loans to people who didn't deserve them, and now look what happens. So we can all happily blame Carter/Reno/Obama/Clinton x2/ ACORN and whoever else we've disliked over the past 30 years.

Sadly, it's not true. The Community Reinvestment Act only said that if the banks were going to lower their standards, they had to lower them for everybody equally. Which they did, and did, and did some more. But if it was all a result of the subprime mess, well, we've allocated enough money to fix all of that already, a few times over. And yet, that's not enough and people are still losing their homes.

No, the real reason is far more complicated, and given the politics of the people involved, far more Republican. I give you, The Evolution of the Credit Default Swap in 7 easy lessons, by Devilstower:

Stage 1 (Perturbo mutans)
You have just made a loan to someone, and now you're nervous that this scoundrel might not pay. What to do, what to do? Ah, but you need not worry! I happen to have assets on hand that can easily cover your petty loan. What's more, for a small monthly fee, I'll be happy to provide you with insurance of a sort. Should the person to whom you've extended a loan prove unreliable, I'll shoulder the burden -- so long as you keep up the payments. Let's call this insurance a... credit default swap.

In 1999, these credit default swaps already existed, but they were a niche product. Only a fraction of banks employed them and then only on a fraction of loans. Without some knock to the system, swaps would probably have remained a relatively small player.

Stage 2 (Perturbo furtiva)
Knock, knock. In 2000 Republican economic hero, Phil Gramm, with the assistance of a small legion of lobbyists, created the Commodity Futures Modernization Act. Along with ushering in the Enron disaster, this bill provided the one thing that credit default swaps needed to grow and mutate -- invisibility. Thanks to the CFMA, not only were credit default swaps unregulated, they were impossible to observe directly. Like black holes in deep space, you could only spot swaps by looking at how other things acted nearby.

So, now you've made a loan to someone, and you're worried about it. I want to offer you a credit default swap so I can collect the fee. Trouble is, I don't have the assets to cover your loan. So how can I... hold on, credit default swaps are so unregulated that no one says I actually have to be able to deliver on my promise. Hey, over here! Have I got a swap for you, and it's a bargain.

So now the CDS is a means of moving the risk, but the risk is still as high (or higher, since the original lender might have been better able to cover the loss). In fact, credit default swaps have gone from being a risk mitigator, to a risk magnifier.

Stage 3 (Peturbo veloxicresco)
You have a loan you're worried about. That's good, because lots of people want to offer you swaps. After all, you don't have to have any assets to issue a swap. The investment bank of First Me and The Change I Found In the Couch Cushions can offer swaps for all the debt at Morgan Stanley, and that's okay. I get free money for issuing the swaps, and the swaps have value on the books. So both me and my pal Mr. Stanley have values that are inflating faster than a tick in a blood bank.

Now you can get a swap for any loan you want, and with all the competition, the cost of these swaps is lower, and lower, and lower. Here's an idea: why not go out and make more loans, riskier loans. Why not offer anyone you can collar on the street a loan, no matter whether or not they can pay it off, not because some 30 year old law makes you do it, but because your friend the credit swap makes it perfectly safe!

So many people are offering these things that you could give a loan to Saddam while the bombs are falling without a care in the world. You can always get a swap.

Stage 4 (Fatum casus)
I have a swap. I really, really want someone to take my swap. Only even with every incentive I can offer, not enough people are loaning. Sure, there's a record amount of hypothetical money sloshing around the system thanks to me and my swaps, but it's still not enough. So what can I...

Wait a second. Swaps are unregulated. No one says I have to have enough resources to cover the swap, and even better, no one says I have to offer the swap to the person who actually made the loan! Hey buddy, see that loan over there? You may think it's iffy, but I think it'll hold up. In fact, I'm so sure it will, I'll sell you a credit default swap on it that pays off if it fails. You don't make the loan, you don't have to pay off on the loan, you don't have anything to do with the loan. You just pay me the fee. And if that guy loses his money, you collect. How sweet is that!

This mutation is enormous (see how the genera changed up there?). At this point, credit default swaps have become completely divorced from the original function. A single loan can be covered by multiple swaps. There's a complicated fiscal term for this. It's called gambling, and at this stage, that's all that remains of those little "insurance" policies. They no longer protect anyone from anything, they just offer a chance to place enormous overlapping side bets on everything.

Stage 5 (Fatum insanus)
I have swaps! Get your swaps here! Want a swap on a loan you made? Okay. Want to bet that the bozo in the next cube is making bad loans? We can do that. Want to bundle up some loans and bet on those? Buddy we can do better than that. I can give you a swap on the value of other swaps. Now we're really in business.

Who owns the original loan? Don't know, don't care. Who's actually responsible for the money if that loan should fail? Ehhh, can't really say. Has anyone noticed that a single bad loan could cause a cascade of swap calls that bounce around the system like a rocket-power pinball? Shut up.

Isn't anyone worried that this is the most massive house of cards ever constructed in human history? Lookit, what part of "we took 120 billion in bonuses out of this place in the last five years" are you missing?

Stage 6 (Fatum exicelebritas)
Hey, my loan went bad. Can I have my money from that swap, please?

Stage 7 (Fatum cerus)
Oh sh*t.

Yes, it's a simple as that. The bankers made up money so they could
gamble. They talked people into loans no one could afford so the bankers could gamble. They made everyone's life miserable by messing up the economy so bad that the only way to feel like you were at all keeping up was to max out your credit cards so the bankers could gamble.

We are all the victims here. Poor, middle-class, white and brown alike.

Come to think of it, maybe the Community Reinvestment Act is part of the problem. If it wasn't, maybe at least the poor, brown people wouldn't be in this handbasket with the rest of us.

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