There is another version to this which I may get into in the comments section. CDS were not known at the time to be dangerous investments by Wall Street Banks. Besides Long Term Capital, AIG was offering CDS insuring other CDS. The problem arose when AIG’s credit default swaps did not call for collateral to be paid in full due to market changes. “In most cases, the agreement said that the collateral was owed only if market changes exceeded a certain value or if AIG’s credit rating fell below a certain level.” AIG was accruing unpaid debts, collateral it owed its credit default swap partners, but did not have to hand over due to the agreements’ collateral provisions. But when AIG’s credit rating was lowered, those collateral provisions kicked in
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There is another version to this which I may get into in the comments section. CDS were not known at the time to be dangerous investments by Wall Street Banks. Besides Long Term Capital, AIG was offering CDS insuring other CDS. The problem arose when AIG’s credit default swaps did not call for collateral to be paid in full due to market changes. “In most cases, the agreement said that the collateral was owed only if market changes exceeded a certain value or if AIG’s credit rating fell below a certain level.”
AIG was accruing unpaid debts, collateral it owed its credit default swap partners, but did not have to hand over due to the agreements’ collateral provisions. But when AIG’s credit rating was lowered, those collateral provisions kicked in and AIG suddenly owed its counterparties a great deal of money.
September 15, 2008 was the day all three major agencies downgraded AIG to a credit rating below AA-. Calls for collateral on its credit default swaps rose to $32 billion and its shortfall hit $12.4 billion—a huge change from $8.6 billion in collateral calls and $4.5 billion in shortfall just three days earlier.
I do not believe it was low interest rates either. It was the gambling on Wall Street which led to companis like AIG to fault. The one thing Greenspan did not do was to create a trading board for Credit Default Swaps or derivatives. He did not see them as dangerous instruments. More on this later.
More on this as you read about the Great Recession.
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Blaming Things Not Named Greenspan for the Great Recession
by Derek Thompson
What caused the Great Recession, anyway? Two years after it began, we don’t know. (Heck, 80 years after the Great Depression, we haven’t decided why it started, or lasted so long, or ended.) So Slate’s Jacob Weisberg went digging for answers. Just about everybody agrees that Alan Greenspan is at fault, somehow. After that, everything is up for debate.
Conservative economists–ever worried about inflation–tend to fault Greenspan for keeping interest rates too low between 2003 and 2005 as the real estate and credit bubbles inflated. This is the view, for instance, of Stanford economist and former Reagan adviser John Taylor, who argues that the Fed’s easy money policies spurred a frenzy of irresponsible borrowing on the part of banks and consumers alike.
Liberal analysts, by contrast, are more likely to focus on the way Greenspan’s aversion to regulation transformed pell-mell innovation in financial products and excessive bank leverage into lethal phenomena.
The pithiest explanation I’ve seen comes from New York Times columnist and Nobel Laureate Paul Krugman, who noted in one interview: “Regulation didn’t keep up with the system.”
In this view, the emergence of an unsupervised market in more and more exotic derivatives–credit-default swaps (CDSs), collateralized debt obligations (CDOs), CDSs on CDOs (the esoteric instruments that wrecked AIG, allowed heedless financial institutions to put the whole financial system at risk. Financial innovation + inadequate regulation = recipe for disaster is also the favored explanation of Greenspan’s successor, Ben Bernanke, who downplays low interest rates as a cause (perhaps because he supported them at the time) and attributes the crisis to regulatory failure.
A bit farther down on the list are various contributing factors, which didn’t fundamentally cause the crisis but either enabled it or made it worse than it otherwise might have been. These include: global savings imbalances, which put upward pressure on U.S. asset prices and downward pressure on interest rates during the bubble years; conflicts of interest and massive misjudgments on the part of credit rating agencies Moody’s and Standard and Poor’s about the risks of mortgage-backed securities; the lack of transparency about the risks borne by banks, which used off-balance-sheet entities known as SIVs to hide what they were doing; excessive reliance on mathematical models like the VAR and the dread Gaussian copula function, which led to the underpricing of unpredictable forms of risk; a flawed model of executive compensation and implicit too-big-to-fail guarantees that encouraged traders and executives at financial firms to take on excessive risk; and the non-confidence-inspiring quality of former Treasury Secretary Hank Paulson’s initial responses to the crisis.
The 15 most persuasive explanations for the economic crisis. (slate.com)
Last year, National Journal’s Jonathan Rauch wrote a essay on this topic that came to an exotic, and fascinating, conclusion. Here‘s the quick summary:
Financial innovation produced a vast network of complicated asset-backed securities traded among what insiders call “shadow banks,” or unregulated banks. Shadow banks looking to park cash where it would hold value and earn interest created a short-term securities market — much like a checking account. But unlike a regular FDIC-insured checking accounts, these deposits would not be guaranteed by the government. So investors borrowing from this shadow depository system had to put up collateral. And they chose … their asset backed securities.
Why is that dangerous? Because in the shadow banking industry, these deposits, backed by sub-prime mortgages instead of the FDIC, acted as money. Banks relied on it for transactions. “Subprime morgage debt had entered the money supply.” But then the housing bubble burst. Depositors dumped their assets to raise cash and tried to withdraw their money, raiding the shadow depository market, and the money supply crashed.
And here’s Rauch in his own words:
In the so-called Quiet Period, 1934 through 2007, systemic bank runs seemed to become relics of an unmourned past. Why? Because for about four decades, banks’ activities were restricted to heavily regulated ventures that were more or less guaranteed a profit — and, even more important, because federal deposit insurance, which began in 1934, assured depositors that their savings were safe.
Financial innovation, however, could be delayed but not denied. Around the walled garden grew a forest of new competitors and products. Money-market funds and other investment vehicles took deposits without offering federal guarantees. In a process known as securitization, investment banks converted predictable streams of income, everything from mortgage payments to health club dues, into securities that investors bought eagerly. Derivatives — securities based on other securities–arose to spread risk and hedge against volatility. In time, shadow banking, as the new institutions and instruments were collectively called, rivaled and even eclipsed old-fashioned commercial banks.
The firms and major financial players making all these trades needed to park cash where it would hold its value and earn some interest, yet be accessible on demand. In other words, they needed the equivalent of checking and savings accounts, the “demand deposits” that banks traditionally provide and that form the backbone of the money supply. But no insured depository could begin to cope with the trillions of dollars involved. And so shadow banking developed what amounted to its own depository system, a short-term securities market called the “sale and repurchase,” or “repo,” market. It is immense. Gorton figures its size at perhaps $12 trillion, but he says no one knows for sure. Gorton says
“It’s important to see that this is a banking system.” But it is like a 19th-century banking system, because repo “deposits” are uninsured. Unable to rely on a federal guarantee, depositors who park their holdings there require that the borrower put up something of value as collateral.
Treasury bonds, because they are safe and liquid, are the ideal form of collateral, but there were nowhere near enough of them to meet the demand. So asset-backed securities — those packages of safe-looking income from mortgages, auto loans, and all the rest — were pressed into service as collateral. In time, the better grades of subprime mortgage-backed securities were mixed into the blend, and they, too, won acceptance as collateral.
All of these asset-backed securities were sorted and re-sorted, combined and recombined, sold and resold, until, as Gorton writes, “looking through to the underlying mortgages and modeling the different levels of structure was not possible.” Users could not independently assess the value of mortgage-backed collateral any more than your grocer can independently assess the solvency of your bank before accepting your check.
You can see, perhaps, where this leads. Repo is a form of money because it acts as a store of value and financial actors rely on it to conduct transactions. But instead of being backed by a federal guarantee, it was backed by, among other things, subprime mortgages. In this way, without anyone paying much notice, subprime mortgage debt entered the money supply. As in the 19th century, the economy had become dependent upon a form of bank-issued money that was not federally guaranteed and that was not as stable as it appeared. Unlike in the 19th century, however, no one understood how vulnerable the system was to a panic.
Calamity then struck, as it had before. First, the unexpected decline in housing prices tanked the subprime market. Repo depositors knew that most collateral was sound, but they had no way to know if their own holdings were safe; so in 2007 they began what amounted to a run on the repo system, effectively withdrawing their money. To raise cash, repo depositories dumped assets, further depressing collateral values and starting a tailspin. In September of last year, when the failure of Lehman Brothers, the mighty investment bank, convinced investors that no one was safe, the crisis turned into a meltdown. As the repo market “virtually disappeared” (in Gorton’s phrase), the money supply crashed and the economy began to suffocate.
The Messenger Wore a Skirt, Brooksley Born, Angry Bear
“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” Alan Greenspan
“I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way,” Rubin told the Washington Post.
“My recollection was . . . this was done in a more strident way” … “characterized as being abrasive.” Arthur Levitt
It would seem these three, coupled with Larry Summers’s push back in Congress on the regulation of derivatives, had the problem and not Brooksley Born. Since then, all three men have suggested there should have been more regulation of the derivatives market that Greenspan has called its recent collapse a “once in-a-century credit tsunami.” Called a modern day Cassandra by Stanford Magazine, one could only wonder where we would be today if the economic and financial wizards had heeded her words.
Short histories on CDO/CDS . . . Collateral Debt Obligations (CDO) were invented by Drexel Burnham Lambert (Milken) as a way to package asset based securities. The CDO was tranched into similar asset backed securities of the same rating allowing investors to concentrate on the rating rather than the issuer of the bond. Ten years later, JP Morgan invented Credit Default Swaps (CDS) was used as a mechanism to bet on a 3rd party default. In 2000, CDS were made legal with the passage of the Commodity Futures Modernization Act and any regulation of them was stymied with this bills passage. Later on, an investment firm decided to team CDS and CDO together, transferring the risk from the CDO to the issuer of the CDS, and creating a synthetic CDO.
Some History
It was 1994, that Bankers Trust lost ~$800 million from various derivative investments. The chief losers were P&G and Gibson Greetings. Bankers Trust was formed by a consortium of banks, shedding the loan image for conducting trades. Bankers Trust was successfully sued by P&G for its losses by claiming racketeering and fraud. Bankers Trust also became known for its remarks about Gibson Greetings not knowing what Bankers Trust was doing. In 1998, Bankers Trust pled guilty to institutional fraud due to the failure of certain members of senior management to escheat abandoned property to the State of New York and other states. Again in 1998, LCTM was struck by a downturn in the market when Russia defaulted on government bonds, a security LCTM was holding. To make a significant profit on small differences in value, the hedge fund took high-leveraged positions. At the start of 1998, the fund had assets of about $5 billion and had borrowed about $125 billion. When investors panicked and sold Japanese and European bonds and bought US treasuries, the spreads between LCTM holdings increased, resulting in a loss of ~$1.8 billion by August 1998. LCTM was saved by an orchestrated Fed bailout utilizing private investors.
It was in 1998 and Brooksley Born testified to Congress about the dangers of the unregulated derivatives market referencing the LCTM losses as a recent example. It was also then that deputy Treasurer Larry Summers testified to Congress that Born’s desire to regulate is “casting a shadow of regulatory uncertainty over an otherwise thriving market.” Larry’s testimony set the stage for Congress to rein in the power of the Brooksley Born’s CFTC and the passage of Phil Gramm’s Financial Service Modernization Act of 1999 prohibiting the regulation of the derivatives market (In 2005, the revised bankruptcy laws would place derivatives outside of the laws also making it the first to receive compensation). W$ and banks had clear unregulated sailing in the sea of laissez faire in 2000 with a closing of the door for debtors in 2005. It was little better than a roach motel, you could check in but you can not check out.
Senator Byron Dorgan
Again in 1999 and in the Senate that opposition arose to the passage of the Financial Services in the form of Senator Dorgan of North Dakota. An excerpt from the Senator Byron Dorgan’s speech the day before the bill was passed:
“I, obviously, am in a minority here. We have people who dressed in their best suits and they just think this is the greatest piece of legislation that has ever been given to Congress. We have choruses of folks standing outside this Chamber who spent their lifetimes working to get this done, to say: Would you just forget all that nonsense back in the 1930s about bank failures and Glass-Steagall and the requirement to separate risk from banking enterprises; just forget all that. Time has moved on. Let’s understand that. Change with the time.
We have folks outside who have worked on this very hard and who very much want this to happen. We have a lot of folks in here who are very compliant to say: Absolutely, let me be the lead singer. And here we are. We have this bill, which I will bet, in 5, 10, 15 years from now, we will be back thinking of this bill like we thought of the bill passed in the late 1970s and early 1980s, in which this Congress unhitched the savings and loans so some sleepy little Texas institution could gather brokered deposits from all around America and, like a giant rocket, become a huge enterprise. And guess what. With all the speculation in the S&Ls and brokered deposits and all the things that went with it that this Congress allowed, what did it cost the American taxpayer to bail out that bunch of failures? What did it cost? Hundreds of billions of dollars. I will bet one day somebody is going to look back at this and they are going to say: How on Earth could we have thought it made sense to allow the banking industry to concentrate, through merger and acquisition, to become bigger and bigger and bigger; far more firms in the category of too big to fail?
No senator who was in the chamber that day can claim they were not warned of the financial crisis upon us today, because Dorgan laid out what would happen in stark language and near-eerie detail.