Or who owns what?
By Melvin J. Howard
First lets begin with the basics to securitize a pool of consumer loans, lets say credit card debt, follow these steps:
First, a bank, a group of banks and/or other credit card issuers decide they'd like to sell the credit card debts owed to them by their customers. In return they will get some cash that they can use for new financial adventures.
An investment banker packages all this debt together in a nice pool of credit card receivables, using what is known as a Special Purpose Vehicle, and does some risk analysis to price the bundled up debt. Then they sell the neat new packages of credit card backed securities for cash in the markets, with the cash proceeds going back to the banks and issuers, less a handsome cut for the creative investment banker.
Then these new securities are then traded around the world markets. This is what happened with mortgages as well. So whether you're paying of your credit card or your house you actually never know whom you are paying to from one day to the next. There in lies the problem who owns what to who. You are just a little slice of income in a much bigger bigger security. On paper the implications of pooling such risks across many issuers and many different bases of borrowers are quite profound and provide many appealing features for investors in these securities that are basically bundles of receivables or income streams. By putting a vast number of receivables behind a security, risks of default are spread across the pool as a whole and the cost of default is much easier to estimate so that was the idea anyway. In theory even if a handful of borrowers did not end up paying their bills, by virtue being such a large pool there will be enough of the ones who keep paying their bills to make up for it. The high interest rates charged and paid by the larger paying group more than makes up for the defaulters, leaving a handsome profit for the investor in the bundled up security. For awhile the program was working thanks to the handsome profits, capital kept flooding into these securities to fund ever more mortgage back securities and the like. Due to this ability to pool risks via securitization, combined with saturation of credit to the middle class and the profits that come from uncapped interest rates, credit flooded into the poorest of homes, in fact the bottom 20% of income earners. People just at the poverty line are less able to resist such access to credit, and due to limited experience with it, often don’t understand the implications they were signing onto including that the huge interest rate they were paying is a killer. Result massive filing for bankruptcy first the poor, then the backbone of society the middle class.
The Greek philosopher Plato condemned charging interest because he felt that it produced an inequality of wealth and destroyed the harmony between citizens of the state. As commerce expanded and money lending became increasingly important, opinions about usury changed. The Romans were more tolerant of usury and were one of the first societies to recognize interest and set maximum legal rates for various types of loans. Throughout much of recorded history, societies around the world have felt it was important to limit the interest rate that a lender can charge in order to restrain lenders from taking advantage of borrowers."
Some banks are pretty highly leveraged and that these risks of leverage must be controlled since the banks lie at the heart of the financial system. The way this leverage is controlled so that risk of collapse is not too high is to set limits on leverage commensurate with the risks of the loans or investments any bank is making. This is what the Basel Capital Accord was discussing recently at the Bank for International Settlements (the central bank of central bankers) in Basel, Switzerland. These accords specify a certain amount of shareholder or equity capital or "safety net" (from a depositors perspective) that banks hold as a function of the riskiness of their loans or investments. Such a safety net sets a bound on leverage and provides protection for depositors and taxpayers who are ultimately on the hook for massive bank failure.
But these controls are continuously circumvented but how? I am glad you asked enter the Credit Default Swap or Credit Derivatives they were being used to get around these safety nets or caps on leverage. A derivative on an underlying asset basically allows you to make a bet on the future price of that underlying asset by betting just a fraction of the cost of that asset. The leverage comes about because the instrument basically replicates borrowing or lending of the underlying asset, without you ever having to physically own it. Derivatives can help you manage risk if you already trade in the underlying asset. Let's say you are wheat farmer worried about wheat prices. Then derivatives can be used to buy insurance on wheat prices. Say if wheat prices go down, you can get compensated for your loss by buying insurance in the form a futures contract or even a "put option" on wheat. Your outlay for this protection is fixed - the cost of the insurance premium - but it has removed the potentially larger loss of plummeting prices.
But and this is a big but, like all such things with a good use, there is a large downside. That is that the leverage and potential returns available on derivatives attracted speculators from all over the globe to play and to become major dealers of Derivatives. Like Private Equity and Hedge Funds, capitalized by wealthy investors and then often also borrowing many multiples of there capital from federally insured banks. With this highly leveraged capital base they then entered into the highly leveraged and potentially lucrative world of derivatives gambling. Private hedge funds were not regulated on the grounds that their investors are sophisticated, and at the time regulators didn’t seem to understand or be worried about the risks that depositors and taxpayers are exposed to by the largest and most highly leveraged of these bodies. In addition the huge hundreds-of-trillions-sized market known as the Over-The-Counter (or OTC) derivatives market is not regulated. But our banks that are regulated were and are among the major players and dealers.
The unregulated credit default swaps market, the hottest game on the block at the time. Enabled institutions that lend money to high credit risks to buy insurance on those risks. For example, a bank with high loan exposures to certain lenders can pay a premium to a third party for a credit default swap, a form of credit insurance, whereby the bank would get reimbursed by the credit swap seller if the borrower defaulted. The bank is thus able to take this credit risk OFF its balance sheet and thereby is no longer required to hold the regulated amount of equity capital, or "safety net", against the risky credit risk. This means that the bank can further increase its leverage. If the seller of the credit default swap is not a bank, and especially if it is an unregulated hedge fund, then there may be no capital requirements (safety nets, or leverage limits) on such credit exposures. Therefore through the use of credit default swaps the overall financial system safety net shrinks and leverage and associated risks of collapse are increased, as always to be borne by depositors and taxpayers if things get too out of hand.
Add to this the fact that banks and others in need of credit protection are entering into these swaps through off-balance sheet Special Purpose Vehicles to remove the underlying transaction from public and regulator scrutiny. So it's was very difficult to tell what was going on, and where and what the real risks were.
Some would argue that there should not be any regulation in this area. They argue this helps ensure capital and risks get allocated efficiently around the markets, which facilitates our economic prosperity. But these arguments always ignore the larger risks being added to the system as a whole and the unfortunate reality of Quantumnomics you cannot predict the non-event. The U.S. economy was becoming increasingly dependent on abstract concepts rather than on the production of real goods, and then about the risk/return trade-off of derivatives and leverage. So I ask again under oath XXXX financial instiution according to your sworn affidavit you submitted do you own and have the rights of said property. Remember you are under oath and subject to perjury!
