I am teaching Negotiable Instruments this semester and have come to the credit systems section in Ron Mann's Payment Systems book. The first part of this section is a discussion of promissory notes, including risk strategies, LIBOR (discussed by Jason Kilborn recently in his post "Who's LIBOR?") and interest rate swaps. Despite my own questions about the mess, the students will surely expect some discussion and perhaps a few answers. How much is true? How much is speculation? What exactly is a credit crunch? Oh, and not to forget how this will affect their student loans? So, here is my attempt at an overview to a complex problem, without trying to cast blame on any actor in particular.President Bush observed in his October 10th speech that the "fundamental problem" that began the financial crisis was the housing market decline, which caused banks holding mortgage assets to suffer serious losses. A simple start to things, but this is where things get complicated. The housing crisis itself would be a bad thing for the United States economy. But we have to add to this problem the credit default swaps (CDS), which Congress exempted from regulation in the Commodity Futures Modernization Act of 2000. Financial companies are always seeking to reduce the risk of default on credit instruments. For instance, this is the reason for mortgage life insurance and private mortgage insurance in home loans.
Imagine the owner of a corporate bond (i.e. Goldman Sachs) wants to manage risk without selling the underlying bond. The owner (buyer) purchases a CDS on the corporation by paying a fee to a seller (i.e. AIG) for the right to payoff of a loan in the event that the maker/corporation defaults. Apparently, there are some $62 trillion in CDS contracts outstanding worldwide. Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaway's 2002 annual report Buffet commented:
"Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses--often huge in amount--in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)."Well, it all seems to come down to whether the seller of the CDS has enough collateral to guarantee the CDS contracts. As we know now, the sellers of CDS did not have sufficient assets to back the contracts, leaving banks exposed when the market declines or the maker defaults. In the end, swaps are kind of like insurance, but not quite (or they would have been regulated). But imagine a large hurricane where property owners purchased insurance from insurance companies did not have enough assets to pay claims. The losses then would fall on those property owners who thought they purchased insurance.
Enter AIG, whose London Financial Products unit sold CDS contracts that declined in value. AIG's CDS contracts insure $441 billion worth of securities originally rated AAA, with$57.8 billion in securities backed by subprime loans. The decline in value led to the need for AIG to post additional collateral to its trading partners, which it could not do. Enter the Federal Reserve, who agreed to lend AIG $85 billion initially, followed by an additional $37.8 billion from the Federal Reserve. The Federal Reserve has received warrants for a large equity stake in AIG.
Back to the financial mess. To sum up:
- Banks that extend loans did not have enough assets to cover losses arising from default (including from the housing market).
- The sellers of the CDS contracts sold to the banks and others also did not have enough assets to cover losses. When the market changed, sellers like AIG could not post enough collateral on these contracts.
- After #1 and #2 occurred, the market declined precipitously. As all of this occurred, credit markets froze up as even banks became hesitant to lend even to other banks.
As John D. Rockefeller once said that "[t]hese are days when many are discouraged. . . . , depressions have come and gone. Prosperity has always returned and will again." Not that we are in a depression or will even enter one, but Rockefeller's optimism is good to remember.
— JSM
