Sunday, October 12, 2008

Explaining the Financial Crisis to Students

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:
  1. Banks that extend loans did not have enough assets to cover losses arising from default (including from the housing market).

  2. 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.
  3. 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

1 comment:

Doug said...

This is a good summary, but a few more points ought to be added for a full picture. I write from in house at a hedge fund so I deal with this regularly.

First, swaps are often entered into purely for speculation, not as insurance (in the hedge fund world, it is mostly for speculation). And you can pretty much swap anything as long as you find a counterparty. Often they are done to avoid regulations such as FIRPTA so that a Cayman fund can buy companies connected to US real estate, for example, or for tax reasons. Thus, e.g., I can swap Libor+3% against the upside in an oil company stock (That is, I pay Libor plus 3% and I get back the rise in value of a stock price, but I have to pay if the stock goes down). Many swaps are just bets on interest rate movements. And some are insurance style swaps that you describe. They are basically anything you can get the other side to agree on. You pretty much agree when you will compare sides of the swap (say quarterly) to see who is ahead and whether one side needs to add collateral. There is a master agreement and a form swap confirmation, but the details are pretty negotiable.

Second, the swap market is otc (over the counter between parties in private agreement), which means it is not reported anywhere, and unregulated, there is no established dispute resolution system, no clearinghouse like an exchange to monitor collateral, etc. There is virtually no law in the area, so it is not even clear when, for example, an event constitutes a 'default' that would trigger payment under the swap contract. The whole area is a morass, and collection from a counterparty is difficult.

Third, swaps have massive hidden leverage. Most investors are stuck at 50% margin under RegT, hedge funds are offshore and outside RegT, but in a swap you can create as much leveage as you like by changing the notional amount. So in the 'real' world if I have $100 I can only bet $200 but in the swap world I can place a bet on the notional amount of 1MM, or 10MM, or 100MM, or whatever the other side agrees. Many swap counterparties have written swaps that aggregate many dozens of times their own equity. In other words, in most cases swaps will amplify leverage but are not shown on balance sheets as a potential loss.

Fourth, many swaps are keyed to downgrades or defaults by referenced companies, so if, for example, Ford files bankruptcy then all the swaps where they were a counterparty are in default and there has also been a massive change in swaps that used Ford as a reference, which means that some counterparties will have to make massive payments, which can affect their swaps, and so on ad infinitum in an endless chain. When these parties are broker dealers (e.g. Lehman) the collateral that they are holding is rehypothecated already and is now lost to senior creditors, so hedge funds with assets parket there go out of business, etc etc.

Lastly, many of the swaps were tied to CLOs and other structured products which have become toxic, so no one has any idea the vastness and interconnectedness of the toxicity. Much of this is held by banks who have no idea the value of what they are holding or the value of swaps that reference it. And some of these structures do not even have 'real' mortgages in them, they are purely synthetic structures that replicate or imitate the real structures. Thus people made bets on swaps against the performance of synthetic tranches of mortgage backed securities. The complexities are mind-boggling, and were created by PhDs in mathematics and physics, believe it or not. It is an unreal world.

The problem, then, is not just bad mortgages but a completely interconnected web of unregulated products among a handful of companies that are so big that the failure of any one could take down the whole market. Mortgages are just a reference point, the problem is the fantastical structures built that use mortgages as a reference point.

Some day, swaps will be traded on an exchange with clear collateral requirements (in the way that futures are traded, for example).

Eventualy, reality will assert its head and we will have to return to regulated markets, real assets, and fundamental accounting principles.