Mortgage-backed securities (MBS) and credit default swaps (CDs) are often referred to, rather loosely, as “alphabetic derivatives.” Most Americans have little idea what these financial instruments are. The terms (derived from the alphabet, cd’s, mbs’s, TARP and all the other acronyms used) have suggested that finance has essentially become a bureaucratic exercise of overwhelming complexity. While the terms may be crazy and the huge amount of money involved in these mind-blowing devices, in another sense it was a pretty simple scam game. Understanding how the robbery occurred can make it possible to minimize future damage.
The derivatives of the alphabet were creatures of the housing boom. When most people buy houses, they make a down payment on part of the price and take out a loan for the rest. The loan is secured by a mortgage on the home, and that simply means that if the homeowner misses a payment, the lender can foreclose on the home, sell it, and pay themselves out of the proceeds. During the housing boom, as the face value of homes increased, more and more people bought new homes or refinanced old ones to take advantage of artificially low interest rates or take some of the “value” out of their homes to spend. gold investment. This created a boom in financial transactions and the need for a big, dumb source of huge amounts of money (the “dove”, to use scam game terminology). The derivatives of the alphabet were designed to hit the pigeon with losses.
This is how it worked. Investment banks realized that if they could package a large number of home loans together, they could create a kind of bond. Governments sell bonds, that is, they borrow money and agree to repay the principal plus interest over time. An mbs works the same way, the source of the payments are the homeowners who borrowed the money and would theoretically repay it over many years. Again in theory, therefore, mbs holders could get a higher interest rate based on prevailing mortgage rates than if they borrowed money elsewhere. However, there was a problem. State and union pension administrators could only purchase “investment grade” bonds of a certain quality. How then were the banks going to put the stock in the hands of the dove? How to create an illusion of security?
During the height of the housing boom, lending standards were eased considerably, as banks often failed to verify information on loan applications, property appraisers presented obscenely inflated price values, and down payments were slashed and often they were completely removed. Therefore, homebuyers did not always have great credit risks. The banks were eager to do the deal anyway: they were making huge profits on the loans, and more profits on the packaging and marketing of the mbs to their customers. So here was the essential scam: a company called AIG was guaranteeing the debt payments on mortgage-backed securities. Since AIG had a triple A rating, investment appraisers also gave mbs that same triple A rating. That allowed pensions to buy the bonds. Everyone who actually thought about how many of these mbs AIG was guaranteeing knew this was a scam, but they thought, or pretended to think, that rising house prices would go on forever and nullify the effects of their carelessness.
When the housing bubble burst and home values began to decline, everything changed.
The banks had offloaded as much mbs as they could onto the fund holders, but when the bubble burst they were still stuck with hundreds of billions of dollars “worth” in their own hands. Then it became clear that AIG could not pay its obligations, and the sudden loss of insurance backing meant that no one was willing to buy the mbs anymore. They became “illiquid” meaning that no one would pay anything for them and therefore their “market value” dropped dramatically and was essentially zero. In an honest market, this would have caused ratings firms to downgrade the bonds, crushing their official market value. Most of the big banks would have been insolvent and forced into well-deserved bankruptcy, and the mbs would have been sold in liquidation sales. The market would have assigned a value to the mbs, and the problem would be over, except that the most reckless and conniving bankers would be out of work instead of taking home multi-million dollar bonuses.
Instead of letting the bankers get what they deserved, the government “bailed them out” in various ways. The Federal Reserve bought about a trillion dollars in mbs to keep some banks out of trouble, the federal government bought a lot of a lot of the big banks, and the government has funneled huge amounts of money into the banks by basically giving them money at no cost. no cost and then borrowing it at a market rate of interest. The trick here is that the government is lending the money to the banks for very short-term loans and borrowing it for very long-term loans. It’s a scam that allows the government to expand the amount of money available for long-term borrowing (thus suppressing interest rates on the national debt) while bailing out its big taxpayers in the banking industry.
In a free market, the banks would be crushed when interest rates rose any time within the next ten years, as they undoubtedly will. Nobody thinks that the government will allow the banks to fail when this happens. Why should they?
What are the costs of government actions to bail out the banks? So far they may seem only theoretical, although I believe they are fundamental and far-reaching.
First, the government has sacrificed its own transparency and encouraged corruption in the markets. It has sacrificed transparency by choosing to act in the market in ways that favored certain players while hiding its actions or misleading the public about those actions. Consider the recent revelations that the New York Fed ordered AIG to hide the recipients of the government bailout, for example. Why has the government bailed out certain companies (AIG, Goldman Sachs, etc.) while allowing others (competitors of the bailed-out companies) to go bankrupt? Who has received federal aid? And because? Nobody will say.
The government has encouraged corruption by bailing out failed industries, shielding them from the economic consequences of their actions. This is known as “moral hazard”, and it basically refers to the fact that if an actor is protected from the negative consequences of his actions, it is more likely that he will commit them again. Banks again provide a shining example. Known for excessive bonuses that depleted their capital, made them vulnerable to economic downturn and led to insolvency and the “banking crisis”, they immediately used most of the government subsidies to give themselves large bonuses. Leaving themselves, again, vulnerable to the economic downturn. They are simply using the government as their source of reserve capital.
Even more important, in my opinion, is the fact that the banks were able to change the accounting rules and no longer have to “mark” their speculative positions “to the market”. That means banks don’t have to assign a current market value to the assets (mbs) they own, but are now free to “mark to make believe”. Since assets are worth much less than their fictitious value, banks have large, unreported, and invisible losses. In reality, they are bankrupt and survive only because the government provides them with large amounts of life support. Most of the big banks, in other words, are “zombie” banks that survive on the lifeblood of the economy.
The government has acted against the clear will of the people by bailing out the big banks. This has not only been undemocratic, but has also created the potential for citizen action and reaction. It has weakened the principles of government accountability while vastly expanding the size and role of government in our daily lives. It has massively increased the federal deficit, weakened the US dollar, and made the promises of Medicare and Social Security unfulfillable. It has taken huge amounts of taxpayer money and given it to the richest 1 percent of the population, widening the economic disparities between the rich and the rest of us. And finally, it has encouraged reckless financial behavior throughout the economy and filled market signals for the industry, causing the misallocation of resources and hampering our ability to compete in global markets.
I think most American citizens are dimly aware of these changes and the “new reality” we are facing.
