Mortgage-backed securities (MBs) and credit default swaps (CDs) are often referred to, rather loosely, as the “alpha 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 far fetched and the sheer amount of money involved in these mind-boggling devices, in another sense it was a pretty simple scam game. Understanding how the heist occurred can make it possible to minimize future damage.
The derivatives of the alphabet were creatures of the housing boom. When most people buy homes, they put 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 with the proceeds. During the housing boom, as home values rose, more and more people bought new homes or refinanced old ones to take advantage of artificially low interest rates or take out some of the “value” 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 con 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 bundle a large number of mortgage 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 is the homeowners who borrowed the money and would theoretically pay it back over many years. Again in theory, therefore, MBS holders could get a higher interest rate based on prevailing mortgage rates than if they lent money elsewhere. However, there was a problem. State and union pension administrators could only buy bonds of a certain “investment grade” quality. How then were the banks going to put the bag in the hands of the pigeon? How to create an illusion of security?
During the height of the housing boom, lending standards were greatly relaxed as banks often failed to verify information on loan applications, property appraisers presented obscenely inflated price values, and down payments were reduced and , often completely removed. Therefore, home buyers did not always have large credit risks. The banks were eager to do the deal anyway: they were making huge profits on the loans and more profits on packaging and marketing the mbs to their customers. So here was the essential scam: A company called AIG guaranteed 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 really 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 negate the effects of their carelessness.
When the housing bubble burst and real estate values began to decline, everything changed.
Banks had offloaded as many mbs as they could to 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 support meant that no one was willing to buy the mbs anymore. They became “illiquid” meaning no one would pay anything for them and thus their “market value” dropped dramatically and was essentially zero. In an honest market, this would have caused rating firms to downgrade the bonds, crushing their official market value. Most of the big banks would have been insolvent and forced into the well deserved bankruptcy, and the mbs would have been sold in fire sale. The market would have assigned a value to mbs, and the problem would be over, except that the most reckless and scheming bankers would be out of a job instead of taking home multi-million dollar bonuses.
Instead of letting the bankers get what they deserved, the government “bailed out” them in various ways. The Federal Reserve bought about a trillion dollars worth of mbs to keep some banks out of trouble, the federal government bought up a lot of a lot of the big banks, and the government has funneled huge amounts of money to the banks basically giving them money in no time at 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 is a scam that allows the government to expand the amount of money available for long-term loans (thereby abolishing interest rates on the national debt) while at the same time bailing out its large taxpayers in the banking industry.
In a free market, the banks would be crushed when interest rates rose at 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 the government’s actions to bail out the banks? Until now 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 a way that favored certain players while concealing its actions or misleading the public about those actions. Consider recent revelations that the New York Federal Reserve ordered AIG to hide 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? No one will tell.
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 means 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 “banking crisis”, they immediately used most government subsidies to give themselves huge bonuses. Leaving, again, vulnerable to economic recession. 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 make believe.” Since the assets are worth much less than their fictitious value, the 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 life blood 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 vastly 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 one 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 industry, causing resource misallocation and hampering our ability to compete in global markets.
I think most American citizens are only vaguely aware of these changes and the “new reality” we are facing.