There are many types of of structured instruments including asset-backed securities (ABS), mortgage-backed securities (MBS), collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs) all of which provide a revenue stream from loans that were chopped into tranches and turned into securities. There are many problems with these complex securities, the biggest of which is that there is no way to unravel the individual pools of loans to isolate the bad paper. That's why subprime mortgages had such a destructive affect on the secondary market, because--even though subprimes only defaulted at a rate of roughly 5 percent--MBS sales slumped nearly 90 percent. Why? Former Secretary of the Treasury Paul O'Neill explained it like this: "It's like you have 8 bottles of water and just one of them has arsenic in it. It becomes impossible to sell any of the other bottles because no one knows which one contains the poison."
Exactly right. So why weren't these structured debt-instruments "stress tested" before the markets were reworked and the financial system became so dependent on them?
Greed. Because the real purpose of these exotic investments is not to provide true value to the buyer, but to maximize profits for the seller by increasing leverage. That is the real purpose of MBS, CDOs and all the other bizarre-sounding derivatives; higher profits with less capital. It's a scam. Here's how it works: A mortgage applicant buys a house for $400,000 and puts 10 percent down. His mortgage is sold to Wall Street, chopped into pieces, and stitched together in a pool of similar loans. Now the brokerage can use the debt as if it were an asset, borrowing at ratios of 20 or 30 to 1 to fatten the bottom line. When Fannie Mae and Freddie Mac were taken into conservatorship by the government, they were leveraged at an eye-popping 100 to 1. This shows that nearly an infinite amount of debt can be precariously balanced atop a paltry amount of capital. This explains why the $4 trillion aggregate value of the 5 big investment banks and the $1.7 trillion value of the hedge funds is now vanishing more quickly than it was created. Once the mighty gears of structured finance shift into reverse, deleveraging begins with a vengeance pulling trillions into a credit vacuum.
Emphasis added by me.
You know what's screwy? This is exactly a laissez-faire market at work and there are people who refuse to recognize that! This is a Comment posted to this blog in response to my scourging the "Austrian school" of economics:
This crisis was neither a failure of laissez-faire capitalism nor Ayn Rand's ideas, it was a failure of intensive regulation —with Greenspan's hypocritical contributions.
Hello! These structured investments had no regulations governing them at all! That's as fucking laissez-faire as gets!
Back to this post:
So far, the Federal Reserve has provided nearly $2 trillion through its lending facilities just to keep the financial system upright. The Treasury is currently distributing $700 billion to key banks and other financial institutions that are perceived to be "too big to fail". In truth, the "too big to fail" mantra is a just public relations hoax to conceal the web of counterparty deals that make it impossible for one institution to fail without dominoing through the rest of the system and wreaking havoc. That's why AIG is still on life-support with regular injections of taxpayer money; because it had roughly $4 trillion of credit default swaps (structured "hedges" that are not traded on a regulated exchange) for which AIG does not have sufficient capital reserves. In other words, the taxpayer is now paying the debts of an insurance company that didn't set aside the money to pay its claims. (As yet, No SEC indictments for securities fraud) In fact, the Fed and Treasury are now providing a backstop for the entire structured finance system which is frozen solid and shows no sign of thawing any time soon.
Emphasis added by me.
Hey, Ayn Randroids and "Austrians," don't squeak about the free market. Read here how no capitalist would touch CitiGroup to rescue it! It's as Ralph Nader said: Capitalism will never die because Socialism will keep rescuing it!
There is much detail in this post about how Paulson's and Bernanke's efforts are nothing more than smoke-and-mirror feel-good triage (my terms) rather than fundamental repairs.
The post concludes:
Rome is burning. It's time to stop tinkering with a failed system and move on to "Plan B" before it's too late.
They have no "Plan B."
Chronicles Of Depression 2.0: #441: Nash V. Smith
Chronicles Of Depression 2.0: #431: Acceleration
Chronicles Of Depression 2.0: #427: 777