The Death of Direct Sales

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Posted By: Jim VB

Jerry,

I'm not an expert either, but here's my understanding.

Credit Default Swaps are a financial instrument that can be purchased to protect you in the event that the bundled mortages go into default. As such, it sounds like insurance. But the people selling them go out of their way to make sure they are NOT insurance. (AIG used a completely different division than their Insurance unit, to avoid conflict.) If they were insurance, they would have been regulated. Reasonable and adequate reserves against claims would have been required. None were. Mostly though, if you go to insure real property, you usually must have an ownership stake in said property. This isn't the case with CDS's. Anyone could buy one. This ability to sell multiple times is what magnifies the amount of the original mortgages. This alone, clearly moves it from the "insurance" category to a form of legalized gambling. When the talk of huge POTENTIAL defaults started, ratings companies downgraded many of these investments from AAA all the way down to junk. Many state funds and pension funds can own AAA investments, but, by law, they can't own junk. This ratings change then forces selling, which causes the investment banks to come up with cash. Short sellers, anticipating this cash squeeze, began to short these investment firms. (Naked shorts can sell the stock, without owning it, promising to repay the shares later.) This selling drove down the stock prices.

This isn't a political issue. Both sides have dirty hands, from enabling and pushing bad mortgages to allowing this whole derivative industry to form without regulation.

Keep in mind, that everyone involved in these transaction made out well from them,at some point. Mortgage brokers made a commission. Homeowners borrowed more, and bought bigger, nicer houses than they should. Mortgage companies bundled these loans and sold them (Fannie and Freddie). Investment banks sold the derivatives, lots of them. Execs at those firms pocketed nice bonuses. And each time a package was resold for a profit, investors had their portfolios grow. And now it comes apart. No one has a clue how big the outstanding liability is.

As I say, I'm not an expert and will gladly step aside for anyone who is, and learn something.