How much did Credit Default Swaps contribute to the Sub-prime Mortgage Meltdown?

We all know about the predatory lending practices which produced loans to people who really couldn't manage to pay for them once the rates adjusted, but I wonder how many of these loans would have been made if there had not been a huge demand for High rate Collateralized Debt Obligations. (the sub-Prime mortgages paid higher rates to the lender but also brought higher risk).

Wall street banks were finding a strong market among institutional investors for CDOs. But the high rate tranches of CDOs were composed of higher risk loans. How could the Wall Street Banks sell these to institutional investors who were constrained by their fiduciary duty the funds contributors to not bet their money on risky investments. Pension funds are restricted to investing in triple A rated debt. How could the investment bankers sell the higher returns of the higher risk CDO tranches to institutional investors limited to low risk investments.

Well, the legalization of Credit Default Swaps (CDS) (CFMA) would have provided an ideal answer to this quandary. They could offer the Higher return CDOs to the institutional investors and also sell them a CDS which would provide perfect protection from default of the underlying mortgages! What a deal.. the investor would get the sweet returns of a higher rate CDO but with none of the risk thanks to the Credit Default Swap. IF the underlying mortgages were to default the CDS protects the investor from losing his investment. ... Or so goes the rationale.

I would think such an arrangement would be a powerful selling point to a pension fund manager trying to get higher returns yet being very wary of any additional risk. Collaterized Debt Obligations were big money makers for the Wall street investment banks. IF you could just eliminate the risk associated with the higher return CDOs you could sell gobs of these things.

There certainly was a hot market for CDOs and that would have created a surging demand for higher rate Collateralized Debt Obligations - those based on sub-prime loans that is.

I just wonder if the legalization of the Credit Default Swap didn't ignite the sub-Prime mortgage market and drive mortgage brokers and other predatory lenders to beat the bushes for anybody they could sign up to a mortgage - whether or not they were able to pay for it in the longer run.

I guess that's why Mother Jones called Phil Gramm Foreclosure PHil.

"Years before Phil Gramm was a McCain campaign adviser and a lobbyist for a Swiss bank at the center of the housing credit crisis, he pulled a sly maneuver in the Senate that helped create today's sub-prime meltdown."

to the meltdown.

which required sub-Prime loans. This demand is what drove the mortgage brokers and other predatory lenders to go out and sign up everybody they could find to sub-Prime loans. NOte the CDS is what made the higher risk loans palatable to institutional investors as the CDSs were supposed to eliminate risk to principal from defaults of underlying loans. So sales of CDOs soared and demand for subprime loans went up with it.

The mark-to-market became necessary because these CDSs were being traded via the over-the-counter (non regulated) market (as per the CFMA) so the current market price was considered the most accurate way to value the asset (CDS) on the banks books.

The banks also took out CDSs themselves from insurers (read: AIG) which they they thought virtually eliminated their risk of default and relieved them of the need for adequate reserves. They told SEC in and SEC let them go from about 12:1 Debt to Equity to 30:1 DtE. Thus when housing defaults rose, billions of dollars of CDOs were reevaluatd and also CDSs on their books had to be revalued downward putting the banks in a negative balance sheet position. LEveraging at 30:1 dramatically increased the market losses entered on the books. ONce the banks were in a severe negative balance position then credit froze.

If everybody paid their mortgages tomorrow, it still wouldn't fix the speculation in the deriviatives and credit default swaps.

It's like saying if everybody paid their gas credit card, it would have any influence whatsoever on $140 a barrel oil.

created a vacuum for the bad loans. The bad loans had the risks moved away from the lenders. The fees supported an army of loan processors and salesmen. But yeah, it would not have been possible without Uncle Phil. The guy who started it all.

the unregulated Credit Default Swap, which Warren Buffet called "weapons of financial destruction".

a bill to regulate CDSs is currently sitting in the Housed Financial Services Committee, chaired by Barney Frank. YOu might consider giving Mr. Frank you thoughts on the matter:

http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=114x59010

These institutions had to be betting that the packages would default. Not only could the creditor insure the amount of their loan against a default, but any other institution could bet on that package defaulting too. AIG thought they were rolling in the cash, so they were willing to insure just about anyone's package of loans. After all they were all AAA securities.

But when the foreclosures started, there wasn't enough money in the World to pay off the insurance on risk that AIG assumed. AIG's securities division had to be run by idiots! That's were jail time should start.

This occurred in the waning hours of the Clinton administration. The Funding bill had to be passed. It came up for a vote on the last day of that congressional session. It was an 11,000 page document and virtually nobody knew that the CFMA was in there. Gramm knew that this was the only way to get this thing passed by sneaking it into some other legislation.



60 minutes did a very good report on this back last October:
http://www.democraticunderground.com/discuss/duboard.php?az=show_topic&forum=114&topic_id=46775

The CDS premiums were poorly priced and badly reserved. No insurance commissioner in his or her right mind would have allowed it.

Of course, they weren't really regulated. So the back stop was just full of holes. And so we are bailing out AIG.

You might consider letting Barney Frank know that we need actio on this right away.

http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=114x59010