The average American is puzzled by the current financial crisis. The reason is that the problem occurred at what can only be viewed as the rarified air of finances, finances that allow CEOs to receive millions of dollars in yearly salary. Let”s follow a loan through the system to the place where CEOs make their money ? and threaten ours.
The average home loan borrower went to a mortgage broker, who would take down personal information, such as annual income and the appraisal of the home the borrower wished to buy. This loan application would then be shopped around loan institutions, generally banks or savings and loans. Once the institution loaned the money, the loan would again be sold to another bank, which would bundle the loan with other loans with similar risks and yields.
This bundle was now a mortgage-back security. This mortgage-backed security was resold and rebundled with similar bundles and was now a collateralized mortgage obligation. This final bundle was sold to large investment groups like pension funds, banks, insurance groups, central banks, as bonds.
These investment groups, however, wanted protection for their bonds just in case the borrowers defaulted. Groups like Bear Stearns, Lehman, and AIG insured these CMOs only their insurance wasn”t called “insurance” because that would have brought them under state and federal regulation. The insurance was called “Credit Default Swaps.” The substitution of “swaps” instead of “insurance,” kept the regulators away.
If everything worked as planned, everyone would have made money, lots of money, but the system broke down because the housing market was inflated. Not only was it inflated but fraud and unethical behavior further inflated values. The way it worked was that the brokers at the point of origin of the loan falsified the income of many borrowers, sometimes not even listing income.
In minority areas, brokers steered prime loan borrowers away from fixed, thirty year loans to ARMs (adjustable rate mortgages) and interest only loans. In many instances, these ARMs didn”t reset with interest rates but automatically, which guaranteed that the borrower would default. However, they brought in more money for the broker. Appraisers inflated the values they put on homes, which was especially important for borrowers who were refinancing since it allowed to increase the size of their loans.
Naturally, defaults began occurring when the inflated properties priced themselves out, leaving borrowers with a steadily declining asset. The ripples went up through the system to the CMOs. The institutions that held these instruments, called upon the issuers of the credit default swaps to pay for the declining value of their CMOs.
It is at this point that the real trouble began. Since there was no regulation of the credit default swap market ? and it is a huge market world wide, estimated at $43 trillion to $54 trillion. Yes, that was ?trillion,” not “billion.” The regulations that determine the capital reserves for insurance companies, for example, were totally lacking for credit default swaps. The only asset that guaranteed these credit default swaps in many cases was simply the reputation of the issuing company.
Even worse, many of these swaps were hedged (leveraged). Thus, a billion dollar asset that plunged 40 cents on the dollar would cost the investors $600 million, but the company that issued the a swap that was hedged would be responsible for as much as $6 billion. When one understands the huge amounts of money involved, combined with the total lack of regulation, it is easy to see how our economy got into trouble.
The failure of the credit default swaps leaves pension funds, for example, with less capital to distribute to its members. The decline in capital for banks if it doesn”t bankrupt them, leaves them less to loan since capital determines how much they can lend. This situation impacts companies, which then hits the stock market.
In short, everyone is affected although the full impact may not be felt yet. In the end, the situation is simply “a big mess.”
Charles Moton is a resident of Lucerne. Opinions are those of the individual writers and do not necessarily reflect the views of the Lake County Record-Bee or its management.
