What's Wrong?

Finance has been in the news in a big way, lately. Listeners of This American Life will be able to point out, from various shows- (#355) Giant Pool of Money, (#363) Enforcers, and (#365) Another Frightening Show About The Economy- exactly what's happened. Anyone who follows the news- and isn't blinded by terms like Mortgage Backed Securities, Credit Default Swaps, Netting, Leverage, Speculation, Naked Short Selling, Hedging, The Commercial Paper Market- will probably also be able to list the flow of problems that have led to the current crisis. In the past few weeks, there has been more and more paper, text, and other information generated about these problems than any other story since 9/11. It's a big deal, with people in the know saying things like Great Depression, Edge of the Abyss, Train Wreck, Epidemic; and for anyone who doesn't know, or can't quiet get their head around it, I'll contribute my meta-analysis of the situation.

Background is available all over; for instance, via the This American Life shows I mentioned above. I will not be spending any time defining terminology, giving the history of scarcity economics, pointing out how Bernanke is better than the Regan-appointed Greenspan (or how he's an expert on The Great Depression), explaining how Chris Cox- the Chairman of the SEC- has failed spectacularly to do the regulatory job he was given, or weighing the pros and cons of regulation, Treasury Secretary Henry Paulson, whether Clinton or the Republican controlled Congress of the time were responsible for dropping the regulatory ball on the CDS market, et cetera. What I will do is explain simply how this has happened, in as general and accurate a way as possible.

How did this happen? Large Banks and other financial institutions were allowed to make undisclosed transactions among themselves. These transactions were not something the general public could participate in, and were initially used as a way of reducing the risk of investment. The transactions were not only never disclosed to the public; but were not disclosed to the other Banks and financial institutions that were participating in the transactions. In other words, Bank1 could make a transaction with Bank2, and Bank2 didn't have to tell anyone (not Bank1 nor Bank3 nor its customers nor anyone else) about what was going on, or who they (Bank2) owed/received obligations. It was determined, by members of both political parties, that these transactions were being handled by very smart people, and since the transactions couldn't be done by Joe Blow off the street the industry and the market were sufficiently regulatory.

But remember, the institutions engaged in these transactions didn't have to disclose anything to anyone else- not even the other institutions involved. The transactions were initially a means of insurance; but rapidly became a lucrative means unto themselves. How lucrative? At a time when there was roughly 5 trillion dollars in actual investment, this insurance was due to pay out 60 trillion.

The problem was, no one really knew this back in March of 2008. Some, few, people suspected; but the practice had gone on for more than a decade- a long time in an industry where fortunes could be won and lost in a matter of minutes- or even seconds. Instead of admitting that business people are- like most other people- greedy bastards, no disclosure (other than that tracking payments and payouts) was required. The transactions were profitable, and it all worked wonderfully, until it nearly fucked everyone in the turd-cutter.

So, what specifically happened? Banks manage risk. Banks, also, need large amounts of money- to do things like make business loans. Primarily, Banks tend to lend to one another. Due to financial turmoil, Banks decided it was too risky to lend to one another. Credit, a major force in world wide economics (especially Capitalist Economies), dried up. Some institutions didn't have the money to pay their bills and went under. Some very big, very old, and- for a long time, up until then- very stable businesses died.

Credit Default Swaps, CDS, were insurance (but not really) on bonds- generally low risk to begin with. A CDS was an agreement, for a fee, that if you owned a bond on a company, and the company went under, you'd get your money back on the bond. Like fire insurance against your house ever burning down.

So, if you managed a Hedge Fund worth $100 million, you could sell a billion dollar CDS against Lehman Brothers, to AIG for 2% annually. Which means you make $20 mil a year, and as long as Lehman Brothers- a very old, very stable business that looked like it would never go away- never goes under, you're okay. Additionally, you double the size of your Hedge Fund in 5 years! Bad-ass, for you.

But it would take you 50 years to make the billion dollars you'd owe AIG if Lehman ever went under. That's risky- not very Risky; but there is risk involved. So, you buy a billion dollar CDS from Goldman Sachs against Lehman Brothers at 1% annually.

AIG is paying YOU 20 million a year to insure that you pay off Lehman Brother's billion dollar bond if Lehman ever dies. YOU pay Golmad SAchs 10 million a year to insure that Goldman Sachs pay off Lehman Brother's billion dollar bond if Lehman ever dies. Get it? (That's Netting, because you pass the risk along while you Net 10 million). Here's the catch- you don't have to actually own the Lehman Brother's Bond, or CDS related to it, before buying/selling CDS against it.

Huh?

Lehman looks like it's about to tank. So, you run to AIG and ask for CDS against a billion dollar Lehman Brother's Bond. Lehman Brothers looks shaky, but they've been around FOREVER, so AIG figures it will reem you for 10% annually. Three years later, you've spent $300 million, Lehman Brothers dies, and now AIG owes you a billion dollars!

You just bought Fire Insurance on a house you didn't own, and the house burnt down. But the insurance company wasn't regulated- so instead of having to keep a certain amount of Cash on-hand in case of insurance payouts, they had nothing, and pass the risk to whoever they had bought insurance from. This works so long as the Bank 20 down the line, where cousin Eddie let cousin Freddie in on a sweet deal and cousin Freddie didn't have time to pass on the risk, can pay off the billion dollars.

We let corporate big wigs, who were concerned with two things: the bottom line and their own huge salaries, do completely unregulated transactions without so much as a disclosure requirement.

I wonder what other financial transactions are happening WITHOUT Regulation, and WITHOUT Disclosure. If there are other ones, just wait, they'll be biting us in our ass sometime later- guaranteed. It's not because they were exceptionally greedy corporate bastards. It happened, and will happen int he future, because they were normal greedy people in a position to make themselves a lot of money, in a seemingly low-risk enterprise, with no way of knowing that $5 trillion worth of Bonds were insured for $60 trillion. Anyone else would have done the smae, in their shoes.

The lesson, Aesop? Don't trust people not to be greedy. Sure, you may know a guy who isn't greedy; but does that mean every other idiot who does his job isn't greedy? Does it mean every other person isn't greedy? No. Disclosure and Regulation are necessary, because the Free Market depends on openness to function properly. If consumers can't discover that they're being screwed how can they "vote with their feet" by going to another institution?

(Yeah, I know I went into all the shit I said I wouldn't.... I'm greedy).

Why?