By Walter Sorochan, Emeritus Professor, San Diego State University
Posted March 18, 2009; updated May 17, 2019.
Purpose of article: To briefly and simply illustrate the events that lead to the real estate meltdown, Wall Street collapse and global financial depression of 2008. This information is detailed and summarized in simple fashion. You need this historical background to perceive where mistakes were made and what needs to be fixed to prevent future swaps.
The initial threat to the Global Economy began to unfold before 2008 in Portugal, Iceland, Ireland, Greece and Spain [PIIGS]. Credit Default Swaps wereused by bankers, lenders, loan companies, insurance companies, wall street and speculators to make money at the expense of a naïve public. It was the baskets of Credit Default Swaps that were sold and purchased without collateral by speculators wanting to make money. The swap scheme broke down when a company that purchased one of the baskets of derivative swaps made a call for cash. The main seller could not come up with the cash and the swap scheme triggered a stock market crash.
By understanding the causes of the many meltdowns, we can reverse engineer the causes and fix the continuing economic problems.
Step 1 Early symptoms ignored: One of the earliest signs that the economic system had flaws was the mid-1970's shortage of oil. There was no long range energy plan! Then there were several mini-stock market crashes thereafter. All these forecasters of the future were ignored! "Business as usual!"
Step 2 Credit default Swaps: A financial instrument, Credit Default Swaps [CDS or SWAPS], was created by Blythe Masters of JPMorgan Chase Bank in the early 1980s. [Teather: is an instrument that is connected, like a rope, to a bank, limiting it's range of movement and giving it credibility.] This instrument developed the credit derivatives which were at the heart of the current financial crisis. It exchanged or swapped paper debt for collateral that really had no backup.
In 1997, Masters and her team developed many of the credit derivatives that were intended to remove risk from companies' balance sheets. The idea was to separate the default risk on loans from the loans themselves. The banks argued that by trading credit derivatives of the kind pioneered by Masters, they had spread their risk elsewhere and therefore needed lower reserves to protect against loan defaults. Regulators looked the other way and the banks loaned ever more. It was a huge success and the market for credit derivatives grew rapidly.
The new instrument, the Credit Default Swap [ CDS ] was used as an insurance to secure paper notes or loans. SWAPS set the stage for a new form of gamble speculation. It allowed banks and big insurance corporations to make money by not assuming responsibility to have enough collateral or cash on hand to cover their bets.
The economic mess the entire world found itself in 2009 started a long time ago; probably 300 years ago with the free enterprise system. But it started surfacing in 2001 when banks began using a special way of providing collateral for money they were borrowing from investment banks and others. Enron, the energy giant in 2000, exploited special credit notes, called Credit Default Swaps, to create a paper money empire [without cash reserves to back up the SWAPS trading] that collapsed in 2002.
Step 3 Enron 1980s: Enron, the defunct energy corporation in Houston, Texas., evolved its own form of an unregulated banking and loan system. Enron borrowed the idea of a new instrument from JPMorgan Chase Bank in the early 1980s; that exchanged or swapped paper debt for collateral. The new instrument was called the Credit Default Swaps [ CDS or SWAPS ] and was used as an insurance to secure paper notes or loans and also generate income for Enron. Politicians in Washington bent over backwards to accommodate Enron.
Enron exploited special credit notes, called Credit Default Swaps, to create a paper money empire that collapsed in 2002. Enron triggered Wall Street speculation that brought the financial institutions and many countries down in 2009.
The tragedy of Enron is that no one did anything about preventing the Enron tragedy from reoccurring! For more information click on: Enron
Step 4 1980 - 2000 Speculative gambling on the stock market started big time in the late 1980’s with Enron. No one understood CDS in the 1980 - 1990's era. Congress gave Enron political and fiscal freedom to use CDS as they wished, without monitoring, accountability or regulation. After all, everyone assumed that Wall Street and free enterprise would work to provide an equal playing field for everyone!
CDS opened the door to all future events such as creating sub-prime loans, allowing unsecured securities to be sold by banks, and disposing of unmonitored CDS to foreign investors. Everyone who participated in the "CDS gambling table" had dollar signs in their eyes and greed and power in their hearts. Politicians had a "hands off" policy toward all these shennanigans.
Step 5 Gramm's Commodity Futures Modernization Act of 2000 in the dark of night: Credit Default Swaps became exempt from regulation with the Commodity Futures Modernization Act of 2000, which was also responsible for the Enron loophole. U.S. Senator Phil Gramm (R-TX) introduced the Act on behalf of financial industry lobbyists. The Modernization Act was rushed through Congress as a companion bill to the omnibus spending bill, the last day before the Christmas holiday at 2:00am in the morning when the senate was empty. Not a single politician read the bill. Most did not know what was in the bill.
The bill by-passed the substantive policy committees in both the House and the Senate so that there were neither hearings nor opportunities for recorded committee votes. The omnibus spending bill, which was 11,000 pages long, is the financial plan the government requires for everyday operations. President Clinton signed the bill into Public Law (106-554) on December 21, 2000. This bill spurred the loaning of easy to get loans to home buyers.
The Modernization Act allowed for even more regulatory bypasses. It became difficult to determine the financial strength of the sellers of protection. CDS came to be issued for Structured Investment Vehicles, which did not have a known entity to follow to determine the strength of a particular bond or loan. The market became rampant with gambling as sellers and buyers of CDS were no longer owners of the underlying asset (bond or loan). Before the Act of 2000, the CDS markets value was 900 billion. By the end of 2007, the CDS market had a notional value of $45 trillion.
Step 6 The real estate boom: Mainstreet was ready to take part in the SWAPS casino. Common folk wanted to live the American dream of owning a home. And banks and loan companies were eager to help them.
7 Prospective Buyers - a Big Housing Market:
After cranking out thousands of sub-prime mortgages, credit began to dry up and Quick Loan eventually closed. But the momentum toward easy loans had a jump-start!
Buyers were persons who could not afford to buy and who did not have a moderate down payment. Mainstreet usually bought houses with an adjustable rate mortgage.
A new loan was created: “the pay option negative amortization adjustable rate mortgage.” It was designed to help first-time homebuyers who couldn’t actually afford the cost of the loan. Those homebuyers would have the option to pay only part of the interest they owed each month. The unpaid interest was added to the total amount of the mortgage. As a result, the mortgage balance increased; instead of the mortgage being paid down, it was getting bigger.
Key motivation for lenders
was earning more commission sales.
Bill Dallas started a new company, Ownit, and offered to sell Wall Street a mortgage for borrowers who weren't quite "prime." It was a 100% home loan for people with good credit who couldn't afford a down payment.
In 2004 homeowners withdrew an estimated $900 billion dollars by refinancing and spent the money on whatever they could buy. Homes had turned into ATM machines and the economy flourished.
Step 10 Tranches -- Restructured Loans made available from Wall Street:
But, just like many homeowners, a lot of investors didn't quite understand what kind of mortgages they were buying. Major Wall Street banks enlisted lenders to supply them with mortgages that banks could sell to investors. Banks eagerly dropped many requirements for the mortgages they were willing to sell: "removing the litmus test ... No income, no asset. Not verifying income... breathe on a mirror and if there's fog you sort of get a loan."
Wall Street bankers pooled together thousands of these mortgages, carved them up into similar packages and profitably sold them as securities.
Credit tranching refers to creating multiple classes (or "tranches") of securities, each of which has a different seniority and value relative to the others. [ more info on tranches in references ]
Step 11 Rating Agencies: During the boom, when home prices surged and virtually no borrowers defaulted, the riskier Triple-B rated securities made from mortgages looked as good as the safe Triple-A's. "Eventually the market gets smart and says, let's lower the requirements for Triple-A."
The key to getting investors to buy those mortgage-backed securities was to get them stamped with a seal of "respectable grade" approval. Big institutions like police retirement funds and universities would only invest if the investment rating agencies — Moody’s, Standard & Poor’s, and Fitch — gave the securities an “investment grade” rating. “Investment grade” can range from the safest triple A-rated investments to the lower triple B-rated investments. Because a triple A security is safer, it pays less than a riskier triple B. credit rating
The credit rating agencies had an incentive to award a security the best possible ratings; agencies were paid for their appraisals by the very banks that issued the securities. [ Moody loan ratings fiasco ]
Step 12 CDOs – Collateralized Debt Obligations:
These structured products are highly complicated investments. The debt securities are bundled and re-sold but often buyers don't really know exactly what they are purchasing. Even Alan Greenspan admitted he was befuddled by the CDO. Hence, these have be referred to as "toxic waste." [ Refer to references about toxic waste for more information]
CDOs are constructed from a portfolio of fixed-income assets. CDOs are divided by the issuer into different tranches: senior tranches ( rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated).
For a simple explaination of how CDO work, [ refer in references to Gagliano and Hirsch: “ …. CDO is an investment that works kind of like a champagne bottle." ]
Step 13 CDOs and CDS are different financial cousins: CDO's [ a form of debt-security bond ] were purchased by investors who were told by "creditable" ratings agencies that these securities were "investment grade". Some of these investors obviously didn't believe the credit agencies and decided to seek insurance in the case that their CDO defaulted. They bought insurance protection in the form of credit Default Swaps or CDS [ often referred to a "swaps" ] so as to insure their investment. Credit default swaps are bought by bond holders to hedge or bet against the default risk of banks.
Credit Default Swaps is basically an insurance policy against the failure of CPO's'. Companies - like AIG, Lehman and Fortis (and many others) found these insurance policies to be a very lucrative business. The problem is that AIG didn't foresee that any of these would default - they thought this was a risk free operation. AIG took in a ton of money to insure the CDO's through Credit Default Swaps - but never had enough reserved for losses. When numerous CPO's defaulted and their investors put a call to be compensated, AIG did not have the money in reserves to do so. Hence AIG declared bankruptcy and had to be bailed out; on assumption that "it was too big to fail!"
Step 14 Fishy odor on Wall Street & Hedge Funds: Credit default swaps were bought by bond holders to hedge or bet against the default risk of banks.
Alert signals were sounded in early 2000's by wall street players like Steve Eisen, Meredith Whitney, Timothy Sykes and Kyle Bass Pittman: Prediction CDS crash that sub-prime lending practices in the housing industry were corrupt and doomed to failure. No one .... but no one listened to them! Big corporations display power with their size. By the spring of 2005, Steve Eisen at FrontPoint, and others, were fairly convinced that something was very screwed up not merely in a handful of companies but in the financial underpinnings of the entire U.S. mortgage market. Eisen refined a betting instrument called hedge fund; which basically bets that a holder [bank lender] of a loan or CDS will not be able to repay the loan in a specific period of time.
Hedge fund speculators began using hedge funds to profit from an anticipated housing meltdown. [ hedge funds, Lewis ] Hedge funds invested in "credit protection," a kind of insurance on various mortgage-backed securities. As those securities decline in value, hedge fund insurance paids off. Kyle Bass' hedge fund made more than a billion dollars in profit.
Step 15 Banks solvency requirements: Banks [ and insurance corporations like AIG ] need a certain amount of cash on hand to be solvent and be able to cover their banking obligations. Many banks in 2000 to 2009 had capital ratios below the required 10 % liquidity requirement. This allowed them to pay the SWAPS game and speculate on investing in busted market for mortgages, derivatives and especially credit default swaps; an unsecured paper debt. [ Refer in references to Bank Capital Requirement for more information ]
The big lending banks, like JPMorgan Chase, Bear stearns, Wachovia, HSBC, Bank of America, CityGroup, PNC Bank, Lehman Brothers, Suntrust Bank and State Street Bank got into trouble when they made big loans and could not pay off to creditors or when a creditor made a "call" on the bank. Unable to pay off their creditors, they had to declare bankruptcy and ask for a government bailout or sell.
Also involved in this bank gambling fiasco were the big bank insurers like AIG. These firms also created similar financial distresses for themselves.
The business of wall street banker Michael Francis was to pool mortgages and sell them to investors who would then get the monthly payments those mortgages produced. The more mortgages lenders provided to homebuyers, the more “product” Francis would have to sell.
Step 17 Speculator buyers worldwide: Example of foreign investor-speculators:
Step 18 The Housing Bubble bursts
Example Narvik, Norway: town far above the Arctic Circle that was convinced it could solve its budget problems by investing in Wall Street's wares... primarily CDOs. In spite of not understanding what it was that they were buying, Town leaders thought it was a safe investment.
But the investment collapsed, forcing the town close a school and slashe services for the elderly to stay solvent.
Step 19 Toxic Poison Today:
Furthermore, SWAPS have been unregulated, sold worldwide; thus difficult to find. [ See Toxic Debt in references ]
Especially alarming is the large growth in credit default swaps in the US Banking system. This chart from contrary investor shows only $16 trillion in exposure, while it is generally estimated (no one really knows) that there are some $60 trillion outstanding worldwide.
Conclusion: Fixing the economic problems requires that we:
[ More information in references as Weissman: 10 Steps to fix CDS 2009 ]
Why bailouts may not work:
1. Because Washington serves corporate America and no longer the American people. We need to free Washington politicians from drinking from the corporate cup![ e.g. lobbyists as in image on right]. Lobbyists and campaign funds are buying a lot of favoritism and cover-up in Congress and the Senate. We need to control lobbying, campaign funding and corporate influence in Washington. For information about campaign contributions from banking, wall street,insurance companies and other sources, refer to following references: Fixing US Economy Senator Dodd Fanny Mae & Freddie Barney Frank
2. Toxic debt festers: as long as the financial wound is infected with SWAPS, the toxic debt will continue to fester. We need to clean the germs [ CPO, CDS ] causing the toxins [ unsecured bad paper debt ]; otherwise the infection can cause gangerine. We need to stop the infection [ economic meltdown ] from becoming a gangerine [ economic depression ] and then the patient [ economy ] will heal quickly!
3. Bailouts are ambiguous & have no accountability. To get more detailed information go to: CNN money for total bailout spending in references.
Bailout efforts were designed to stimulate the economy, avoid a housing bust, restore public confidence, contain the credit crunch, reduce the danger of a global debt collapse, and shore up sinking banks. There is no evidence that all or any of these efforts are working! Indeed, Presidents are trying to restore confidence in the banking, loan and insurance system as a way of rebuilding confidence in the capitalistic system. Instead, they should be passing solid legislation to regulate wall street and the policies that lead to outsourcing jobs, gambling on wall street and fix the broken federal bank and printing of money.
4. Not identifying the real problem(s):
Abuse of credit: what is this, anyway?
Bank Capital Requirement: Bank regulations require that a bank have a specific amount of cash as liquidity to cover bank obligations. The capital requirement is a capital ratio , or the percentage of a bank's capital to its risk-weighted assets.
Bond: is a loan; the issuer is the borrower, the bond holder is the lender, and the coupon is the interest. It is a formal contract to repay borrowed money with interest at fixed intervals. Wiki: what is a bond
Dauenhauser Scott, "MBS, CDO's and CDS in Layman's Terms," The meridian, September 29, 2008. CDOs & CDS relationship
Deeter Karl, Missed mortgage payment? Bad debt? How a bad debt caused a crisis,” March 11, 2008. Deeter: Bad debt caused a crisis 2008
Enron is a classic and famous example of a CDS gone wrong.
Gaffen David, “ Worry Seeps Into Financials (Again),” Wall Street Journal, April 10, 2008. Inactive on internet Website
Gagliano Rico & Hatley Mike, “Financial Crisis 101: CDOs explained,” Market Place, October 03, 2008. Gagliano: Financial Crisis 101: CDOs explained 2008
Goodspeed Ingrid, "Overview of the sub-prime market meltdown," Goodspeed: Overview of prime-sub meltsown
Hedge funds, wikipedia. Wiki: Hedge fund info Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949.[ Steve Eisen took this insturment to a another level about 2005 ]
_____, "House of Cards - Origins of the Financial Crisis''Then and Now,'' Slideshow. House of Cards Slideshow 2008
Hull, John, et la, “ The relationship between credit default swap spreads, bond yields, and credit rating announcements,“ University of Toronto, January, 2004. Hull: CDS information 2004
Interest payments on CDS: Pretend that you have a mortgage (okay, most of us aren't pretending) and you make principal and interest payments each month - these payments are made to your loan servicer and then split up as follows:
Investor A - Gets all of the interest payments from years 1 - 4
International Swaps and Derivatives Association, Inc., “Contract CDS Syndicated-Secured-Loan CDS-Standard Terms Supplement,” May 22, 2007. International Swaps Association
Jarrow Robert A., “Understanding CDO, CDS and the American's Crash of 2008.” Jarrow: Understanding CDO, CDS 2008
Kaufman George G., "Bank Runs," The Library of Economics and Liberty Kaufman: Bank runs
Kirk Edward J., "An overview of the crisis and potential exposure," 2008. Kirk: 2008 CDS crisis
Lewis Michael,"The End," Portfolio.com, December 2008 Issue. Lewis: The End 2008
Market size for CDS, Cyclic Economist March 07, 2009: The market for the credit default swaps has been enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market. Also in sharp contrast to traditional insurance, the swaps are totally unregulated.
Martin Eric, “ U.S. Stocks Fall on Profit Concern; “ Bloomberg, April 08_08. Martin: Stocks fall 2008 Website
Mason, Joseph R., and Rosner, Joshua, “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions,“ Academia, May 2007. Mason: safety in CDSs 2007
Mayerowitz Scott, “ECON 101: Credit Crunch for Dummies,” ABC NEWS Business Unit, March 20, 2008. [ A Step-by-Step Look at What Caused the Nation's Economic Troubles ] Credit Crunch for Dummies
Momura, "CDOs in Plain English," Nomura Fixed Income Research, September 13, 2004. Nomura Securities International, Inc. Momura: Income 2004
Morgensen, Gretchen, “Arcane Market is next to face big credit test,” New York Tines, February 17, 2008. Morgenson: Arcane market credit test 2008
Morrissey Janet, “Credit Default Swaps: The Next Crisis?” Time, March 17, 2008. Morrissey: Credit Default Swaps crisis
Moses Abigail and Harrington Shannon D., “Company Bond Risk Rises on Emergency Fed Cut, Bear Stearns Sale,” March 17, 2008. Moses: Bear Sterns sale 2008
Neidenberg Milt, “ What lurks behind Bear Stearns bailout? “Worker’s World, April 10, 2008. Neidenberg: Bear Sterns bailout 2008
Newman, Rich, “ A beginner’s Guide to Credit Default Swaps,” December 09, 2007. Newman: Guide to CDS 2007 website
Nolan Gavin, “Back to basics “ Credit, December, 2007. No longer on internet Website
Oehmke Martin and Adam Zawadowski, "The Anatomy of the CDS Market," The Review of Financial Studies, Volume 30, Issue 1, January 2017, Pages 80–119. Oehmke:Anatomy of CDS market 2017
Partnoy, Frank and Skeel, David A., “The Promise and Perils of Credit Derivatives,” UC BerkleyLaw School Repository, 2007. Partnoy: Credit derivatives 2007
Pittman Mark, "God I Hope You're Wrong' Wall Street," Bloomberg magazine, December 19, 2007. Pittman: Prediction CDS crash
Pittman, Mark, Katz Alan and David Mildenberg, “Citigroup, Wells Fargo May Loan Less After Downgrades (Update3),“ Bloomberg, April 8, 2008. Not on internet
Predescu, Mirela and Hull, John C. and White, Alan, The Relationship between Credit Default Swap Spreads, Bond Yields, and Credit Rating Announcements (January 9, 2004). Rotman School of Management Working Paper No. 2173171. Available at Predescu.Hull: CDS information 2004
Rating: In the USA there are seven credit rating institutions. For example, Moody's assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, . Standard & Poor's and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, D.
Schwartz, Nelson D. And Creswell, Julie, “ What Created This Monster? “ New York Times, March 23, 2008. Schwartz: who created CDS 2008 Website
Schwartz, Robert F., “RISK DISTRIBUTION IN THE CAPITAL MARKETS: CREDIT DEFAULT SWAPS, INSURANCE AND A THEORY OF DEMARCATION.“ Fordham Journal of Corporate & Financial Law, 2007, Schwartz: Risk distribution CDS 2007
Sharon Bill, “The Federal Reserve - isn’t,“ Between the Cracks, March 31st, 2008. Not on internet
Shedlock, Mish, “ Mishs Togele Bonds – Yet Another High Wire Act,” Global Economic Trend Analysis, June 25, 2007. Shedlock: Bonds 2008
Singletary Mary, "Yes, all debt is bad debt," The Washington Post, April 14, 2017. Singletary: All debt is bad 2017
Smith Yves, "Credit Default Swap Worries Go Mainstream," Naked Capitalism, February 17, 2008. Smith: CDS go mainstream 2008
Sub-prime: From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds. These were mortgages issued to home-buyers who bought with no down payment.
Supkis Elaine Meinel, “Bank Rescues Means Exact Replication Of Great Depression,” EZ Reading Money Matters, March 21, 2008. Supkis: Bank rescues 2008
Swaps concept: This is similar to the old fashioned bargaining. Swapping is exchanging one item or commodity for another of equal value. For example:
Sykes Timothy,"Who Is Steve Eisman?" Trade Monster, November 07, 2008. Teather, David,"The woman who built financial 'weapon of mass destruction,'" The Guardian, September 20, 2008. Sykes: Maker of CDS
The Financial, “ What went wrong, “ The Economist, March 19, 2008. [ shadow banking system ] The Financial: What went wrong 2008e
Underwriters for CDO:
____, “ UPDATE 3-Financial swaps weaken on credit exposures,” Reuters, March 4, 2008. Removed from internet.
___ WaMu's credit protection costs fall 19, pct-Markit,” Reuters, Apr 7, 2008. Removed from internet
Weissman Robert and Donahue James, “Wall Street’s Best Investment: Ten Deregulatory Steps to Financial Meltdown,” Multinational Monitor, March, 2009. Weissman: 10 Steps to fix CDS 2009
Wikipedia Encyclopedia, “ Credit Default Swaps.“ Wiki: Credit Default Swaps
Wikopedia, “Federal Deposit Insurance Corporation.“ Wiki: Fed Deposit Insur Corp
Zabel, Richard (2008-09). "Credit Default Swaps: From Protection To Speculation". Robins, Kaplan, Miller & Ciresi L.L.P. Zabel: Protection to speculation 2008