Why the “Alphabet Derivatives” Have Brought So Much Destruction

Mortgage backed securities (mbs’s) and credit default swaps (cds’s) are often referred to, rather vaguely, as the “alphabet derivatives.” Most Americans have little idea what these financial instruments are. The terms (alphabet derivatives, cds’s, mbs’s, TARP and all the other acronyms thrown around) have suggested that finance has become essentially a bureaucratic exercise of mind-numbing complexity. Although the terms can be bewildering, and the sheer magnitude of money involved in these devices mind-boggling, in another way it was a rather simple con game. Understanding the way the heist went down may make it possible to minimize future damage.

The alphabet derivatives were creatures of the housing boom. When most people buy houses, they make a down-payment for part of the price and take a loan for the rest. The loan is secured by a mortgage on the house, and that simply means that if the house owner misses a payment, the lender can foreclose on the house, sell it, and pay itself from the proceeds. During the housing boom, as houses went up in nominal value, more and more people either purchased new homes or refinanced their old ones in order to take advantage of artificially low interest rates or pull some of the “equity” out of their houses to spend or invest. This created a boom in financial transactions and the need of a large, dumb source of huge amounts of money (the “pigeon,” to use con-game terminology). The alphabet derivatives were designed to stick the pigeon with the losses.

Here’s how it worked. The investment banks realized that if they could package a large number of mortgage loans together, they could create a sort of bond. Governments sell bonds-that is, they borrow money and agree to pay back principal plus interest over time. An mbs works the same way, the source of the payments being the house-owners who borrowed the money and would theoretically be paying it back over many years. Again in theory, therefore, the mbs holders could get a higher rate of interest based on prevailing mortgage rates than they could by lending money elsewhere. There was a problem, though. State and union pension managers could only buy bonds of a certain, “investment grade” quality. How then were the banks to get the bag into the pigeon’s hands? How to create an illusion of safety?

During the height of the housing boom lending standards were considerably relaxed, as banks often failed to verify information on loan applications, property appraisers rendered obscenely inflated price values, and down-payments were reduced and often eliminated entirely. The house buyers were therefore not always great credit risks. The banks were eager to make the deal anyway: they were making huge profits on the lending, and more profits on the packaging and marketing the mbs’s to their clients. So here was the essential con: a company named AIG guaranteed the debt payments on the mortgage backed securities. Since AIG had a triple-A rating, the investment raters also gave the mbs’s that same triple-A rating. That allowed the pensions to buy the bonds. Everybody who really thought about how many of these mbs’s AIG was guaranteeing knew this was a con, but they thought, or pretended to think, that the rising house prices would continue forever and negate the effects of their carelessness.

When the housing bubble popped and real estate values began to decline, that all changed.

The banks had unloaded as much of the mbs’s as they could on the fund holders, but when the bubble popped they still got trapped with hundreds of billions of dollars “worth” of them in their own hands. It then became clear that AIG could not pay off its obligations, and the sudden loss of insurance backing caused no one to be willing to buy the mbs’s any more. They became “illiquid,” meaning nobody would pay anything for them, and their “market value” was therefore drastically reduced and essentially zero. In an honest market this would have caused the rating companies to cut the rating on the bonds, crushing their official market value. Most of the big banks would have been insolvent and forced into the bankruptcy they so richly deserved, and the mbs’s would have been sold in liquidation sales. The market would have assigned a value to the mbs’s, and the trouble would be over by now, except that the most reckless and scheming bankers would be unemployed rather than taking home multi-million dollar bonuses.

Instead of letting the bankers get what they had coming, the government “bailed them out” in a variety of ways. The Federal Reserve purchased about a trillion dollars worth of mbs’s to keep some banks out of trouble, the federal government purchased large parts of many of the big banks, and the government has funneled huge amounts of money to the banks by basically giving them money at no cost and then borrowing it back at a market rate of interest. The trick here is that the government is lending the money to the banks for very short-term loans and borrowing it back for very long-term loans. It is a scam that allows the government to expand the amount of money available for long-term borrowing (thus suppressing interest rates on the national debt) and at the same time bail out their large contributors in the banking industry.

In a free market, the banks would then be crushed when interest rates rise at any time within the next ten years, as they undoubtedly will. No one thinks the government will allow the banks to fail when this happens. Why should they?

What are the costs of the government actions bailing out the banks? So far they may appear only theoretical, although I believe they are fundamental and far-reaching.

First, the government has sacrificed its own transparency and fostered corruption in the markets. It has sacrificed transparency by choosing to act in the market in ways that favored certain players while hiding its actions or misleading the public as to those actions. Consider recent disclosures that the New York Fed instructed AIG to hide the beneficiaries of the government bail-out, for example. Why has the government bailed out certain companies (AIG, Goldman Sachs, etc.) while allowing others (competitors of the bailed out companies) to fail? Who has received federal help? And why? No one will say.

The government has fostered corruption by bailing out industries that failed, shielding them from the economic consequences of their actions. This is known as “moral hazard,” and basically this refers to the fact that if an actor is protected from the negative consequences of its actions it is more likely to do them again. The banks again furnish a shining example. Notorious for excessive bonuses which depleted their capital, made them vulnerable to economic down- turn, and led to their insolvency and the “banking crisis” they have immediately used most of the government subsidies to give themselves large bonuses. Leaving themselves, again, vulnerable to economic down-turn. They are simply using the government as their source of reserve capital.

Even more important, in my view, is the fact that the banks were able to get the accounting rules changed and no longer have to “mark” their speculative positions “to the market.” That means the banks do not have to assign a current market value to the assets (mbs’s) they hold but are now free to “mark to make-believe.” Since the assets are worth far less than their make-believe value, the banks are holding large, undeclared and invisible losses. They are actually bankrupt, surviving only because the government is giving them vast quantities of life support. Most of the large banks, in other words, are “zombie” banks surviving on the life-blood of the economy.

The government has acted contrary to the clear will of the people in bailing out the large banks. This has not only been undemocratic, it has also created the potential for citizen action and backlash. It has weakened the principals of government accountability at the same time it has greatly expanded government size and role in our daily life. It has increased the federal deficit enormously, weakened the U.S. dollar, and made the promises of Medicare and Social Security unkeepable. It has taken enormous amounts of money from tax-payers and given it to the richest one percent of the population, increasing economic disparities between the rich and the rest of us. And finally it has encouraged reckless financial behavior throughout the economy and fouled up the market signals to industry, causing mis-allocation of resources and hampering our ability to compete in the global markets.

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