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Knocked Out of the Final Four

Posted by Larry Doyle on April 3, 2009 8:40 PM |


Cartoon by Chip Bok

  • fiscalliberal

    Off topic

    Larry – in your experience, who are the folks that set up the majority of securities. Is it correct to think that the entity that set up the security, got the credit default swap to enable the sale of risky securities?

    Then the question would be: who wrote the credit default swaps? We know about AIG, but were the banks writing thier own or other banks writing them. Hence the interconnectivity. For the sake of the discussion, we have to remember the CDS entities did not hold adequate or any reserves.

    I think it is the presence of the CDS that enhanced the AAA ratings. The AAA rating allowed pension funds to buy. As soon as the security lost the AAA rating thay by charter the pensions had to sell them into a fire sale, hence the losses. Defaults started the surge and once it started, the dam broke

    I think my point is that the banks were writing paper between themselves to get and protect the AAA rating. So when Lehman went to bankrupcy, that exposed the whole thing. Then AIG came on quickly.

    So – If I am correct in understanding the banks were the securitizing agencies and the other banks wrote CDS, this becomes a collusionary ponzi scheem.

    Any correction or correction of the above would be helpfull.

  • Larry Doyle

    Fiscal…Great question.

    The banks/brokers/dealers (they are all synonymous in this process) would pool assets (mortgages, consumer credit receivables, commercial mortgages), securitize them and sell them.

    As part of the securitization process, the bank would take the profile of assets with plenty of detail to the rating agency. The rating agency would indicate how much credit support (meaning what percentage of the assets) had to be given lower ratings (thus absorbing initial losses in case of defaults) in order for the remaining assets to be considered AAA.

    This process was one way of determining credit ratings. In addition to this process of credit support, a rating agency would also provide a AAA rating if a monoline insurer (MBIA, Ambac, FSA) would provide insurance on the pool of assets. This monoline insurer’s protection is known in the business as a “wrap.” It is NOT a CDS but it is a direct obligation of the monoline insurer. The protection was as good as the creditworthiness of the monoline insurer. Initially that creditworthiness was deemed evry strong and then the market realized it was not so strong.

    Those are the two methods used for securitized assets to receive their respective ratings.

    The CDS were then used by investors to hedge their purchases. The CDS were also used as collateral for deals in lieu of an actual pool of collateral. The CDS merely mimiced the cash flows of an underlying pool of assets. This point of deals backed by CDS (known as synthetic transactions) has gotten very little color but it is the source of fuel that has caused the quick and wide spreading of the fire.

    The CDS were written between the banks but it was not at the initial point of securitization it was after assets had been securitized.

    Thus the risk was not only in the underlying performance of the assets but then also the creditworthiness of the monoline insurers and providers of CDS.

    Does this make sense?

    I hope so.

  • fiscalliberal

    It makes sense, however it is worse than I thought. The insurance was povided by two entities, at different points. In the end, both insurances defaulted.

    So – this tangled web brought on by the best and brightest MBA’s is wholly not manageable by the regulators. The only way out of this is to let them fail no matter how big they are. That is the only thing that will bring on the market discipline. I think there is room for enhancement of transparency and making them adhere to addequate reserves for the risk. I also like the concept, the bigger you are, the larger the reserves.

    Grahm Leach Bliley really set us up for all of this and greed took over. There is a bill in congress which repeals Grahm Leach Bliley, I wonder if it will get traction.

    We also need to view financial innovation as a form of fraud to get the proper perspective

  • Larry Doyle

    All valid points.

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