The 1994 Orange County Bankruptcy

Remember the bankruptcy of Orange County, California? What caused Orange County's downfall, you guessed it those demonic derivatives! Who would have thunk that derivatives/swaps would tank the world financial system. Good gravy, we the people just need to grow-up and learn a thing or two from history.

Demonic Derivatives and the Greenspan Legacy

The New York Times examines the Former Fed Chairman, Alan Greenspan, in an article entitled, The Reckoning: Taking Hard New Look at a Greenspan Legacy:

...“Clearly, derivatives are a centerpiece of the crisis, and he was the leading proponent of the deregulation of derivatives,” said Frank Partnoy, a law professor at the University of San Diego and an expert on financial regulation.

The derivatives market is $531 trillion, up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them.

If Mr. Greenspan had acted differently during his tenure as Federal Reserve chairman from 1987 to 2006, many economists say, the current crisis might have been averted or muted.

Over the years, Mr. Greenspan helped enable an ambitious American experiment in letting market forces run free. Now, the nation is confronting the consequences.

Derivatives were created to soften — or in the argot of Wall Street, “hedge” — investment losses. For example, some of the contracts protect debt holders against losses on mortgage securities. (Their name comes from the fact that their value “derives” from underlying assets like stocks, bonds and commodities.) Many individuals own a common derivative: the insurance contract on their homes.

On a grander scale, such contracts allow financial services firms and corporations to take more complex risks that they might otherwise avoid — for example, issuing more mortgages or corporate debt. And the contracts can be traded, further limiting risk but also increasing the number of parties exposed if problems occur.

Throughout the 1990s, some argued that derivatives had become so vast, intertwined and inscrutable that they required federal oversight to protect the financial system. In meetings with federal officials, celebrated appearances on Capitol Hill and heavily attended speeches, Mr. Greenspan banked on the good will of Wall Street to self-regulate as he fended off restrictions.

Read the entire article here.

Wall Street Got Drunk on Swampy Swaps

Steve Kroft from 60 Minutes covered the Wall Street meltdown story: "A Look At Wall Street's Shadow Market." I've been crying like a voice in the wilderness that the whole Wall Street mess was from the demonic derivative market and their skanky cousin the swampy swaps. The Republicans are trying to smear the poor and minorities with the whole financial market meltdown, but if anyone just scratches below the surface, they'd see that the derivatives and the swaps are the reason for this market freefall.

From the transcript of the 60 Minutes show:

Before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they are much simpler than they sound. "A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails," he explains.

"It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," Greenberger adds.

"So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy?" Kroft asks.

"A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument," Greenberger says.

But he says there was a big problem. "The problem was that if it were insurance, or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap, and not insurance, there was no requirement that adequate capital reserves be put to the side."

"Now, who was selling these credit default swaps?" Kroft asks.

"Bear Sterns was selling them, Lehman Brothers was selling them, AIG was selling them. You know, the names we hear that are in trouble, Citigroup was selling them," Greenberger says.

"These investment banks were not only selling the securities that turned out to be terrible investments, they were selling insurance on them?" Kroft asks.

"Well, it made it easier to sell the terrible investments if you could convince the buyer that not only were they gonna get the investment, but insurance," Greenberger explains.

But when homeowners began defaulting on their mortgages, and Wall Street's high-risk mortgage backed securities also began to fail, the big investment houses and insurance companies who sold the credit default swaps hadn't set aside the money they needed to pay off their obligations.

Bear Stearns was the first to go under, selling itself to J.P. Morgan for pennies on the dollar. Then, Lehman Brothers declared bankruptcy. And when AIG, the nation's largest insurer, couldn't cover its bad debts, the government stepped in with an $85 billion rescue.

Asked what role the credit default swaps play in this financial disaster, Frank Partnoy tells Kroft, "They were the centerpiece, really. That's why the banks lost all the money. They lost all the money based on those side bets, based on the mortgages."

How big is the market for credit default swaps?

Says Partnoy, "Well, we really don't know. There's this voluntary survey that claims that the market is in the range of 50 to 60 or so trillion dollars. It's sort of alarming that, in a market that big, we don't even know how big it is to within, say, $10 trillion."

"Sixty trillion dollars. I know it seems incredible. It's four times the size of the U.S. debt. But that's the size of the market according to these voluntary reports," says Partnoy.

He says this market is almost entirely unregulated.

The result is a huge shadow market that may control our financial destiny, and yet the details of these private insurance contracts are hidden from the public, from stockholders and federal regulators. No one knows what they cover, who owns them, and whether or not they have the money to pay them off.

One of the few sources of information is the International Swaps and Derivatives Association (ISDA), a trade organization made up the largest financial institutions in the world. Many of them are the very same companies that created the vast shadow market, lobbied to keep it unregulated, and are now drowning because of unanticipated risks.

Read the entire transcript here. Or, better yet, watch the Kroft 60 Minutes segment.

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$700,000,000,000 Bailout!!!

"Buffett's "time bomb" goes off on Wall Street" by James B. Kelleher from Reuters:

On Main Street, insurance protects people from the effects of catastrophes.

But on Wall Street, specialized insurance known as a credit default swaps are turning a bad situation into a catastrophe.

When historians write about the current crisis, much of the blame will go to the slump in the housing and mortgage markets, which triggered the losses, layoffs and liquidations sweeping the financial industry.

But credit default swaps -- complex derivatives originally designed to protect banks from deadbeat borrowers -- are adding to the turmoil.

"This was supposedly a way to hedge risk," says Ellen Brown, the author of the book "Web of Debt."
"I'm sure their predictive models were right as far as the risk of the things they were insuring against. But what they didn't factor in was the risk that the sellers of this protection wouldn't pay ... That's what we're seeing now."
Brown is hardly alone in her criticism of the derivatives. Five years ago, billionaire investor Warren Buffett called them a "time bomb" and "financial weapons of mass destruction" and directed the insurance arm of his Berkshire Hathaway Inc (BRKa.N: Quote, Profile, Research, Stock Buzz) to exit the business.

LINKED TO MORTGAGES

Recent events suggest Buffett was right. The collapse of Bear Stearns. The fire sale of Merrill Lynch & Co Inc (MER.N: Quote, Profile, Research, Stock Buzz). The meltdown at American International Group Inc (AIG.N: Quote, Profile, Research, Stock Buzz). In each case, credit default swaps played a role in the fall of these financial giants.

The latest victim is insurer AIG, which received an emergency $85 billion loan from the U.S. Federal Reserve late on Tuesday to stave off a bankruptcy.

Over the last three quarters, AIG suffered $18 billion of losses tied to guarantees it wrote on mortgage-linked derivatives.

Read the entire story "Buffett's "time bomb" goes off on Wall Street" byJames B. Kelleher from Reuters.

Wall Street's Demonic Derivatives

As the markets begin to unravel, the usual suspects will start pointing their tainted fingers at the sub-prime markets; but, sub-prime is only the Genesis of the story. The real devil lies in the fancy financial instruments that the dirty dealers on Wall Street traded called derivatives. The Oracle of Omaha himself, Warren Buffett called derivatives a "time bomb, both for the parties that deal in them and the economic system." Back in 2003, Mr. Buffett infamously dubbed the demonic derivatives as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

Oh my, here we are sobering-up from a drunken Wall Street binge. Even President George W. Bush said: "There is no question about it. Wall Street got drunk." Then Bush continued by address those nasty derivatives, when he declared: "The question is, How long will it (take to) sober up and not try to do all these fancy financial instruments?"

Junichi Abe Yomiuri Shimbun writes in his article entitled, "Lehman fall exposes fallacy Subprime debacle showed financial alchemy was impossible": Essentially, a subprime loan is just another home mortgage. In addition, it is practically "subprime," not "prime," meaning that the solvency of borrowers in this category is low. Normally, those in charge of loans at financial institutions will not extend loans to such borrowers before closely examining their financial situation, ability to repay loans and their income and assets.

With the magic of financial engineering, a combination of finance and information technology, subprime loans were turned into derivative products, which investors were willing to buy. It was claimed that the product's risk was divided up by splitting the right to claim repayment of subprime loans and securitization, under which subprime loans were combined with other credit.

If this had been true, it would truly have been alchemy, whose goal in days of old was to change ordinary metal into gold.

Yomiuri Shimbun continues by adding: Against the backdrop of the problem is the nature of derivatives products, which are designed utilizing highly complicated mathematical and statistical theories. Therefore, it is difficult even for financial experts to understand their essential nature.

Unable to set appropriate standards to rate derivatives, credit-rating agencies ended up giving lenient evaluations to such products.

Philip Klein from the American Spectator writes in "Warren Buffett Told You So": Buffett seized on the news to deliver a lecture on the danger of such investments, noting the fact that Freddie was a company overseen by a board of directors, the U.S. Congress, and a separate regulatory body, and yet nobody was able to get a handle on them. And he informed the crowd that even the CEOs whom he knew didn't understand the investments.

"I know the people that run these companies and they don't have their minds around what is happening," he said.

And then Buffett predicted: "Some time in the next 10 years, you will have a huge problem that will either be caused by or accentuated by people's activities in derivatives."

The goofy media whores will try to pin this Wall Street fiasco on sub-prime, but that was just the host of the greedy parasites that are thus named derivatives. It's easy to point the finger at some poor guy that can't pay his mortgage or is in hock up to his ears that used his home equity and collateral to stay afloat or do something mindless and silly like Bush suggested after 9-11......go shopping! Get millions of these guys that actually are the real faces behind the unemployment figures to default on their sub-prime loans after the greedy guts on Wall Street repackaged and bundled them off to unsuspecting investors and folks you're looking at the proverbial chickens coming home to roost.

But, the little guy that is now jobless and homeless will get the middle finger from the feds, while the fat cats will find US minted, taxpayer funded golden parachutes. In short, the Republicans suck wind in a big way.

Watch this youtube clip from CNBC’s Senior Economics Reporter, Steve Liesman, who knows and explains the demonic derivative market quite well.