I was watching the Grateful Dead on MSG last night and I began to think about the song"Ramble On Rose"that was recorded from a live show in 1972.There is one line from the song that summed up the counter culture movement for me..."the wine ain't sweeter,the grass ain't greener,either side of the hill"(Zen Buddhism). I love that line because I interpret it as a call to avoid the race for materialism and an acceptance of the great gift of life. It is life, with the wonder of our own breathing, that is important.To go beyond this thought and wish for more would be disrespectful to the life that has been given to us.Life and nature,with all its beauty,should be enough for our souls.Greed,with all its illusions,is counter to the purpose of life and hinders our spiritual development. I also remember casting aside the business section of the Times for so many years.I would go to the art section or the op-ed articles and swing around and read the wonderful play of the Knicks. I rarely stopped to read what business was doing. I guess we all should have been watching more closely. We left the door open and they stole everything,even the plumbing.
Credit de-fault swaps were started by J.P.Morgan around 1989. The Basel rules in banking required that each bank had to hold 8% of their capital in reserve against the risk of outstanding loans.These rules limited the amount of lending they could make and profit they could achieve. Morgan was the first to sell a line of credit(loan) to another bank for a fee. The bank that was sold the loan would be responsible to pay for the outstanding loan if it defaulted(Morgan's insurance).Morgan would now be in a position to lend the same,original credit to another customer and increase profit on the same amount of money. They could continue to do this endlessly if they could find the willing partners. Morgan's risk was free and the capital could be used for "sexier" activities.
Securitization was an invention to allow this process to happen.What securitization did was bundle together a package of such loans and then rely on safety in numbers and the law of averages:even if some loans did default,the others wouldn't;they would keep the stream of revenue going,and thus the risk of default would be spread and minimized.These securities would also be divided into different levels of risk and sold of accordingly,into riskier and less risky"tranches" of debt, all paying different rates of interest in return for differing levels of risk.
There was one final component of the Morgan invention.It set up an offshore shell company,called a special purpose vehicle,or SPV, to fulfill the role of the bank that served as Morgan's insurance.The shell company would assume the line of credit(loan) risk.After this SPV assumed the loan, it would sell off the risk to investors in the form of securities paying different rates of interest according to the risk. The shell companies were located in the Caymans,Bermuda,the Bahamas or the British Virgin Islands to avoid paying taxes(so un-American and un- patriotic).
AIG was the main insurance company for all these securities It was worth $200 billion at its peak.They had their tentacles around the world and certainly throughout the U.S.When the crises came in 2008,AIG was saved because so many banks were tangled with them in this security game.Our government gave AIG $190 billion so our whole economic system didn't collapse. So far have we strayed since the days we produced the products we bought. We produce securities instead of appliances today. Today,the finance industry and the manufacturing industry have switched their importance in our present economy.
The collapse came because mathematical geniuses devised formulas that took risk out of the equation so banks could run wild and free. In 2000,David X.Li,while working for Morgan applied a piece of mathematics called a Gaussian copula formula to the creation of CDO's(Collateralized Debt Obligations). This formula could measure and analyze risk in subprime mortgages through correlation for the first time.This model made banks feel safer about credit obligations especially concerning ones with great risk and great profit(subprime mortgages).Banks and financial institutions could now buy job lots of mortgages and put them together in a single pool.Eventually,they were divided up into units and sold to investors.The problem with the formula was the newness of the subprime market and it had never been through a severe period of market difficulty.From 2000 to 2006, subprime mortgages were given to anyone who could walk and talk.The banks.mortgage companies,etc. wrote non- conforming mortgages because they passed the risk along and didn't care about initial repayment.The formula failed the test and citizens defaulted in numbers not imagined by the financial community.The Grateful Dead were masters of improvising, our financial community failed because they didn't understand the basics of playing.
More to come from"I.O.U" by John Lanchester tomorrow.
No comments:
Post a Comment