They encouraged and exploited the unprincipled expansion of the sub-prime mortgage market by buying and packaging portfolios of these mortgages and selling high-risk securities backed by them. You know that. And I discussed their evolution in my e-mail/blog post of 9/29/08. But then to shore up the marketability of these high-risk, sub-prime mortgage-backed securities, they also bought and sold a form of complicated hedging/"insurance" contract to cover them called "credit default swaps (CDSs)." They were like insurance, but with no reserves to back them up. "60 Minutes" called it the "Shadow Market," and it's nominal value may be as high as $60 trillion--give or take $10 trillion or so. Yes, trillion, but they are very difficult to value reliably. And whatever their value, it is disappearing fast as they too are being defaulted on.
In my earlier e-mail/blog article, which was primarily about supporting the rescue plan, I focused only on the principal offenders (the investment bankers) and their central weapon of choice (the sub-prime mortgage-backed security), trying to keep to basic themes in what was alread a long article. But it was pointed up to me that I should have addressed the complicit role of government, and it also became clear from my reading that the credit default swaps were playing a bigger role than I realized. So I edited my 9/29 post to add some coverage of the sad supporting role of the federal government, but primarily to add this paragraph about CDSs:
And the hedging/insuring vehicle of choice for the mortgage-backed investments was often the so-called "credit default swap" (CDS), a non-regulated, highly complex "insurance" instrument that could be structured, valued and understood, if at all, only using space-age mathematical models. Then speculative players started buying them, too. The investment banks, commercial banks and insurance companies that created and owned them (without any regulatory requirement for adequate loss reserves) eventually had no meaningful way of dealing with or representing what the value at risk in these huge portfolios might be. Warren Buffet referred to them as "financial instruments of mass destruction."
So, as the housing market fell and mortgages defaulted, the sub-prime mortgage-backed securities market also defaulted and failed, in turn so did the credit default swaps in the face of the huge obligations with no reserves to cover them. The failure of these instruments played a major role in the failure or weakness of many of these institutions, including Bear-Stearns, Lehman Bros., and particularly in the demise of AIG. (Hyde Park's Corner, http://www.hydeparkgh.blogspot.com/2008/09/bail-out-bastards-we-have-to.html )
But from the piece by "60 Minutes," I can only conclude that I still failed to appreciate how frightening a role the CDSs are playing. Steve Croft interviews several with insider knowledge, including James Grant, who for many years has been one of the most respected and knowlegeable commentators on credit markets (Grants Interest Rate Observer). He unflinchingly, matter-of-factly characterized our situation: "This is a full-blown financial storm and one that comes around perhaps once every 50 or 100 years. This is the real thing."
You can see the entire "60 Minutes" piece as reported by clicking on the link below, then clicking on the video picture that says "Wall Street."
http://www.cbsnews.com/stories/2008/10/05/60minutes/main4502454.shtml
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