Derivatives - or what could possibly go wrong?

By: FLwolverine , 7:39 PM GMT on February 06, 2014

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Over on Birthmark's blog, our friend tramp said no one had ever explained "derivatives" to him in a satisfactory manner. Since this is something I do know about - as opposed to weather, where I am a mere beginner - I thought I would give a try.

Derivatives are a type of security instrument - like the promissory note you sign when you buy a car or a house or a washing machine and promise to pay for them in installments. In those cases, your promise to pay is secured (backed up) by the item you have purchased - by the security interest created in the car or the washing machine, or the mortgage given on the house. If you don't pay as you promised, the seller or lender can repossess the item.

Derivatives follow this same principle, but with a lot more bells and whistles attached.

A short course in derivatives.

Before derivative became a dirty word, there was the secondary mortgage market. A bank (or other lender, but we'll keep this simple) would loan you, tramp/homebuyer, money to buy a house. In return the bank received your promise to pay back the loan with interest (promissory note) and a security interest in the house (mortgage, or in some states a deed of trust, but we'll go with mortgage here for simplicity's sake). Yes there are a lot of other papers signed at a mortgage closing, but these are the key.

The bank doesn't want all its funds tied up in mortgage loans, so it packages your loan with a bunch of others (Package 1) and sells it to FNMA (Fannie Mae), that is, it endorses the note and assigns the mortgage. In return it receives the amount of the mortgages, some "profit" based on interest rates, and various other chips and clips. As a bonus the bank gets to be the services on your mortgage - receiving payments, handling tax escrow, etc - and is paid a fee for that by FNMA. Theoretically, the bank now takes the amount it receives from the sale and turns around and lends it to other homebuyers.

So far so good. Worked fine for many years.

But Fannie Mae also needs to raise money so it can buy more packages, so it takes Package 1 (with your mortgage in it), bundles it with other packages (to create Big Package 2) and sells the whole lot to a group of investors, or a big pension fund, or a BIG BANK. Fannie Mae endorses the notes and assigns the mortgages, receives payment in the amount of the mortgages plus some profit based on the interest rate, and turns around to buy more mortgages from the banks making the original loans. Your bank continues (usually) to service your loan, so you have no idea any of this is happening.

Problem is: investor groups and pension funds don't really want to hold notes and mortgages. So someone comes up with the idea of creating a new form of security - basically a promissory note backed by the Package 2 and other big packages. This is the derivative, because it is a single promise to pay backed up a bunch of other security interests.

Let's say BIG BANK has bought Package 2. It bundles that with other big packages, and creates a promissory note for $x. X in this case being the amount of income BIG BANK expects to receive from the mortgages in all the packages, less some income stream that BIG BANK intends to keep for itself. An investor or investment group or pension fund or another big bank then buys this new note from BIG BANK, who also gives the buyer some kind of security interest in the packages of mortgages. Notice that BIG BANK does not endorse your promissory note or assign your mortgage to the buyer. No, BIG BANK keeps those, and receives your mortgage payments, which it uses to pay back the promissory note to the buyer.

What's in this for BIG BANK? It doesn't have to wait for you to make your mortgage payment in order to recover its money. If it paid $100,00 for your mortgage, it has received $100,00 from the buyer, and it can go on to use that money for new investments. It will pay the buyer back when you (and a thousand other borrowers) make your mortgage payments. (Yes, I know, there's a lot of discounting and future calculating going on so tramp's $100,000 mortgage isn't really sold for $100,000 - but let's keep this simple and just look at structure for now)

What's in this for the Buyer? It's an investment; Buyer will (theoretically) receive back its entire initial investment with interest. (BIG BANK gets the money to make the interest payments from the interest payments tramp and others make - in the simplest scenario.)

There's nothing inherently wrong with this scheme so far. But here's where things start to get interesting.

A short course in derivatives - round II

So here's Buyer - let's say, an investment group like, oh, say, Bain Capitol - now holding a promissory note from BIG BANK $100,000,000, secured by all those mortgages. But Buyer doesn't own the mortgages (Buyer never wants to own the mortgages); it just wants BIG BANK to use the income stream from the mortgages to pay off the promissory note.

Buyer can then use the repayment to repay its investors or to make new investments.

If Buyer acquires several of these promissory notes, it may not want to wait for repayment. Maybe Buyer wants to make more investments right away. So Buyer bundles (again) the promissory notes from BIG BANK and others - let's say totaling $500,000,000 - writes up one big security instrument (actually a kind of promissory note on steroids) and sells 50 shares in it at $10,000,000 each. Who buys the shares? Other investors, pension funds, banks. In our example, let's use a municipal pension fund, although there were plenty of cases where the buyer here was another investor who went on to create yet another layer of derivatives.

Did I mention that when this was going on, there were a lot of wealthy people in the Middle East and Far East who saw the US as the safest place for their money? And everybody knew that the American homeowner had an excellent record of paying for their home and not going into foreclosure. Next to US Treasuries, what better investment could there be.

This last point is important, because this is where insurance comes in. When Buyer goes to buy the promissory note from BIG BANK, Buyer may say "look, I never want to end up owning a bunch of mortgages, and I don't want your guaranty, because even BIG BANKS can fail. So instead of giving me a security interest in the mortgages, buy me some insurance". Buyer and BIG BANK go to insurance company (let's call them AIG), which rubs its hands together greedily and says, oh, yes, I'll insure this for a properly large fee - all the while thinking, I'll never have to pay up on this; whoever heard of American homeowners defaulting on their mortgages en masse?

Same thing when Buyer wants to sell shares in its $500,000,000 steroidal security. In return for a sizable premium, AIG insures those transactions too.

Now things really start to get kinky. Gambler is standing by watching all these transactions thinking: there's really a chance for this to go bad, but nobody seems to see it. So Gambler goes to AIG and says "I want you to give me the same insurance you just gave Buyer, that is, I want you to insure me that BIG BANK will not default on the promissory note it owes Buyer. No, I don't have an insurable interest - I'm not part of the transaction - but I'll pay you a good premium. If BIG BANK pays up, you keep the premium. If BIG BANK defaults, you pay me the insured amount."

AIG thinks "American homeowners are not going to default" so it sells the insurance to Gambler.

And did I mention that AIG (and others) has managed to convince the US Congress that these transactions are not really insurance policies, so AIG does not have to set up any cash reserves to back them up?

A short course in derivatives - Round III

So what could go wrong?

Let's start with those original mortgages. Fannie Mae guidelines require certain backup with each loan before they will buy it: acceptable title work, survey, credit checks, and appraisals. For a long time, this system works fine. But as more investors, banks, and mortgage companies see the profits to be made by selling the derivative securities, and as more people (in other countries especially ) keep looking for relatively safe places to invest their money, the system breaks down.

Appraisals and credit checks in particular get very dicey, to the point of being fraudulent in many cases. But no one is looking at that. The realtors and mortgage brokers and lenders and appraisers and credit bureaus are looking at the money to be made. So lots of loans are made that shouldn't be made - to people who don't have the income to repay, on terms that are too onerous to be repaid, on houses that will never be worth the amount of the mortgage.

And then when the tramp is laid off because the company he works for moves oversees, or when the mortgage interest rate kicks up to 12% after five years but tramp's income is still the same, or when tramp incurs $500,000 in medical bills for a condition his health insurance won't cover:

- tramp and thousands like him get behind on their mortgages and a lot of properties go into foreclosure;
- original lender bank can't collect any money to send to BIG BANK (which still owns the notes and mortgages);
- BIG BANK doesn't receive any money to repay the promissory note to Buyer;
- Buyer doesn't receive any money to pay to pension fund on the steroidal security;
- Buyer and Gambler go to AIG to collect on their "this is not insurance" policies - to which AIG says: I can't pay out that much money - and declares bankruptcy.
- pension fund says to its members: sorry, but we just lost $10,000,000 of your money.

OK - this is really simplified. There are as many complications and variations as there are people involved. But I hope this helps someone (maybe tramp?) understand derivatives better.

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59. FLwolverine
12:25 PM GMT on March 11, 2014
Would you feel the same if one of the lawyers suing the EPA over regulating emissions participated in a protest opposing those regulations? What about a lawyer bringing suit against gun control legislation participating in an anti-gun control rally? Or a lawyer whose defending the murderer of an "abortion doctor" participating in an anti-abortion demonstration, or at a protest supporting his client?

How much of your feeling has to do with the nature of the crime - killing a policeman? As I said, Adegbile may not be the best choice for this nomination, but he hasn't done anything illegal, immoral, or unethical, and has not IMO "gone too far". His opponents in Congress mostly just don't like what he did.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
58. tramp96
3:40 AM GMT on March 11, 2014
Quoting 56. FLwolverine:
Why do you say Adegbile went too far? He may not be the right person to head the civil rights division of DOJ, but as a lawyer for the NAACP Legal Defense Fund it seems to me he was doing his job to make sure that even a convicted cop-killer got justice. That's an important part of our system of justice. As nauseating as it nay be sometimes, the legal profession can't just back away from someone accused of a heinous crime and say, oh, no, you're a bad guy, we can't defend you!

The guy was showing up at protests and participating.
Member Since: August 15, 2009 Posts: 0 Comments: 1530
56. FLwolverine
2:53 AM GMT on March 07, 2014
Why do you say Adegbile went too far? He may not be the right person to head the civil rights division of DOJ, but as a lawyer for the NAACP Legal Defense Fund it seems to me he was doing his job to make sure that even a convicted cop-killer got justice. That's an important part of our system of justice. As nauseating as it nay be sometimes, the legal profession can't just back away from someone accused of a heinous crime and say, oh, no, you're a bad guy, we can't defend you!
Member Since: January 6, 2013 Posts: 3 Comments: 2320
55. tramp96
5:30 AM GMT on March 06, 2014
Quoting 54. FLwolverine:
Objection overruled. I remember inviting you to discuss eminent domain because it was off topic on Rood's blog. Your comment on Johnson was not about eminent domain. I'm not interested in open ended political discussions.

Ok how bout talking about lawyers that go to far

Link
Member Since: August 15, 2009 Posts: 0 Comments: 1530
54. FLwolverine
5:29 AM GMT on February 23, 2014
Quoting 53. tramp96:

I object
When we were on Rood's blog you invited me to come here and continue the conversation since you had determined that it was political therefor you set aprecedent.
John since I'm awaiting a ruling I'll see you on Birthmark's blog
Objection overruled. I remember inviting you to discuss eminent domain because it was off topic on Rood's blog. Your comment on Johnson was not about eminent domain. I'm not interested in open ended political discussions.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
53. tramp96
3:25 AM GMT on February 23, 2014

Quoting 49. FLwolverine:
I'm glad you were listening to NPR, but the politics blog is over at Birthmark's.
I object 
When we were on Rood's blog you invited me to come here and continue the conversation since you had determined that it was political therefor you set a precedent.
John since I'm awaiting a ruling I'll see you on Birthmark's blog
Member Since: August 15, 2009 Posts: 0 Comments: 1530
52. Patrap
11:36 PM GMT on February 22, 2014
Member Since: July 3, 2005 Posts: 421 Comments: 127592
51. Grothar
10:31 PM GMT on February 22, 2014
Very interesting read and comments. But I want to know what the word is derived from. :)
Member Since: July 17, 2009 Posts: 69 Comments: 25371
50. JohnLonergan
2:18 PM GMT on February 22, 2014
Quoting 49. FLwolverine:
I'm glad you were listening to NPR, but the politics blog is over at Birthmark's.




I don't know what he heard on NPR, the facts disagree, the Act passed on a strictly NORTH/SOUTH divide:

From Wikapedia

By party and region[edit]
Note: "Southern", as used in this section, refers to members of Congress from the eleven states that made up the Confederate States of America in the American Civil War. "Northern" refers to members from the other 39 states, regardless of the geographic location of those states.

The original House version:
Southern Democrats: 7–87 (7–93%)
Southern Republicans: 0–10 (0–100%)
Northern Democrats: 145–9 (94–6%)
Northern Republicans: 138–24 (85–15%)

The Senate version:
Southern Democrats: 1–20 (5–95%) (only Ralph Yarborough of Texas voted in favor)
Southern Republicans: 0–1 (0–100%) (John Tower of Texas)
Northern Democrats: 45–1 (98–2%) (only Robert Byrd of West Virginia voted against)
Northern Republicans: 27–5 (84–16%)


I checked the politics blog and nothing had been posted in days, so I responded here to correct o falsehood, the tax cut mentioned garnered no southern votes.
Member Since: June 27, 2012 Posts: 0 Comments: 3173
49. FLwolverine
9:01 PM GMT on February 21, 2014
Quoting 48. tramp96:
So i was listening to NPR the other day and they we talking
about LBJ and his agenda after Kennedy's assassination
He had two major bills he wanted passed.
1) Civil rights but he was having a problem getting
the southern dems to go along with it
2) A tax cut so they could get the economy going
Very enlightening
I'm glad you were listening to NPR, but the politics blog is over at Birthmark's.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
48. tramp96
12:56 PM GMT on February 21, 2014
So i was listening to NPR the other day and they we talking
about LBJ and his agenda after Kennedy's assassination
He had two major bills he wanted passed.
1) Civil rights but he was having a problem getting
the southern dems to go along with it
2) A tax cut so they could get the economy going
Very enlightening
Member Since: August 15, 2009 Posts: 0 Comments: 1530
47. FLwolverine
8:05 PM GMT on February 16, 2014
Quoting 42. tramp96:

I'm saying cut big bank out sounds like they are a middle man.
One other thing why is the option even available for
gambler and when he does show up at your doorstep why
aren't one million red flags raised. What the heck is all that mess about.
Who's going to cut out BIG BANK? It's got as much right as anyone to invest its money. I'm just telling you one way this financing could work - there are lots of variations. If it isn't a big bank playing that particular role, it will be someone else. The only way you could keep BIG BANK out is to make it illegal for BB to buy and sell that type of security.

Gambler can buy that "insurance" from AIG because there's nothing to prevent him. Yeah, AIG should have been suspicious, but what we really have is some high flying agent for AIG who sees a chance for a big premium and (for him) a big commission, talking to some internal AIG guy who sees a chance to make his numbers look good by hauling in this big premium. What do either of them care if the risk to AIG is too great?
Member Since: January 6, 2013 Posts: 3 Comments: 2320
46. Daisyworld
8:00 PM GMT on February 16, 2014
Quoting 38. Skyepony:
Well wrote..

Another thing that happened that caused many foreclosures was.. lets say Chase ended holding your mortgage... They would "mis-code" people's mortgage checks. Tramp may have sent in $1000 payment but Chase would say it was only $900. They had like a year to straighten it out on their end but could start foreclose on you in 6 months if you didn't pay all the snow balling late fees or better yet refinance & let the new lender's lawyer deal with it.


I would add onto this that the banks played it both ways, even to the new buyers. I purchased a distressed property during the mortgage crisis, and it was a short-sale. Even after the seller and I had settled on a price, when we were about to close the deal, because they technically owned the property, the bank stepped in and cranked up the selling price about $3000. It was perfectly legal, too. Even though the seller and I had settled, the bank knew that (1) the seller would still be desperate to offload the property if I declined, and (2) knew that the buyer was already prone to accepting the property as-is, and would most likely accept the boost in price.

Those banks are sick devils, in my opinion....
Member Since: January 11, 2012 Posts: 6 Comments: 851
45. FLwolverine
7:51 PM GMT on February 16, 2014
Quoting 41. tramp96:

Are you saying the check you wrote to Chase wasn't cashed because if it was you would have all the proof you need.
No, she's saying that once Chase had posted the payment incorrectly, it took a long time and a lot of effort to get the mistake corrected, and in the meanwhile Chase kept showing the account as delinquent.

There were reports of a lot of this kind of stuff going on, and I know from my professional work that it was impossible to find anyone to talk to. And if you did find someone they had no power to negotiate or to make arrangements or modifications so people could try to keep their homes. Many homeowners got royally screwed over.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
44. FLwolverine
7:44 PM GMT on February 16, 2014
Quoting 40. tramp96:

Read this and a comment by Angelica.
Link
I would agree more with a lot of the other commenters, especially the one who said things would have gone better if Paulson had been ready with an expedited liquidation of Lehman.


What are people saying six years later?
Member Since: January 6, 2013 Posts: 3 Comments: 2320
43. FLwolverine
7:42 PM GMT on February 16, 2014
Quoting 39. tramp96:

I'm not trying to attack dem's but at one point I heard that people like Barney Frank were telling the banks to relax the regs and lend to people who didn't qualify.
Common sense dictates that some regulation must exist
and the laws in place must be enforced because if they are not then we know what happens.
I know I really don't need to explain this to you but it seems like I constantly have to explain my position
Frank and other Dems were encouraging banks to loosen lending restrictions a little so first time homebuyers, especially in developing neighborhoods, could get financing a little easier. At the time (2008 or so) it was a common Republican meme to blame the problems on "all these bad loans" the banks had been forced to make, but there's also a report by Bernanke to Congress that this policy was not a actor on the crisis.

On the other hand, both Reps and Dems let AIG go unregulated (not required to create reserves for the "insuring " these transactions because that weren't insurance).
Member Since: January 6, 2013 Posts: 3 Comments: 2320
42. tramp96
4:56 PM GMT on February 16, 2014
Quoting 36. FLwolverine:
I understand your words but I'm not sure what you mean. Are you saying stop the process with Fannie Mae (the secondary market) and don't them sell the mortgages to BIG BANK? Fannie Mae would still need to issue bonds to raise money to buy mortgages from entities like Bank, but it would be ok with me to stop the process there. But I don't think that's gonna happen in this political environment.

I'm saying cut big bank out sounds like they are a middle man.
One other thing why is the option even available for
gambler and when he does show up at your doorstep why
aren't one million red flags raised. What the heck is all that mess about.
Member Since: August 15, 2009 Posts: 0 Comments: 1530
41. tramp96
4:47 PM GMT on February 16, 2014
Quoting 38. Skyepony:
Well wrote..

Another thing that happened that caused many foreclosures was.. lets say Chase ended holding your mortgage... They would "mis-code" people's mortgage checks. Tramp may have sent in $1000 payment but Chase would say it was only $900. They had like a year to straighten it out on their end but could start foreclose on you in 6 months if you didn't pay all the snow balling late fees or better yet refinance & let the new lender's lawyer deal with it.

Are you saying the check you wrote to Chase wasn't cashed because if it was you would have all the proof you need.
Member Since: August 15, 2009 Posts: 0 Comments: 1530
40. tramp96
4:44 PM GMT on February 16, 2014
Quoting 37. FLwolverine:
Complicated situation. Not sure I have an answer. But are you advocating for government intervention in business? If they made bad choices, shouldn't we just let them fail? Free market and all that?

Read this and a comment by Angelica.
Link
Member Since: August 15, 2009 Posts: 0 Comments: 1530
39. tramp96
4:29 PM GMT on February 16, 2014
Quoting 35. FLwolverine:
I thought you didn't like regulations on business? Now you're saying the mortgage business should have been more regulated for its own good?

The necessary regs were in place, but there wasn't much will to enforce them because there was too much money too be made. And did you miss the part about the false appraisals, etc?

I'm not trying to attack dem's but at one point I heard that people like Barney Frank were telling the banks to relax the regs and lend to people who didn't qualify.
Common sense dictates that some regulation must exist
and the laws in place must be enforced because if they are not then we know what happens.
I know I really don't need to explain this to you but it seems like I constantly have to explain my position
Member Since: August 15, 2009 Posts: 0 Comments: 1530
38. Skyepony (Mod)
2:41 PM GMT on February 16, 2014
Well wrote..

Another thing that happened that caused many foreclosures was.. lets say Chase ended holding your mortgage... They would "mis-code" people's mortgage checks. Tramp may have sent in $1000 payment but Chase would say it was only $900. They had like a year to straighten it out on their end but could start foreclose on you in 6 months if you didn't pay all the snow balling late fees or better yet refinance & let the new lender's lawyer deal with it.
Member Since: August 10, 2005 Posts: 161 Comments: 37377
37. FLwolverine
2:00 PM GMT on February 16, 2014
Quoting 33. tramp96:

If they would have propped Lehman up would the whole thing been avoided? The way I understand it is they were the first domino and I'm guessing now it was cause of derivative problems
Complicated situation. Not sure I have an answer. But are you advocating for government intervention in business? If they made bad choices, shouldn't we just let them fail? Free market and all that?
Member Since: January 6, 2013 Posts: 3 Comments: 2320
36. FLwolverine
1:58 PM GMT on February 16, 2014
Quoting 34. tramp96:
The more you slice a pie and giveaway the pieces
the less you have for yourself at the very least
keep Big Bank out of it.
I understand your words but I'm not sure what you mean. Are you saying stop the process with Fannie Mae (the secondary market) and don't them sell the mortgages to BIG BANK? Fannie Mae would still need to issue bonds to raise money to buy mortgages from entities like Bank, but it would be ok with me to stop the process there. But I don't think that's gonna happen in this political environment.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
35. FLwolverine
1:48 PM GMT on February 16, 2014
Quoting 32. tramp96:

The rules got to lax and they gave mortgages to people who couldn't afford them. How the rules got so lax is the question.
I thought you didn't like regulations on business? Now you're saying the mortgage business should have been more regulated for its own good?

The necessary regs were in place, but there wasn't much will to enforce them because there was too much money too be made. And did you miss the part about the false appraisals, etc?
Member Since: January 6, 2013 Posts: 3 Comments: 2320
34. tramp96
4:43 AM GMT on February 16, 2014
The more you slice a pie and giveaway the pieces
the less you have for yourself at the very least
keep Big Bank out of it.
Member Since: August 15, 2009 Posts: 0 Comments: 1530
33. tramp96
4:39 AM GMT on February 16, 2014
Quoting 31. FLwolverine:
Mortgage insurance isn't that widespread. If a borrower had insurance, that would have been paid to whoever owned the note and mortgage (BIG BANK in our example), who could use it to make its payment to Buyer, but probably, being a bank and in the midst of a lot of confusion, didn't.

But the insurance payments probably came too late to prevent the crash. The crash didn't start - as I understand it - because borrowers were defaulting on their mortgages all over the place; it started because someone in the financing chain got nervous that borrowers would default. That became a self fulfilling prophecy.

If they would have propped Lehman up would the whole thing been avoided? The way I understand it is they were the first domino and I'm guessing now it was cause of derivative problems
Member Since: August 15, 2009 Posts: 0 Comments: 1530
32. tramp96
4:35 AM GMT on February 16, 2014
Quoting 30. FLwolverine:
No, this caused the mortgage crisis. In order to have more and more mortgages to serve as the basis for the financing structure - because there was more and more investment money out there trying to get in on the proceeds of the derivative instruments - the mortgage companies went looking for new borrowers. This is where the subprime loan comes in. "Subprime" doesn't refer to the interest rate, it refers to the borrower. A borrower was subprime if his credit rating was below a certain number, if the loan to value ratio wasn't sufficient, if his income didn't meet certain standards. To get around this (so they could make these risky loans), lenders ad mortgage brokers would get fake credit reports, false appraisals, untrue financial statements - whatever it took to slip the loans through so they would have another one to sell. And they would charge the borrower some kind of variable interest rate, that started out affordable but increased automatically after 5 years or so.

So when the economy in the US got a little shaky - borrowers were getting laid off, or those higher interest rates came due and borrowers couldn't pay them, or borrowers who thought they would sell before the higher interest rates kicked in couldn't find a buyer - some of those banks and institutions further down the line got nervous. In our example, say that BIG BANK gets nervous and says to Buyer, we can't make the next payment that we owe you. So Buyer now has to say to his buyer (maybe a pension fund), gee, I'm not getting paid by BIG BANK, so I can't make my next payment to you.

This is when BIG BANK, Buyer, pension fund, and Gambler go to AIG to collect on their insurance/bet. AIG can't pay because it didn't create any reserves. The stock market notices all of this and gets nervous so the Dow Jones falls. BIG BANK cuts back on its commercial lending because it's got to accumulate some funds (for lawyers, if nothing else). Buyer and pension fund start selling stock (in a down market) to meet their other obligations. Maybe pension fund cuts back on its payments, and maybe some retirees miss their mortgage payments because of that.

(And don't forget that when the lending stops, so does the home building. Jobs lost there. Many small businesses run on lines of credit. If the banks stop lending, or refuse to honor those lines of credit, the business is in trouble. Jobs lost there too. Lost jos mean people can't pay their mortgages.)

Suppose instead of a pension fund, the purchaser from Buyer is a city or a county. When they can't collect on their investment, they start cutting back services and laying off people, who then may default on their mortgage.

So I suppose you could, if you wanted, place all the blame on the Amercan home buyers, who wanted to buy a house or maybe a bigger house or maybe just get in on the housing boom. You could say that they made bad choices. And probably some of them did. Some of them weren't smart enough or experienced enough to understand they were being scammed. Some of them surely didn't expect to be laid off or downsized or have their employer close. But, as you have said, life isn't fair.

The rules got to lax and they gave mortgages to people who couldn't afford them. How the rules got so lax is the question.
Member Since: August 15, 2009 Posts: 0 Comments: 1530
31. FLwolverine
4:18 AM GMT on February 16, 2014
Mortgage insurance isn't that widespread. If a borrower had insurance, that would have been paid to whoever owned the note and mortgage (BIG BANK in our example), who could use it to make its payment to Buyer, but probably, being a bank and in the midst of a lot of confusion, didn't.

But the insurance payments probably came too late to prevent the crash. The crash didn't start - as I understand it - because borrowers were defaulting on their mortgages all over the place; it started because someone in the financing chain got nervous that borrowers would default. That became a self fulfilling prophecy.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
30. FLwolverine
4:11 AM GMT on February 16, 2014
Quoting 29. tramp96:
So in effect the mortgage crisis did cause all of this
Where does mortgage ins. that the homeowner
pays factor in on this.
No, this caused the mortgage crisis. In order to have more and more mortgages to serve as the basis for the financing structure - because there was more and more investment money out there trying to get in on the proceeds of the derivative instruments - the mortgage companies went looking for new borrowers. This is where the subprime loan comes in. "Subprime" doesn't refer to the interest rate, it refers to the borrower. A borrower was subprime if his credit rating was below a certain number, if the loan to value ratio wasn't sufficient, if his income didn't meet certain standards. To get around this (so they could make these risky loans), lenders ad mortgage brokers would get fake credit reports, false appraisals, untrue financial statements - whatever it took to slip the loans through so they would have another one to sell. And they would charge the borrower some kind of variable interest rate, that started out affordable but increased automatically after 5 years or so.

So when the economy in the US got a little shaky - borrowers were getting laid off, or those higher interest rates came due and borrowers couldn't pay them, or borrowers who thought they would sell before the higher interest rates kicked in couldn't find a buyer - some of those banks and institutions further down the line got nervous. In our example, say that BIG BANK gets nervous and says to Buyer, we can't make the next payment that we owe you. So Buyer now has to say to his buyer (maybe a pension fund), gee, I'm not getting paid by BIG BANK, so I can't make my next payment to you.

This is when BIG BANK, Buyer, pension fund, and Gambler go to AIG to collect on their insurance/bet. AIG can't pay because it didn't create any reserves. The stock market notices all of this and gets nervous so the Dow Jones falls. BIG BANK cuts back on its commercial lending because it's got to accumulate some funds (for lawyers, if nothing else). Buyer and pension fund start selling stock (in a down market) to meet their other obligations. Maybe pension fund cuts back on its payments, and maybe some retirees miss their mortgage payments because of that.

(And don't forget that when the lending stops, so does the home building. Jobs lost there. Many small businesses run on lines of credit. If the banks stop lending, or refuse to honor those lines of credit, the business is in trouble. Jobs lost there too. Lost jos mean people can't pay their mortgages.)

Suppose instead of a pension fund, the purchaser from Buyer is a city or a county. When they can't collect on their investment, they start cutting back services and laying off people, who then may default on their mortgage.

So I suppose you could, if you wanted, place all the blame on the Amercan home buyers, who wanted to buy a house or maybe a bigger house or maybe just get in on the housing boom. You could say that they made bad choices. And probably some of them did. Some of them weren't smart enough or experienced enough to understand they were being scammed. Some of them surely didn't expect to be laid off or downsized or have their employer close. But, as you have said, life isn't fair.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
29. tramp96
11:26 PM GMT on February 15, 2014
So in effect the mortgage crisis did cause all of this
Where does mortgage ins. that the homeowner
pays factor in on this.
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28. tramp96
4:48 PM GMT on February 15, 2014
Darn cell phone
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27. tramp96
4:45 PM GMT on February 15, 2014
Quoting 25. Naga5000:


Austerity doesn't, hasn't, and will never work. The current problem is out of control wealth inequality and lack of aggregate demand.

That article was absurd and nonsensical. No idea about the research about minimum wage laws, nonsense regarding gold. It's all pop economics. This is how people get taken for their money.

Just another "Invest in Gold, out of control inflation will be here any moment" nut job. That line of thinking has been shown false by every mainstream ethical economist. See: Bruce Bartlett.
Quoting 25. Naga5000:


Austerity doesn't, hasn't, and will never work. The current problem is out of control wealth inequality and lack of aggregate demand.

That article was absurd and nonsensical. No idea about the research about minimum wage laws, nonsense regarding gold. It's all pop economics. This is how people get taken for their money.

Just another "Invest in Gold, out of control inflation will be here any moment" nut job. That line of thinking has been shown false by every mainstream ethical economist. See: Bruce Bartlett.

Do you have a background in this area.
Just a question no hidden agenda
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26. FLwolverine
2:49 PM GMT on February 15, 2014
Quoting 25. Naga5000:


Austerity doesn't, hasn't, and will never work. The current problem is out of control wealth inequality and lack of aggregate demand.

That article was absurd and nonsensical. No idea about the research about minimum wage laws, nonsense regarding gold. It's all pop economics. This is how people get taken for their money.

Just another "Invest in Gold, out of control inflation will be here any moment" nut job. That line of thinking has been shown false by every mainstream ethical economist. See: Bruce Bartlett.
I'm always highly suspicious of Buy Gold ads and websites. Do you remember the Twilight Zone episode where two men stole a pile of gold in the 1960's, then climbed in to suspended animation capsules in a cave in the desert, intending to wake up many years later when their crime would be forgotten and they would be rich? One man wakes up (centuries later, it turns out) to find that a falling rock has punctured the other capsule (so his companion is dead) and that gold no longer has any value. He dies. Interesting twist on "do not put up treasure for yourself where moth and rust doth corrupt".
Member Since: January 6, 2013 Posts: 3 Comments: 2320
25. Naga5000
1:57 AM GMT on February 15, 2014
Quoting 24. FLwolverine:
I don't feel qualified to comment on tha statement - I don't have enough facts and information. However, after reading the article, I will observe that austerity didn't work very well in 1920s Germany, and it doesn't seem to be working in present day Greece.


Austerity doesn't, hasn't, and will never work. The current problem is out of control wealth inequality and lack of aggregate demand.

That article was absurd and nonsensical. No idea about the research about minimum wage laws, nonsense regarding gold. It's all pop economics. This is how people get taken for their money.

Just another "Invest in Gold, out of control inflation will be here any moment" nut job. That line of thinking has been shown false by every mainstream ethical economist. See: Bruce Bartlett.
Member Since: June 1, 2010 Posts: 4 Comments: 3281
24. FLwolverine
1:47 AM GMT on February 15, 2014
Quoting 23. tramp96:

Looks like everything is slowing down so next week I'll
start have time to study your post but in the meantime
what do you think of this statement

Of course things will keep getting worse until somebody understands that the real issue is debt. There are $694 trillion in derivatives. That is financial debt that can never be paid off. The world has been a giant casino for the last 20 years, and it's all coming to a head.
Link
I don't feel qualified to comment on tha statement - I don't have enough facts and information. However, after reading the article, I will observe that austerity didn't work very well in 1920s Germany, and it doesn't seem to be working in present day Greece.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
23. tramp96
11:11 PM GMT on February 14, 2014
Quoting 22. FLwolverine:
You're welcome. One of the great bits of luck in my life was to work in (my first) law firm with a bunch of very bright, very outspoken guys who did not hesitate to tell me (or any other young associate) when they thought we were blowing smoke (to use one of their clean expressions). So I learned to try to always break things down so I could explain them clearly. I figure I don't really understand something until I can explain it - at some level - to someone else.

Looks like everything is slowing down so next week I'll
start have time to study your post but in the meantime
what do you think of this statement

Of course things will keep getting worse until somebody understands that the real issue is debt. There are $694 trillion in derivatives. That is financial debt that can never be paid off. The world has been a giant casino for the last 20 years, and it's all coming to a head.
Link
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22. FLwolverine
5:55 PM GMT on February 09, 2014
Quoting 21. Picatso:
This is outstanding! I've tried to wade into this topic before and always gotten lost in the layers. This time, I kept up and have a much better understanding of not only the process itself, but also how the failure really was a cascade.

Thank you for taking the time to build such a clear description.
You're welcome. One of the great bits of luck in my life was to work in (my first) law firm with a bunch of very bright, very outspoken guys who did not hesitate to tell me (or any other young associate) when they thought we were blowing smoke (to use one of their clean expressions). So I learned to try to always break things down so I could explain them clearly. I figure I don't really understand something until I can explain it - at some level - to someone else.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
21. Picatso
5:13 PM GMT on February 09, 2014
This is outstanding! I've tried to wade into this topic before and always gotten lost in the layers. This time, I kept up and have a much better understanding of not only the process itself, but also how the failure really was a cascade.

Thank you for taking the time to build such a clear description.
Member Since: June 12, 2011 Posts: 0 Comments: 67
20. tramp96
3:11 AM GMT on February 07, 2014
Quoting 16. FLwolverine:
#6 - Creideiki - exactly. I hope Tramp reads all this.

Thanks for the work you put into this. Things have
just become super busy but I will read what you have written
as soon as I have some good time to put towards it
Thanks again
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19. JohnLonergan
2:46 AM GMT on February 07, 2014
Quoting 17. FLwolverine:
John, thanks for the Stiglitz article. I don't mean to trivialize anything he says, but I have always felt that this crisis of unmitigated greed can be laid at the feet of Ronald Reagan. I hold him and his cronies primarily responsible for promoting the philosophies of "greed is good" and "I've got mine so #%*€£# the rest of you" and making them acceptable - even esteemed - in American culture.


There are many things the he and his cronies should be held responsible for Iran Contra and murder of the American Maryknoll nuns in Nicaragua, suporting any number of despots in Latin America, IMNVHO,the worst is setting in motion the class divisions we see today.
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17. FLwolverine
2:31 AM GMT on February 07, 2014
Quoting 12. JohnLonergan:


I'll buy souless evil people, maybe add a vile, dispicible to the mix.
John, thanks for the Stiglitz article. I don't mean to trivialize anything he says, but I have always felt that this crisis of unmitigated greed can be laid at the feet of Ronald Reagan. I hold him and his cronies primarily responsible for promoting the philosophies of "greed is good" and "I've got mine so #%*€£# the rest of you" and making them acceptable - even esteemed - in American culture.
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16. FLwolverine
2:25 AM GMT on February 07, 2014
#6 - Creideiki - exactly. I hope Tramp reads all this.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
15. FLwolverine
2:24 AM GMT on February 07, 2014
Quoting 7. Creideiki:


I would place it primarily on Greenspan, but more on the ideology that he championed. The NPR "Frontline" episode The Warning showed how Greenspan along with Rubin and other proponents of Randian economics argued to stifle Brooksley Born and remove her ability to act in her oversight capacity over the derivatives market.

But, yes, the whole thing gets complex and laying at the feet of a single person is "hard", but Greenspan championed the philosophies of a little girl who was scared by the Trotskyite revolution in Russia and made them the official financial policy of the United States.
I had forgotten about Brooksley Born. Thanks for reminding us. The story about the Econ class is fascinating and scary. And these people are running the financial part of our economy!?!
Member Since: January 6, 2013 Posts: 3 Comments: 2320
14. FLwolverine
2:15 AM GMT on February 07, 2014
Quoting 5. Patrap:
..tis all "Voodoo" to me.
That's a real good description, Pat.
Member Since: January 6, 2013 Posts: 3 Comments: 2320
13. JohnLonergan
2:13 AM GMT on February 07, 2014
A quote from Adam Smith is in order:



Such regulations may, no doubt, be considered as in some respect a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as or the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.
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12. JohnLonergan
1:50 AM GMT on February 07, 2014
Quoting 11. Creideiki:


Rand's influence on Greenspan

It's possible Friedman influenced Greenspan. Or it could be that they're both equally soulless evil people and it becomes hard to tell the difference between shades of midnight.


I'll buy souless evil people, maybe add a vile, dispicible to the mix.
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11. Creideiki
1:38 AM GMT on February 07, 2014
Quoting 9. JohnLonergan:


I'm not sure about Rand, I'd put a lot more blame on Milton Friedman for creating Alan Greenspan.


Rand's influence on Greenspan

It's possible Friedman influenced Greenspan. Or it could be that they're both equally soulless evil people and it becomes hard to tell the difference between shades of midnight.
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10. JohnLonergan
1:30 AM GMT on February 07, 2014
In a 2008 essay in Vanity Fair Joseph Stiglitz listed five events which, in his opinion, lead to and exacerbated the finanacial collapse, I'll list them below:

No. 1: Firing the Chairman

In 1987 the Reagan administration decided to remove Paul Volcker as chairman of the Federal Reserve Board and appoint Alan Greenspan in his place. ...

No. 2: Tearing Down the Walls

The deregulation philosophy would pay unwelcome dividends for years to come. In November 1999, Congress repealed the Glass-Steagall Act-the culmination of a $300 million lobbying effort by the banking and financial-services industries, and spearheaded in Congress by Senator Phil Gramm. Glass-Steagall had long separated commercial banks (which lend money) and investment banks (which organize the sale of bonds and equities); it had been enacted in the aftermath of the Great Depression and was meant to curb the excesses of that era, including grave conflicts of interest. ...

...No. 3: Applying the Leeches

Then along came the Bush tax cuts, enacted first on June 7, 2001, with a follow-on installment two years later. The president and his advisers seemed to believe that tax cuts, especially for upper-income Americans and corporations, were a cure-all for any economic disease-the modern-day equivalent of leeches. The tax cuts played a pivotal role in shaping the background conditions of the current crisis. Because they did very little to stimulate the economy, real stimulation was left to the Fed, which took up the task with unprecedented low-interest rates and liquidity. ...

No. 4: Faking the Numbers

Meanwhile, on July 30, 2002, in the wake of a series of major scandals-notably the collapse of WorldCom and Enron-Congress passed the Sarbanes-Oxley Act. The scandals had involved every major American accounting firm, most of our banks, and some of our premier companies, and made it clear that we had serious problems with our accounting system. Accounting is a sleep-inducing topic for most people, but if you can't have faith in a company's numbers, then you can't have faith in anything about a company at all. Unfortunately, in the negotiations over what became Sarbanes-Oxley a decision was made not to deal with what many, including the respected former head of the S.E.C. Arthur Levitt, believed to be a fundamental underlying problem: stock options. Stock options have been defended as providing healthy incentives toward good management, but in fact they are "incentive pay" in name only. If a company does well, the C.E.O. gets great rewards in the form of stock options; if a company does poorly, the compensation is almost as substantial but is bestowed in other ways. This is bad enough. But a collateral problem with stock options is that they provide incentives for bad accounting: top management has every incentive to provide distorted information in order to pump up share prices. ...

No. 5: Letting It Bleed

The final turning point came with the passage of a bailout package on October 3, 2008-that is, with the administration's response to the crisis itself. We will be feeling the consequences for years to come. Both the administration and the Fed had long been driven by wishful thinking, hoping that the bad news was just a blip, and that a return to growth was just around the corner. As America's banks faced collapse, the administration veered from one course of action to another. Some institutions (Bear Stearns, A.I.G., Fannie Mae, Freddie Mac) were bailed out. Lehman Brothers was not. Some shareholders got something back. Others did not.

The original proposal by Treasury Secretary Henry Paulson, a three-page document that would have provided $700 billion for the secretary to spend at his sole discretion, without oversight or judicial review, was an act of extraordinary arrogance. He sold the program as necessary to restore confidence. But it didn't address the underlying reasons for the loss of confidence. The banks had made too many bad loans. There were big holes in their balance sheets. No one knew what was truth and what was fiction. The bailout package was like a massive transfusion to a patient suffering from internal bleeding-and nothing was being done about the source of the problem, namely all those foreclosures. Valuable time was wasted as Paulson pushed his own plan, "cash for trash," buying up the bad assets and putting the risk onto American taxpayers. When he finally abandoned it, providing banks with money they needed, he did it in a way that not only cheated America's taxpayers but failed to ensure that the banks would use the money to re-start lending. He even allowed the banks to pour out money to their shareholders as taxpayers were pouring money into the banks...


I think that one and two were the most important in setting the markets up to fail.

1.Greenspan's anti-regulatory beliefs led the Fed to abrogate their regulaory duties. In essence, the fox was gurding the henhouse.

2. Glass- Steagle was designed in the 1930's to prevent commercial from being invoved with risky investments; I'm shocked, shocked that nobody could foresee that the same practices would resume once the restrictions were removed.

My thoughts for now, I want think more on Stiglitz other points.
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About FLwolverine

UMich grad; retired attorney; lives in Michigan, spends time in Florida.

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