Greenspan Could Have Prevented the Current Financial Meltdown

[audreyh1]

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Originally Posted by Bikerdude I was just pointing out some of the key characters in the "Frontline" piece. According to Frontline in the late 90's (Bush wasn't President yet) Brooksley Born wanted to regulate the derivative market and most of the cast of characters mentioned ran her out of Washington on a rail. It is what it is. They were all aware and chose to do nothing.

And was it mentioned how Phil Gramm played a huge role in this?

Audrey

[Bikerdude]

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Originally Posted by audreyh1 And was it mentioned how Phil Gramm played a huge role in this? Audrey

I suggest you watch the piece and draw your own conclusions.

[audreyh1]

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Originally Posted by Bikerdude I suggest you watch the piece and draw your own conclusions.

Well, I guess I'll have to figure out how to watch it. It seems from the comments that a great deal has been left out - like the massive leveraging that occurred during the 2000s when the restrictions on large investment banks were lifted, the total lack of rein in on improper lending standards.

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Although Greenspan, Summers, Rubin and Levitz are singled out for particular criticism in this fine program, the list of culprits is long. Certainly near the top would be Milton Friedman, Phil Gramm and Wendy Gramm. My only reservations about the show was that it did not discuss Phil and Wendy Gramm's tireless efforts to deregulate everything in sight. Their damage to the economy started with Enron, as prime enablers of that fiasco. Alas, it did not end there.

And of course, none of this would have happened if the Glass-Steagall hadn't been repealed.

So, there were many contributions to the failure.

It wasn't just derivatives and plenty happened during the 2000s to bring on the crisis.

Audrey

[jdw_fire]

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Originally Posted by audreyh1 It seems from the comments that a great deal has been left out - like the massive leveraging that occurred during the 2000s when the restrictions on large investment banks were lifted, the total lack of rein in on improper lending standards. ... It wasn't just derivatives and plenty happened during the 2000s to bring on the crisis. Audrey

i am not real clear on the financial instrument that was created that converted these very risky loans into AAA rated investments but i thought they were derivatives. am i wrong?

[audreyh1]

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Originally Posted by jdw_fire I am not real clear on the financial instrument that was created that converted these very risky loans into AAA rated investments but i thought they were derivatives. am i wrong?

No, those weren't derivatives - those were CDOs - collateralized debt obligations or CMOs - collateralized mortgage obligations (both a.k.a toxic assets), that the rating agencies (in collusion - there is no doubt about that) rated as AAA based on some extremely dubious mathematical models. And then so many institutions bought these based on the ratings, even though the ratings were dubious.

Those had nothing to do with derivatives. But I think some companies used derivatives to hedge against the risk of these CDAs - realizing that there was some risk, but figuring that the derivative would save their butt - another fallacy.

It was a big insane mess.

And I really, really don't understand why the ratings agencies haven't been keelhauled over this.

Audrey

[Gone4Good]

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Originally Posted by jdw_fire i am not real clear on the financial instrument that was created that converted these very risky loans into AAA rated investments but i thought they were derivatives. am i wrong?

Derivatives were used to multiply the effect but turning subprime loans into Aaa rated securities happened without derivatives. It is simple structuring.

Consider a bunch of junk bonds. Each individual bond has a high probability of default and a low recovery in default. But even if every bond defaults, there will be some recovery on the portfolio. I can create a security that gets 1st priority on the recovery and cash flow of the portfolio and, as a result, will have a very high credit quality (low probability of default and high recovery expectations). Then I create a security with a 2nd priority on that portfolio and it will have a slightly lower credit quality . . . and so on and so forth until I create the last, unrated, "equity" tranche.

There is nothing inherently wrong or devious with this. The original intention was to use this "securitization" process to convert illiquid securities into liquid ones and take out the liquidity premium. If the securities were evaluated correctly there never would have been a problem. But somewhere along the way the process got corrupted. Rating agencies got paid to give high ratings to increasingly junky structures and portfolios. Institutional investors stoped caring what they were buying and deferred to the rating agencies. Derivatives were used to create new securities based on the old, increasingly junky ones.

[samclem]

Does the (continued) failure to accurately rate bonds argue in favor of actively managed bond funds instead of indexes? Seems it might be worth a little in annual expense ratio if there's a real human who takes an interest in actually studying the bonds objectively before adding them to the portfolio.

[Gone4Good]

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Originally Posted by samclem Does the (continued) failure to accurately rate bonds argue in favor of actively managed bond funds instead of indexes? Seems it might be worth a little in annual expense ratio if there's a real human who takes an interest in actually studying the bonds objectively before adding them to the portfolio.

Not really.

The index holds all bonds by market weight, just like the S&P 500. Ratings don't really matter except for the distinction between "Investment Grade" and "High Yield", which is based on ratings.

A lot of actively managed funds rely heavily on the rating agencies and will simply buy bonds that are "cheap for the rating". Many fixed income shops are very thinly staffed and don't have the resources to do detailed credit work (although there are exceptions Fidelity, Loomis, PIMCo, etc).

The sad truth is that a staggeringly large number of places have outsourced credit analysis to the rating agencies. I've seen entire pension funds managed by two guys. Why bother? I've long thought the market would be better off if the rating agencies didn't exist.

[Helen]

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Originally Posted by audreyh1 And was it mentioned how Phil Gramm played a huge role in this? Audrey

This surprisingly was not mentioned in the Frontline segment, but it is still worth watching because they do bring a lot of interesting things up.

I really hope it gets made into a motion picture. There are so many different ways to think about what happened and how it came about and why. The Frontline show is an hour long and only scratches the surface, please watch it, I'd like to hear what you think.

[jdw_fire]

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Originally Posted by audreyh1 Those had nothing to do with derivatives. But I think some companies used derivatives to hedge against the risk of these CDAs - realizing that there was some risk, but figuring that the derivative would save their butt - another fallacy. Audrey

so then credit default swaps (CDS's) are derivatives?

[Gone4Good]

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Originally Posted by jdw_fire so then credit default swaps (CDS's) are derivatives?

Yes.

[Independent]

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Originally Posted by . . . Yrs to Go Derivatives were used to multiply the effect but turning subprime loans into Aaa rated securities happened without derivatives. It is simple structuring. Consider a bunch of junk bonds. Each individual bond has a high probability of default and a low recovery in default. But even if every bond defaults, there will be some recovery on the portfolio. I can create a security that gets 1st priority on the recovery and cash flow of the portfolio and, as a result, will have a very high credit quality (low probability of default and high recovery expectations). Then I create a security with a 2nd priority on that portfolio and it will have a slightly lower credit quality . . . and so on and so forth until I create the last, unrated, "equity" tranche. There is nothing inherently wrong or devious with this. The original intention was to use this "securitization" process to convert illiquid securities into liquid ones and take out the liquidity premium. If the securities were evaluated correctly there never would have been a problem. But somewhere along the way the process got corrupted. Rating agencies got paid to give high ratings to increasingly junky structures and portfolios. Institutional investors stoped caring what they were buying and deferred to the rating agencies. Derivatives were used to create new securities based on the old, increasingly junky ones.

I followed you all the way down to the last sentence. To me, you're describing "securitization" up to that point. The connection to "derivatives" that I see is that some of the final securities were "insured" by CDSs.

I can also see "synthetic CDOs" as being composed of derivatives, is that what you are talking about?

[Bikerdude]

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Originally Posted by audreyh1 And was it mentioned how Phil Gramm played a huge role in this?

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Originally Posted by Helen This surprisingly was not mentioned in the Frontline segment, but it is still worth watching because they do bring a lot of interesting things up.

I think your missing the point of the “Frontline” segment. It is titled “The Warning” and is set during the latter years of the Clinton administration. Clinton appoints a brilliant lawyer to chair the “Commodity Futures Trading Commission" to oversee securities fraud. She has spent most of her life studying “derivatives”. Long story short, she recommends to Congress to regulate them. When asked “why?” By Congressman Waxman she replied “because the average American citizens savings are at risk.” Keep in mind this is 1998 when she issued this “warning”. She was beaten up by the 3 horseman, Greenspan, Rubin and Somers and forced to resign when Congress denied her regulating request. Greenspan has admitted he was wrong, the others involved have not.

I would assume there will be more Frontline segments dealing with the financial meltdown. Maybe one titled “Hang Phil Gramm next to George Bush” I don't know or care. The fact remains that a very clear warning was given by a fully qualified person and it was ignored in 1998.

[Gone4Good]

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Originally Posted by Independent I can also see "synthetic CDOs" as being composed of derivatives, is that what you are talking about?

Yes.

The "beauty" of derivatives is that they are not bound by any physical constraint. In order to create a Residential Mortgage Backed Security (RMBS) I need a pool of residential mortgages. So the size of the RMBS market is constrained by the size of the mortgage market. But once I have one RMBS security outstanding I can create as many "synthetic" RMBS securities as the market will bear, all of which use the same pool of assets as a reference point (and perversely enough, the "raw material" for the synthetic RMBS are the other side of CDS contracts from people who want to bet against the original RMBS. Neat huh?)

These synthetic transactions have the effect of magnifying the loss potential of a single default. So while in the real world, only the actual lenders lose money when a mortgage defaults, in the synthetic world all of those who own securities referencing that mortgage can lose too. So $1 lent can yield more than $1 in loses. Of course in the synthetic world someone else stands on the other side as a winner so gains and losses even out in aggregate . . . that is, of course, as long as the losing party stays solvent. Oops.

And there you have a recipe for cascading bankruptcy as defaulting "losers" wipe out the assets of the "winners".

[tjscott0]

To watch Frontline's The Warning:
FRONTLINE: home | PBS

More on this story:

The Born Prophecy | ABA Journal - Law News Now

Shortly after she was named to head the Commodity Futures Trading Commission in 1996, Brooksley E. Born was invited to lunch by Federal Reserve Chairman Alan Greenspan.


The influential Greenspan was an ardent proponent of unfettered markets. Born was a powerful Washington, D.C., lawyer with a track record for activ*ist causes. Over lunch in his private dining room at the stately headquarters of the Fed in Washington, Green*span probed their differences.

“Well, Brooksley, I guess you and I will never agree about fraud,” Born, in a recent interview, remembers Greenspan saying.

“What is there not to agree on?” Born says she replied.

Shortly after she was named to head the Commodity Futures Trading Commission in 1996, Brooksley E. Born was invited to lunch by Federal Reserve Chairman Alan Greenspan.

The influential Greenspan was an ardent proponent of unfettered markets. Born was a powerful Washington, D.C., lawyer with a track record for activ*ist causes. Over lunch in his private dining room at the stately headquarters of the Fed in Washington, Green*span probed their differences.

“Well, Brooksley, I guess you and I will never agree about fraud,” Born, in a recent interview, remembers Greenspan saying.

“What is there not to agree on?” Born says she replied.

“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” she recalls him saying. Greenspan, Born says, believed the market would take care of itself.

The debate came to a head April 21, 1998. during a Treasury Department meeting of a presidential working group that included Born and the other top regulators, Greenspan and Rubin took turns attempting to change her mind. Rubin took the lead, she recalls.

"I was told by the secretary of the Treasury that the CFTC had no jurisdiction and, for that reason and that reason alone, we should not go forward,” Born says. “I told him ... that I had never heard anyone assert that we didn’t have statutory jurisdiction ... and I would be happy to see the legal analysis he was basing his position on.”

She says she was never supplied one. “They didn’t have one because it was not a legitimate legal position," Born says.


At congressional hearings that summer, Greenspan and others warned of dire consequences;Born and the CFTC were cast as loose cannons.

Reverting to a theme Born claims he raised at their earlier lunch, Greenspan testified there was no need for government oversight because the derivatives market involved Wall Street “professionals” who could patrol themselves.

[jdw_fire]

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Originally Posted by . . . Yrs to Go Yes. The "beauty" of derivatives is that they are not bound by any physical constraint. In order to create a Residential Mortgage Backed Security (RMBS) I need a pool of residential mortgages. So the size of the RMBS market is constrained by the size of the mortgage market. But once I have one RMBS security outstanding I can create as many "synthetic" RMBS securities as the market will bear, all of which use the same pool of assets as a reference point (and perversely enough, the "raw material" for the synthetic RMBS are the other side of CDS contracts from people who want to bet against the original RMBS. Neat huh?) These synthetic transactions have the effect of magnifying the loss potential of a single default. So while in the real world, only the actual lenders lose money when a mortgage defaults, in the synthetic world all of those who own securities referencing that mortgage can lose too. So $1 lent can yield more than $1 in loses. Of course in the synthetic world someone else stands on the other side as a winner so gains and losses even out in aggregate . . . that is, of course, as long as the losing party stays solvent. Oops. And there you have a recipe for cascading bankruptcy as defaulting "losers" wipe out the assets of the "winners".

i can understand someone buying into the "original RMBS" for the cash flow but where does the cash flow come from in the "synthetic RMBS"? and if there is no cash flow, what is the reason for buying it? seems to me for all this to work everybody involved needs some type of profit motive (or atleast a return on investment) but i am not sure where the profit is after the original RMBS and maybe one round of CDS hedging the buyer of the original RMBS against default. would you please help me understand?

[Gone4Good]

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Originally Posted by jdw_fire i can understand someone buying into the "original RMBS" for the cash flow but where does the cash flow come from in the "synthetic RMBS"? and if there is no cash flow, what is the reason for buying it? seems to me for all this to work everybody involved needs some type of profit motive (or atleast a return on investment) but i am not sure where the profit is after the original RMBS and maybe one round of CDS hedging the buyer of the original RMBS against default. would you please help me understand?

The cash flows come from the parties to the CDS transaction and don't rely on any cash from the original security. The seller of CDS receives a coupon from the buyer in exchange for giving the buyer "protection" on the principal value of a reference security in the event of default. You can think about it like an insurance contract on a property that you may or may not own. You pay a premium to the insurance company in exchange for a promise to pay if a building burns down.

Theoretically a properly structured funded CDS position should replicate the cash flows and performance of the "underlying" security. So these synthetic securities can be put in investment vehicles and resold.

The "profit" motive comes from various sources. All of these deals arbitrage price difference among different markets (the whole loan market, vs. the asset backed market, vs the CDS market). And because I can structure a deal to achieve whatever credit quality I want (more Aaa's vs. fewer BBBs for example) I can also arbitrage price differentials between rating categories.

This is also helpful because certain institutional buyers (like insurance companies) need very specific securities to help them match assets and liabilities. These securities may not exist in the "real world" in sufficient size or liquidity to meet the company's needs. So the insurance company says "I need a 7 year Aa2, floating rate security with a 3 yr average life and a spread over LIBOR greater than x%". "No problem", says the investment bank who can custom tailor a product to meet the clients needs. All of this structuring generates fee income for the underwriting bank too, of course.

[Helen]

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Originally Posted by Bikerdude I think your missing the point of the “Frontline” segment. It is titled “The Warning” and is set during the latter years of the Clinton administration.

Good point. Here is the timeline for the video:

FRONTLINE: the warning: video timeline | PBS

It begins in 1987 during the Reagan years when Greenspan was recently hired. It also stresses the climate in Government at the time was built on Reaganomics and small Government. Reagan was quoted as saying, "Government is the problem".

[jdw_fire]

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Originally Posted by . . . Yrs to Go The cash flows come from the parties to the CDS transaction and don't rely on any cash from the original security. The seller of CDS receives a coupon from the buyer in exchange for giving the buyer "protection" on the principal value of a reference security in the event of default. You can think about it like an insurance contract on a property that you may or may not own. You pay a premium to the insurance company in exchange for a promise to pay if a building burns down.

well this is how i was thinking it worked, i.e. a CDS is in essence an insurance contract. so you have the RMBS and an insurance contract (CDS) on it. soo where does the next CDS come in, ensuring the 1st CDS? and then is a 3rd written to ensure the 2nd? is that how the number of CDS's grow?

BTW thank you for your help and patience

[Gone4Good]

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Originally Posted by jdw_fire well this is how i was thinking it worked, i.e. a CDS is in essence an insurance contract. so you have the RMBS and an insurance contract (CDS) on it. soo where does the next CDS come in, ensuring the 1st CDS? and then is a 3rd written to ensure the 2nd? is that how the number of CDS's grow? BTW thank you for your help and patience

Yes.

But part of the confusion is that you can have multiple insurance contracts written on the same asset. I don't need to own the asset to "insure" it. Often times I don't. So there is no limit to how many CDS contracts can be written against an individual security. And then no limit to how many contracts can be written against the unlimited number of synthetic securities that may have been created in reference to the 1st security.