Why Did The Government Care About Insurance On Mortgages?

For many people, such as myself, who are very conservative investors, the current crisis seems strange because it involves such, in retrospect, obviously poor investments. How can people, very savvy with money and investing, have made such obvious mistakes and taken such obvious risks? I think that some of us believe it can only be greed, and that is why you hear it often mentioned in this crisis. So, let's look at one such investment, which Jacob Weisberg brought up in the Slate post on the end of libertarianism, which mainly interested me only because of the ideologue reference,i.e., the idea that libertarians are inherently ideologues as opposed to liberals or conservatives. Otherwise, I wasn't very interested in it and found it more amusing than anything else. By the way, the policing of who is a libertarian is an inherently uninteresting question to me.

Here's a quote from one of the stories he mentions, which was in the Washington Post:

"Greenspan, Rubin and Levitt had reacted with alarm at Born's persistent interest in a fast-growing corner of the financial markets known as derivatives, so called because they derive their value from something else, such as bonds or currency rates. Setting the jargon aside, derivatives are both a cushion and a gamble -- deals that investment companies and banks arrange to manage the risk of their holdings, while trying to turn a profit at the same time.

Unlike the commodity futures regulated by Born's agency, many newer derivatives weren't traded on an exchange, constituting what some traders call the "dark markets." There were now millions of such private contracts, involving many of Wall Street's top firms. But there was no clearinghouse holding collateral to settle a deal gone bad, no transparent records of who was trading what.

Born wanted to shine a light into the dark. She had offered no specific oversight plan, but after months of making noise about the dangers that this enormous market posed to the financial system, she now wanted to open a formal discussion about whether to regulate them -- and if so, how."

Okay, so you have these derivatives. Some of them are privately traded, and there's no third party holding the collateral or public records. Because they began to constitute a seemingly large sum of money, the protagonist of the story wants them regulated, but doesn't say how or why, just that they are mounting up in terms of money.

"Privately, Rubin had expressed concern about derivatives' unruly growth. But he agreed with Greenspan and Levitt that these newer contracts, often called "swaps," weren't exactly futures. Born's agency did not have legal authority to regulate swaps, the three men believed, and her call for a discussion had real-world consequences: It would cast doubt over the legality of trillions of dollars in existing contracts and create uncertainty over how to operate in the market."

So they're swaps, not futures really, and therefore can't be regulated.

"The industry had been fighting regulation for years, and in the meantime, you saw them accumulate a huge amount of stuff and it was already causing dislocations in the economy. The government was being kept blind to it."

What's a huge amount of stuff? So what? What are the dislocations?

"Derivatives did not trigger what has erupted into the biggest economic crisis since the Great Depression. But their proliferation, and the uncertainty about their real values, accelerated the recent collapses of the nation's venerable investment houses and magnified the panic that has since crippled the global financial system."

Who was uncertain about them? The government? Investors? Both? How could investors not know what they're worth?

"She told a group of business lawyers in 1998 that the "lack of basic information" allowed traders in derivatives "to take positions that may threaten our regulated markets or, indeed, our economy, without the knowledge of any federal regulatory authority."

How could lack of information do this? Whose? The government? Traders? Why would one type of investment threaten our markets and economy?

"...gave birth to more complex securities and derivatives, this time linked to the inflated value of millions of homes bought by Americans ultimately unable to afford them. That created a new chain of risk, starting with the heavily indebted homebuyers and ending in a vast, unregulated web of contracts worldwide. "

Here's our first clear problem. People are overpaying for homes because they can't really afford the payments. Therefore, at some point, they'll be foreclosed on. Now, who made these poor loans and why?

"By appearing to provide a safety net, derivatives had the unintended effect of encouraging more risk-taking. Investors loaded up on the mortgage-based investments, then bought "credit-default swaps" to protect themselves against losses rather than putting aside large cash reserves. If the mortgages went belly up, the investors had a cushion; the sellers of the swaps, who collected substantial fees for sharing in the investors' risk, were betting that the mortgages would stay healthy. "

Okay, the people who lent the money ( now just a mortgage holder ) buy a credit default swap to protect their investment if the mortgage is foreclosed upon. What about the houses? Aren't they still owned by the investor? In any case, the CDS is insurance for a mortgage default when the buyer can no longer pay for his house. The investors could have put money aside, but they buy insurance, probably because they don't have the money and insurance involves payments over time. But notice, the mortgage holder thinks they're protected. After all, they have the house and insurance. On the other hand, the insurers don't say if they can pay out in any situation, because, well, because they can't. In other words, for many buyers of this insurance, it's worthless.

Forget the figures for a second, because they involve an oddity of accounting.

"When the housing bubble burst and mortgages went south, the consequences seeped through the entire web. Some of those holding credit swaps wanted their money; some who owed didn't have enough money in reserve to pay."

So the insurance is worthless, again.

"The government had a legitimate interest in preserving the enforceability of the billions of dollars worth of swap contracts that were threatened by the concept release," said Mark Brickell, a managing director at what was then J.P. Morgan Securities and former chairman of the International Swaps and Derivatives Association. "

Why does the government have an interest in the fact that private businesses are paying for worthless insurance? After all, the businesses will simply lose money. So what?

"He later wrote in a 2003 book that "derivatives, with leverage limits that vary from little to none at all, should be subject to comprehensive and higher margin requirements," forcing dealers to put up more capital to back the swaps. "But that will almost surely not happen, absent a crisis."

Once again, so what? It's bogus insurance, sure. But why do we care if mortgage holders are buying bogus insurance? Haven't they looked into how the insurance will pay them? Didn't they look to see how much capital these so-called insurers had? It's beginning to sound like fraud.

"Greenspan shot back that CFTC regulation was superfluous; existing laws were enough. "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary," he said. "Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living."

Greenspan, and I'm no fan of his, makes a fair point. Why should we care about this private insurance? And if the insurere can't pay out, isn't that fraud? Why would we need to regulate this fraud any more?

"Long Term Capital Management, a huge hedge fund heavily weighted in derivatives, told the Fed that it could not cover $4 billion in losses, threatening the fortunes of everyone from tycoons to pension funds. After Russia, swept up in the Asian economic crisis, had defaulted on its debt, Long Term Capital was besieged with calls to put up more cash as collateral for its investments. Based on the derivative side of its books, Long Term Capital had an astoundingly high debt-to-capital ratio. "The off-balance sheet leverage was 100 to 1 or 200 to 1 -- I don't know how to calculate it," Peter Fisher, a senior Fed official, told Greenspan and other Fed governors at a Sept. 29, 1998, meeting, according to the transcript. "

So LCM goes out of business because they don't have the capital to pay up, and some investors lose money. So what? As to not knowing the figure, who does the accounting for LCM? Or did they know they could not cover these investments? The word fraud occurs again to me.

"Two days later, Born warned the House Banking committee: "This episode should serve as a wake-up call about the unknown risks that the over-the-counter derivatives market may pose to the U.S. economy and to financial stability around the world."

Once again, what's the risk. LCM goes bankrupt. Some investors lose money. So what?

"The near collapse of Long Term Capital Management didn't change anything. Although some lawmakers expressed new fervor for addressing the risks of derivatives, Congress went ahead with the law that placed a six-month moratorium on any CFTC action regarding the swaps market. "

So LCM survives. Fine. People own very poor insurance. What to do? And why?

"The report raised some alarm over excess leverage and the unknown risks of the derivative market, but called for only one legislative change -- a recommendation that brokerages' unregulated affiliates be required to assess and report their financial risk to the government. "

I'm still wondering what the problem is. The government should get involved why?

"...an industry clearinghouse to hold pools of cash collected from financial firms to cover derivatives losses. But the report had also called for federal oversight to ensure that risk-management procedures were followed. The swaps industry generally supported the clearinghouse concept. One amended version of the bill made federal oversight optional."

Here's a real proposal. A third party to hold enough capital to make sure that this insurance can pay up.

"Alarmed, SEC lawyers argued that the agency at least needed to retain its authority over fraud and insider trading. What if a trader, armed with inside knowledge, engaged in a swap on a stock? Treasury Undersecretary Gary Gensler brokered a compromise: The SEC would retain its antifraud authority but without any new rulemaking power. "

Okay, here I'm bothered. If the insurers know that they can't pay up, it's fraud, and needs to be prosecuted.

"A clearinghouse would have created layers of protections that don't exist today, said Craig Pirrong, a markets expert at the University of Houston. "An industry-backed pool of capital could have cushioned against losses while discouraging risky bets."

But afterward, the clearinghouse idea sat dormant, with no one in the industry moving to put one in place."

So a third party holding more capital would have meant more people would have received this insurance. Everybody? Not likely. Is it a good idea? Of course. But why does the government care, other than fraud?

"Five years later, the European regulators were forcing the issue again. Restricted by Gramm-Leach-Bliley, the SEC proposed a voluntary system, which the big investment banks opted to join. The holding companies would be permitted to follow their own computer models to assess how much risk they were taking; the SEC would get access to make sure the complex capital and risk-management models were up to the job."

Can they pay up? Again.

"It was too late. All five brokerages in the program had either filed for bankruptcy, been absorbed or converted into commercial banks."

It turns out that they can't pay up. They go out of business or are bought. Again, so what?

"When its losses mounted, the credit-rating agencies downgraded AIG's standing, triggering a clause in its credit-default swap contracts to post billions in collateral that it didn't have. The government swooped in to prevent AIG's default, hoping to ward off another chain reaction in the already shaky financial system."

AIG can't pay up on the insurance. Not enough capital. Again, they go out of business. So what?

"In hindsight, there's no question that we would have been better off if we had been regulating derivatives -- and had a clearinghouse for it."

"I guess if I had to do it over again, I certainly would have pushed for some way to give greater transparency to products which turned out to be injurious to our markets."

So, we could have had higher capital standards held by a third party, or it could have been clearer that the insurers can't pay up in a crisis, like an insurance company that can't pay up after a natural disaster. Too many claims at one time.

So we've reached the end of our story. There are good guys and bad guys, or, at least, less prescient guys.

Would a clearinghouse have covered all the insurance? Would people still have bought this insurance if they knew that it couldn't pay out in a crisis? No answers. At best, I see reason to believe that regulation, namely higher capital standards on this insurance, would have paid some money out, but not all. Still a problem.

But still no answer to our basic question. Why should the government get involved or care?

To our basic question, about the foolishness of investors, we have a sort of answer now. The mortgage holders thought that they had insured themselves against loss. In other words, they had lowered their risk and made a fairly conservative investment. They were wrong.

I have asked the question about the government's involvement. Surely the government should regulate by prosecuting fraud, but why do we care if some businesses go bust ( obviously we care as human beings for people losing their jobs, for example, but why should the government intervene here as opposed to elsewhere) .

Well, one answer is that if a lot of them go bust at once, it will hurt the economy overall. Another answer is that the government has implicitly guaranteed to intervene in a finacial crisis that hurts the overall economy, so the taxpayer's interests would have been better served by regulators lessening the risk.

From my perspective, it is the government guarantee that leads me to believe that we should have had more regulation. If the taxpayer has to pick up the tab, I believe that regulation should keep the risk to the taxpayer at very conservative levels.

But what if this implicit guarantee had not been there? Would these businesses have taken such risk? Or, could we have let the market work itself out of this crisis?

On the second question, I've already said that since these implicit guarantees were in place, we needed to intervene in this crisis. However, going forward, we need to decide whether we want to have the government give an explicit, it should be debated and determined, guarantees to back up these businesses. If we do, we should regulate accordingly. If not, then we should have regulations, but they need not be as tight as if the taxpayer is involved.

However, the idea that the government guarantees did not play a role in the behavior of AIG and other investors in taking on this added risk, I do not accept, and I believe that the reaction of the markets to Lehman proves that.