More "Derivatives for Dummies": Proportionality

First, if you're not sure what an "insurable interest" is and how it relates to derivatives, please see my earlier post, "Credit Derivatives for Dummies: 'Insurable Interests'."

In order to fix the system, we – YOU AND ME – must understand the main factors in the current economic meltdown. Because from what our leaders have done so far, I'm very worried that either they don't understand it, or they're actually hoping we never will.

It's not as hard as it may seem. I think a lot of the people who helped create the crisis understood perfectly well that they were creating a glorified Ponzi scheme and have been deliberately obfuscating, first in order to pursue their own profits, and later to avoid being called to account for what they've wrought. Explaining it takes some words, but the concepts are simple.

The following is simplified, but I hope it'll make it easier to see the forest for the trees.

Assuming you've already got what an insurable interest is . . . here's another aspect of why the kind of speculation possible though credit derivatives is inherently problematic.

When someone gets a mortgage or an insurance policy on a property that they have a vested interest in, say, a house they're buying, there tends to be some kind of proportionality between the amount of the mortgage debt, the insurance, and the value of the property. Typically, there's a mortgage (historically for LESS than the total appraised value of the house, but never for more), and there's an insurance policy on the house for no more than the replacement cost of the house. The mortgage and the insurance are both outstanding obligations, but they are related to one another and to the actual value of the house, in that if the house is destroyed, the insurance will either go to rebuild the house or to pay off the mortgage.

So, suppose the house was purchased for $400,000. The worst-case scenario is that the house is completely destroyed.  In that case, the insurer has to pay out $400,000, but the borrower and mortgage lender are protected from loss. If the borrower and lender were deluded about the value of the property to begin with and the purchase price and loan were much bigger than they should have been – say the property was really worth only $100,000 – the borrower or lender's loss may be $300,000, which is very bad; but in any scenario, the total amount of losses that can actually be suffered by all of the parties put together is limited to $400,000.

The more deluded the parties were about the true value of the house, the bigger the potential losses; but while you may be able to pretend the house is worth four times its true value, you can't fool anyone into thinking it's worth hundreds of times its true value. So, so long as the insurance can only be sold to parties owning at least an indirect interest in that specific house, the total potential losses are intrinsically limited to something that bears some kind of proportionality to an at least tenuously plausible notion of the value of the house.

The bad mortgage loans on banks' books now are a problem, even if there were nothing else to worry about, probably much bigger than what we faced after Pres. Reagan's deregulation of S&L's led to that other debacle back in the 1980's. In the '80's, the S&L's that made the riskiest loans were declared insolvent and were liquidated. Resolving those loans was painful, but it was much less expensive than resolving the current crisis will be, because then, the borrower could re-negotiate the loan with her/his original lender, so many avoidable foreclosures were avoided (which tends to minimize the losses). Now, most borrowers won't easily be able to do that, because we allowed the banks that made the risky loans to "minimize" the risks by rolling them into pools of mortgage-backed securities that were sold to untold numbers of lenders. In fact, rather than minimizing the risks, securitization increased them by reducing banks' incentives to lend only to borrowers who could actually pay, effectively creating a race to the bottom in loan quality. So now, we may have even more bad loans, and, unless the gummint steps in, each borrower, in order to re-negotiate her/his loan, would have to negotiate with untold numbers of lenders, which would cost everyone involved much more than the amount of the loan. So, yeah, the bad mortgage loans are a problem.

But all those bad mortgage loans are still nowhere near the biggest factor in our current meltdown, because at least those losses can't exceed what people could persuade themselves or pretend the underlying properties were worth. The magnitude of the total of all the losses incurred by all of the borrowers, lenders, and insurers due to bad mortgage loans may be staggering, but they are not unlimited; they will bear at least some tenuous proportionality to the value of the underlying properties.

The really scary, mind-boggling factor is the credit derivatives. Because, since derivatives were sold to parties who had NO "insurable interest" in the assets on which they were betting (see my similarly-titled previous post), there was NO limit to the quantities of obligations that could be incurred with respect to the same assets. It's as if, instead of there being just one insurance policy with respect to any given house, thousands of insurance policies were sold with respect to the same house, to speculators with no property or other interest in that house but who just had a hunch it might burn down. So there was no proportionality, no inherent limit to the total amount of potential losses that could be incurred with respect to any single, actual asset. (Not to mention the vastly increased probability that one of the many who bought such insurance might succumb to the temptation to torch the place.)

And now you and I are being indirectly bankrupted to pay off on all those "policies."

AIG is one of the companies that sold the most "policies" in the form of credit derivatives.

Theoretically, if AIG had been charging appropriately large "premiums" for the derivatives they sold, and if they had segregated and invested enough of those premiums to cover their potential losses, they could have covered all the obligations they incurred.  But insuring companies have little incentive to underwrite their risks responsibly, unless they're regulated; and credit derivatives have not been regulated.  And the individuals who run insuring companies have little incentive to make sure their companies act responsibly, so long as those individuals can't be held personally liable for their "mistakes."  One of the things government regulators do with respect to ordinary insurance is to regulate insuring companies, including requiring them to disclose their reserves and potential liabilities and to maintain sufficient reserves to pay potential claims.

AIG didn't collect enough premiums, and/or they paid too much of what they did collect to senior management and shareholders, instead of retaining adequate reserves. They claim they didn't understand the risks. Well, I'm no economist, but I understand the risks better than AIG apparently did, and (a) it was their job to understand it, and (b) I find it hard to believe that all the people who spent their workdays creating and being the bosses of this mess, day in and day out over several years, were utterly clueless.

And the money did not just all go "poof"; some people made a lot on the bubble before it popped. They finance a lot of political campaigns.

Again, I was and remain strongly in favor of fast action by the gummint to restore confidence in the financially stronger banks and to stimulate the economy, but I do question the details with respect to how the money's being applied and why we know so little about that. E.g., some parties who bought derivatives may have been pension funds trying to hedge risks with respect to an "insurable interest" they actually owned, while others may simply have been extremely wealthy speculators who owned no such interest but simply wanted to place a bet that, say, Company Z was gonna tank.

It wouldn't give me any heartburn at all if the gummint simply said, you know what, we can't afford to pay speculators big winnings we never guaranteed in the first place.

The current chaos and continuing lack of transparency is a continuing looting opportunity. Credit derivatives are still unregulated and still continue to be sold (UPDATE: Timothy Geithner essentially confirmed this 3 mos. later here, while also failing to deny that derivatives sold today might be bailed out tomorrow), relating to mortgage-backed securities and lots of other things – only issuers like AIG could tell us what, but as far as I know, the gummint still hasn't required them to tell.

Where the people lead, the leaders will follow – I have a vintage button that says that, from back when Boomers helped force an end to the Viet Nam War.

For more details about the bailout and derivatives, see Dean Baker's piece at CommonDreams.

FURTHER UPDATE: Vanity Fair has a great excerpt from The Big Short by Michael Lewis, on the guy who was probably the first to figure out how to make a fortune betting against bad mortgage loans, Michael Burry.

FURTHER FURTHER UPDATE: Another good discussion of this subject at Charles Hugh Smith's oftwominds, with a description of the current state of looming, derivatives-driven disaster as of Feb., 2012: "[a]ccording to the Bank of International Settlements, as of June, 2011 total over-the-counter derivatives contracts have an outstanding notional value of 707.57 trillion dollars, (32.4 trillion dollars in CDS’s alone). Where does this kind of money come from, and what does it refer to? We don’t really know, because over-the-counter derivatives are [still] not transparent or regulated."