A member of CIRCLE should get upset when we have government people (Greenspan, senators, etc) saying that the banking industry was self regulated. Over 10 government agencies overlook the banking system. The problem is that the government, through “regulation”, decided to push uneconomical policies through the system. The banking subcommittees mandated (through the Community Reinvestment Act) that Freddie and Fannie should buy loans from banks and mortgage originators that were way out of wack with what would have normally been done. It was George Bush, Barney Frank, and Maxine Waters that pushed for accelerating the “ownership society”, making people that couldn’t afford homes get into them at stupid rates and no money down. Let me break here to describe the process:

Using criteria set by Fannie and Freddie, banks and mortgage originators make loans and sell those “conforming” loans to Fannie and Freddie. (Non-conforming loans are either kept by the banks or sold to some investment banks). Then, Fannie, Freddie, and I-banks package a large number of them together and sell to bond investors. In the case of Fannie and Freddie, their loans are backed by the government. For investment banks, they had to buy insurance on theirs to make them more appealing to the market. For anyone that buys insurance, someone has to be on the other side to sell it. In the investment banks case, they bought their insurance from companies formed just for that purpose. These guys really scrutinize the packed loans since it’s their neck on the line and actually require the banks to overfund these loan packages to better insure the value.

What happened here (as best as I can tell) is that the government made policy decisions that allowed a whole bunch of people that would have never been in the market for a home, enter at no money down (the big deal in CA was to buy a house with a 105% loan or use a conventional loan tied with a maxed out equity line. The end result was the ability to get into a house for absolutely nothing or less. Imagine if you could buy something without spending a dollar, would you be willing to get into a bidding war to get it? Yes, since you have nothing at stake). The government did this by telling banks that they can’t make loans based on basic risk techniques since they are unfavorable to minorities (studies show inner city individuals have 4x the risk. And, by coincidence, most of the people in the innercity are minorities). Up to then, banks did not lend money to those that had a high risk of not paying their debts (go figure) or would price the loan accordingly. Once they mandated this, the government instructed Freddie and Fannie to buy these loans. The banks were all too happy to sell them since they knew they were bad but had no choice in the matter.

These loans, as well as better loans packaged up by i-banks, were packaged together into these bonds sold to investors. Once the housing market bubble popped, everyone who owned these bonds started to freak, fearing that the bad loans within these bonds would default and the bonds would be worth far less than advertised. Who was freaking out? It was mostly foreign governments and banks that owned them since they had too many dollars (because US consumers spent more than they made).

Another aside: Up until this cycle, housing markets within the US were not tied to each other, meaning that Boston would go through a funk but CA would be ok. This helped in the packaging of the loans as they were careful to package in a way to minimize the cyclical impact of housing prices. The problem was that Fannie and Freddie’s actions (and the mania created by it) made the entire nation have the same housing price boom which negated the attempts to diversify within these bonds.

Once investors imagined the toxicity of these bonds, it caused the prices of them to drop dramatically (especially dramatic for bonds since these bonds were viewed as near cash like in nature). Then banks (that owned these pieces of paper) started to fear that the other banks who had them also were at risk of defaulting themselves, causing this massive credit freeze that we are now experiencing.

So, now that the base has been built, let’s talk about Credit Default Swaps, aka CDS’s. Up a few paragraphs I mentioned how investors would buy insurance to protect/increase the value of the packaged loans. They did this through CDS’s, just like investors will buy options to protect the value of their stocks. The difference is that options are regulated by the industry (and overseen by the government) and have safeguards to make sure that the person selling the option can make good if the option has value. In the case of the swap market, the contracts are essentially handshake agreements between two parties with both accepting the risk that the other side may not make good. When the contracts are very specific and the parties know each other, the risks are minimal, but buyer beware is in place. This CDS market really didn’t exist until the last decade and grew as the housing market grew. Smart people started to see the risk in these packaged loans and started to bet against first the insurers of the bond insurance, then i-banks, then banks that owned these toxic bonds, and on and on and on. Who was selling this insurance to the speculators? Mostly i-banks, some commercial banks, hedge funds, and insurance companies. For awhile it was a lucrative venture since, like options, you receive a payment for selling the swap and most of them would expire worthless.

At present, the credit freeze has caused a mispricing of these bonds (in many cases we would have to see such a drastic foreclosure rate where 40% of the country would default on their house and those would have no value for the bonds not to be priced at full value) as fear has taken over from logic. This mispricing has caused CDS’s to actually take on value. How much is still very much unknown but is a pimple on the ass of the real problem, in my opinion. An example, Fannie and Freddie corporate bonds were being priced in the market at 30-50 cents on the dollar, making the $1 Trillion dollars of CDS exposure look like it could bankrupt everyone. When they went through the process (a well defined industry defined process) to assess the true value of those CDS contracts, it turned out to be less than $20 Billion of real exposure, a large yet very manageable number. The total notional value of CDS’s is somewhere around $50 Trillion. But that number doesn’t mean much. After looking into this a little more (and this e-mail is already too long), the impact all of these will have on the market is immaterial.

Now, to finally get to the point about the need for regulation… Regulation is a very good thing and needed in almost every market (not just financial markets, but in food production, technology, etc). Regulation, when done correctly, represent the basic rules of engagement for 2 or more parties. Regulatory rules help lessen the friction in transactions and ease the transfer of value (not wealth). They also set up recourse in case there is fraud. The problem I have is that once the government gets involved with regulation, the actual purpose of regulation is subjugated by the desire of politicians to enact their own whims/policies. In the case of housing and the financial markets, it was the federal government’s desire to boost the percentage of homeownership and make lending “fair” that caused good economic regulatory efforts to be thrown aside as they were diametrically opposed to the policies they wanted to enact.

The best example of good regulation I can think of is in the tech world. The IEEE (Institute of Electrical and Electronics Engineers) is a non-government involved body of engineers that sit around a table to decide on the common protocols required for electronic devices to interact with each other and within an electronic system. This group was formed by engineers, for engineers in an effort to make electronics more useable, to lessen the “reinvention of the wheel” for basic knowledge, and to strengthen the value proposition for consumers of technology. It has had its ups and downs, but it is a stable process that everyone trusts. If someone wants to break away, they can, but everyone understands that there is a risk in doing so (incompatibility, higher development costs, lower potential end market). If a core group tries to take control of the IEEE process (much like Microsoft and IBM have tried in the past), they typically fail as the majority of the players bypass them since it is done through consensus. Just think if the government got involved and a senator decided that XYZ corporation, run by a minority, was being treated unfairly by IEEE because they would not adopt his great idea. The senator would put pressure on the group to accept XYZ’s suggestions. Why didn’t they accept his suggestion in the first place even if it was a great idea? Probably because it wasn’t a great idea for everyone (too costly, too risky, etc). Now that the senator pressured them to accept it, the whole industry goes down a path that was not the most optimal solution. The costs would be born by the consumers and the businesses in the industry through higher priced products, lower investment returns, and lower innovation. All because politicians wanted to help the little guy. Nice intentions, drastic results.