The Making of a Financial Crisis Part II

Previously we discussed what a derivative is and, more specifically, what a credit default swap (CDS) is and how they work. We saw that credit default swaps are actually comparable to simple insurance policies. Today I want to discuss a specific market where credit default swaps are used and what impact that has on our economy as a whole.

I want to focus on a place where people, companies, and governments go when they want to borrow money or lend money. After all, this is the kind of place where we could expect to find widespread proliferation or credit default swaps right? Enter the bond market. There are many kinds of bonds, but what I want to focus on are the ones that are backed by mortgages. 

Many people think that when you get a loan for your house the lender lends money of their own and you pay them back interest, making them money over time. That's the case sometimes, but most of the time the "lender" only holds the loan for a little while before the loan, along with many others similar in size, length and risk profile, are packaged and turned into something called a Collateralized Mortgage Obligations (CMO) and sold in the bond market. 

This is commonly referred to as the secondary mortgage market. As you may have guessed, the riskier loans are packaged into higher risk CMOs that yield higher interest. For example, a CMO comprised of mostly subprime loans would have pay more interest than a CMO comprised of mostly A-paper loans, but of course the subprime backed CMO comes with a higher risk of default.

As you can see, the lenders credit guidelines are simply a main street manifestation of what the bond market wants. The golden rule says "he who has the gold makes the rules". In the world of residential lending, the secondary mortgage market has the gold and they make the rules.

We all know the crisis started with subprime mortgages. Many are asking why the lenders guidelines were so lax; why they lent out so much money to so many under-qualified people inflating a huge bubble? But since we know now that the lenders are merely a reflection of what the bond market want we can ask a more informed question:  Why did the demand for riskier loans increase in the bond market, or more specifically, the secondary mortgage market? This is where we turn back to the credit default swap. 

Normally the the secondary market's appetite for subprime CMO's was kept in check. Consequently the lenders on main street originated a modest amount of subprime loans. Many bond buyers found places for subprime CMOs in their portfolios, but were careful not to be overly exposed.  But with the advent of the credit default swap, the game changed dramatically. Buyers of subprime backed CMOs could now, if ostensibly, insure themselves against potential losses. With this safety net the  demand for subprime debt went through the roof. After all, if you're insured, why not invest in the high paying CMOs?

This increase in demand for subprime debt in the secondary mortgage market trickled down to main street lenders who were funding them left in right in order to satisfy the now voracious demand. 

Still though, how did this happen? Surely the credit default swaps on these risky CMOs would become prohibitively expensive and demand for subprime debt on main street would be kept in check. But it was not. Why? Because there is one huge and unbelievable problem with credit default swaps: they are subject to absolutely no regulation.

Next week we will get into how a trillion-dollar industry looks with no regulation

-Jonathan Biggerstaff