While recovering from another illness I read an interesting piece on Daily Kos. I originally was writing this up as a response to Billmon's excellent article today, Chocolate Covered Cotton. For the record, he makes some very valid points. The whole system is now burnt, and we the average citizen has to pay for what really is fraud on a massive scale. Saying all this, I have to take issue on the idea on the concept of CDOs, Swaps and the entire idea of securitization of loans being total junk. That isn't to say that whats out there isn't toxic, but I'm looking forward.

The problem was never the product, it was the handling and regulation (or lack of) of these instruments. Derivatives that were traded were not transparent or executed on a clearing mechanism that most other commodities are traded on. The concept of the Credit Default Swap is actually good, yet how it was implemented was not. What we had was the equivalent of State Farm selling insurance it could not back, which in most states is considered fraud. Whether it is CDOs or something else, once more, what you had was T3 all the way for most of these things.

These instruments, if traded on an open exchange, in a standardized package that is fungible, would be excellent tools. What you need is clearing, when you trade corn or stocks, you have this. Clearing, for the uninitiated, is simply matching up and settling accounts between buyers and sellers on an exchange. You know who bought what and from whom at what price.

Derivatives, in regards to housing, should have been implemented in the same way that those used in other commodities, as a hedging tool. Now there are many forms of derivatives, but at the end of the day all it means is something that derives it's value from the value of something else. Price is "discovered" when the fundamental forces of supply and demand attempt to find some sort of equilibrium (for the record I subscribe to George Soros's view that there is no such thing, or central price point, only "cloud" of prices that sort of converge). In all markets, one has speculators and hedgers (also known as "commercials"). Despite the bashing of speculators, they provide an improtant resource...liquidity. Price requires information, from the fundamentals of the commodity at hand (crop reports for example) or even exchange-related information like trading volume and open interest. Ideally, all derivatives that are standardized should operate on a mark-to-market, that is whatever the last price was for such a thing last traded is the Price.

Don't get me wrong, there were bad products

Yet, what we had was several fundamental problems with these derivatives. First there was no real standardization, mortgages packaged together, all sorts of residential properties were jumbled together. These were not assembled by an exchange, but by an investment house. Often the investor was ignorant and wasn't exactly sure what was in those MBSes, just that they were promised a tantalizing yield. The Mortgage-Backed Security became a traded instrument, like a stock To make matters worse, when it came to hedging of such instruments, the Swap itself was also a non-standardized contract. Actually that wasn't the worst part, the worst part was that in many cases the same insurance was taken out time and time again.

These issuances were designed using the most sinister details on what would be considered "default", and like I said non-standardized. One contract, for example, would make one party liable for payment if their stock fell below a certain price. Credit Default Swaps should have stayed on their original purpose, as insurance, nothing more. And CDSes should have only been issued with their corresponding mortgage. You have a galaxy of Credit Default Swaps that are in reality not tied to any real mortgage! Well that's not entirely true. As stated in the previous paragraph, you had companies like Goldman Sachs and the late Lehman Brothers who issued multiple contracts on the same MBS. The dirty secret to this big sticky mess is that no one is sure who's derivative is actually tied to that MBS.

Picture it, here you purchased a home with a new mortgage. The mortgage was sold to other investors because the bank that issued you yours needed the cash to make more lending. The investors on the secondary market want to hedge against you possibly defaulting on your mortgage, engage in a CDS. Now the seller of that CDS, unless they hedge, hopes that you the borrow of that mortgage doesn't stop paying. Now take this situation and multiply it by a couple hundred mortgages and then packaged like those Frito variety packs into one thing. Yes, I could go into CDOs, but I'm trying to make this as easy to understand for the those who never even heard of the word derivative. So here we have these Mortgage Backed Securities, all not really standardized. All of them now have a CDS tied to them. So far, so good. But here's where things begin to get hair, so hang on, gang!

Chances are those Fritos...er Mortgage-Backed Securities (MBS), or in this case your home, was sold to another investor. So we've gone from the bank issuing the mortgage then selling it to say Investor #1, now Investor #1 has sold it to Investor #2. Because there is no real central exchange, there is no clearing. That means that others aren't aware that your mortgage was sold again to someone else. Worse yet, remember those Default Swaps? By the time Investor #2 got that MBS, another Credit Default Swap was issued, in fact, two or possibly three or four more were issued. Why? How is this possible? In many cases, as we are all learning, the original issuer of that CDS wasn't aware of the sale from Investor #1 to Investor #2. On top of that, because these aren't cleared and unregulated, there is no rule or law that says there has to be one Credit Default Swapt tied to one MBS. Its like me selling you a car and then going to another person and selling them the same car.

At this point I have left out two critical things, price and why the hell would someone want to sell a CDS. The two are actually interlinked. Under a normal market operating enviromnent, everyone knows the prices of something. If you punched up the price for IBM, you will get (as of this typing) the last traded price of $89.12, with a Bid (that is what someone is willing to pay for it) $89.11 and an Ask(that is what someone is willing to sell it for) $89.12. At the end of the trading day, whatever the last price was at close, that's the "value" of your position. Mortgage-backed Securities worked on a Mark-to-Model system. Basically it eschews the market system and product is valued by what is essentially a series of assumptions. These assumptions came in the form of formulas showing things like cash flows and leases and future value of homes, etc. There were no standard models, you couldn't really say well MBS #1 looks cheaper than MBS #2, unless one package was nothing more but subprimes and the other luxury condos for the Fortune 500. The investor had only one guidepost, you could say, and that was the ratings agencies like Moodys. It was extremely difficult to investigate every mortgage in that security, so an almost sense of laziness overtook the investor and just relied on whatever the rating agency said.

So why would someone want to sell a credit default swap? I mean, what if the homeowner went bust? When it came to mortgages and CDSes, the Swap was tied to the Mortgage-backed Security, not to an individual mortgage. Sellers of CDSes essentially figured that if they bet right, that a few rotten apples inside an MBS package won't bring the whole thing down. In return for a promised payout if things did go bad, the CDS seller would be getting payments. Remember, a Credit Default Swap was nothing more than a fancy insurance plan. These would be structured, for example if X amount of mortgages went into delinquencies and/or the ratings agency said that MBS was no good, then the payout would be made to the buyer of that Credit Default Swap.

Now remember how I told you that firms were selling more Credit Default Swaps than there were mortgages? Because they were unregulated, it was like the Wild West. The ratings agencies helped the CDS issuers and the mortgage originators, so long as they said things were kosher, why not issue? Because banks and other financial institutions were able to utilize the power of leverage (also known as gearing), issuers (and buyers) could sell (or buy) much more with their capital. For example the average leverage in some places was 40, so for every buck they had they could pretend they had 40 dollars or euros or what have you. Believe it or not, that's the cherry on the sundae, the real good part was that they were able to borrow at ubber cheap rates.

Enter the speculators. Previously, I told you that speculators provided an important resource, liquidity. In a normal market operating environment, this is great. But in situations like this, where things start to go askew, they can be a liability. Now the speculator in this case, he's hoping that there are defaults, he wants the big payout. And when you're dealing with leverage, the return on capital is astronomical.

A funny thing happened off the exchange

You also get odd situations. For example, Goldman Sachs was a large purchaser of Mortgage-backed Securities, yet also bet against themselves buy purchasing those Credit Default Swaps. In a way, they were going long and short the mortgage market. But it isn't Swaps on mortgages that just interest them, it's also Credit Default Swaps on corporate debt...now we get to what I call the killing fields of the financial world.

Imagine if you will....you take out a life insurance policy, and unbeknown to you, your banker taking out a life insurance contract on you and then hiring a hit man. Lets set it up this vicious triangle. Now pay attention here. You have:

1) The issuer of the CDS
2) The purchaser of the CDS
3) The firm issuing new debt.

Credit Default Swaps also occured with corporate debt as it did with mortgages. In one scenario that has happened in reality, you have Company A (in this case, oh I don't know, lets just say IndyMac) that needs to issue $50 million in new corporate debt so it could finance new mortgages. This debt is quickly sold to Company B (say Goldman Sachs), but Goldman wants assurances so it goes to Company C (say Lehman Brothers) to buy some Credit Default Swaps. Lehman says "why not? The market looks good, we'll back those loans with a potnential payoff if there's trouble." Now comes in the lawyers and financiers, they negotiation the definition of "trouble". Remember, all of these products right now are unregulated, there is no clearing, nothing..no rules. So in this case, "trouble" is defined if X amount of mortgages behind that debt issuance goes bad..AND/OR the price of Lehman's stock drops..AND/OR the credit rating of both go down to say AA (S&P rating) or Aa1 (Moody's rating). If these variables occure, the deal is considered in default and a payout is issued. But wait it gets more evil.

Goldman comes back to Lehman and says "listen, you want more premium?" They offer to buy more Credit Default Swaps several times over on the same original debt, lets say ten times over. So here we have $50 million in debt outstanding, but Swap contracts now representing $550 million (the first CDS plus the ten more). For Lehman, they figure why not, their ratings are good, Moodys and Standard & Poors says that first 50 mil debt is good. Free cash to them they think. So the deal is done.

No sooner than closing the deal, Goldman has their trading desks shorting Lehman Brother's stock. Remember, there are triggers in those CDSes, one of which is a fall in the stock price. Word gets out that Goldman Sachs is bearish on Lehman, so others like to follow in Goldman's coat tails, also begins to short Lehman. On top of that, folks begin to bid down the price of Lehman's debt. Eventually one of the triggers happens.

Much ado about Derivatives

After hearing my story, you are probably wondering why am I still defending the idea of MBSes and Credit Default Swaps. What I highlighted above was the end result of no regulation. Regulation keeps everyone honest....well for the most part.

Though an over simplification, I needed to show in the abuse that not only can..but has occurred. The Right Wing loves to say less government. The Libertarian will say no government when it comes to business. Yet as shown above, in the absence of rules and clearing, no one comes out a winner.

Goldman Sachs, though appearing a "winner" in the above example, today is only a shadow of its former self. Indeed, the entire investment banking industry is now in the toilet for the most part. But there is ways to fix this.

Derivatives should be meant to be a tool. Banks need capital to issue loans, they cannot be tied up to existing mortgages. Mortgage securities need to be regulated, if you cannot package them, then place them on an exchange by themselves where there is clearing and regulation. Clearing is critical, I cannot emphasize this enough. It is important to know if there truly was a buyer and a seller and have that transaction recorded.

Regarding Mortgage-backed Securities, either the Commodities Futures Trading Commission or a new governmental body is going to have to come up with standards. They also need to be fungible, meaning you can exchange one commodity with the same, or for housing one prime mortgaged single-family home with another. Classifications for real estate need to be harmonized through contracts that can be traded. Perhaps, for example, MBSes that are only single family homes of a certain credit quality and ONLY meeting those criteria. A separate one for sub-prime, another for duplexes or commercial buildings. All of these securities should have their properties' information available for the investor. On a regulated exchange, this could happen.

For Credit Default Swaps any issuer of such instruments MUST be able to show it has access to capital to back up any claim. If I were to issue a CDS for $100 million, I better either have that or a % amount in the bank, but also easily available to borrow the money. If there has to be borrowing to cover the claim, then I can't borrow more and be forced to curtail further activities until that CDS is off my books. For speculation of CDSes, impose a margin scheme like we do for other commodities. In a margin scheme, for the seller of the CDS has to put down an X % of the total value of the contract, and the same should be for the buyer. CDSes are often quoted in spreads, or points, use the same mechanisms we have had for futures contracts on the 10-year note for example.

Now I know what I'm going to be asked, why bother with this at all? Why not just let the banks local banks go to the fed window and get the money? By doing that, you put more stress on monetary policy and frankly it is much faster and easier to simply sell off the loan to a secondary market. Before things collapsed, Mortgage-backed securities made good (though speculative) investments for organizations like pension funds. What ruined it was the greed and abuse of the tools invented. Markets work great when regulated, not unregulated. You need rules and transparency.

The mess we have now, perhaps the solution I can think of is to separate the Mortgage-backed Securities from their Swaps. Or more to the point, separate the extra CDSes from that same loan. It would not surprise me to find say 30 Swaps to that one security. Find out which was the first one, and make good on paying that. For the rest, well the loss there is the premiums paid. Unfortunately, given the non standardization of the existing pool, mark-to-model must be re-implemented to stabalize things, but also a re-examination of the portfolios.

This comes to the credit rating agencies. They not only dropped the ball here, I would some criminal negligence has happened. Frankly, if any industry ought to be nationalized outright, it's this one. Here we have select group of companies that really dictate whether a company or a nation's debt is viable. OK, I can see the conflict of interest if the US government outright owned say Moody's or AM Best. But perhaps a non-profit organization that isn't beholden to private owners or political influence should be the best route. We could keep Moody's and Standard & Poors, but we need a new organization that rates corporate, mortgage, and government debt. A true neutral party.

But don't give up on derivatives, if used wisely they can be an excellent hedge. In stocks, if one purchases a 100 shares, one can hedge by purchasing a Put option (an instrument that gives the option owner the right but not the obligation to sell something at a specific price until a given time). Every investor has a right to hedge their portfolio. One needs assurances of these things for capital to flow. Counter-party risk must be met.