Are "swaps" a good or bad thing?

So often I hear folks ask "Who is to blame for the current financial crisis, home buyers who obtained mortgages they could not afford, or the banks that lent them money? But in the cases of real estate mortgages, at least there is an asset should the borrower default. I don’t see how risky mortgages should be enough to bring down huge financial institutions.

And then I read about these “swaps” - and I wonder how these things can even be legal? As I understand it, institutions would sell various financial instruments, and then would offer “swaps” - essentially guarantees that the instruments would not lose money. Because swaps are not technically insurance, there is no need for the issuing institution to have any assets on reserve backing their obligation. So when the various financial instruments started to go south, folks started to call in their swaps to cover their losses. And there are some $50 trillion worth of these essentially worthless guarantees out there, that the issuing institutions cannot afford to pay off.

Have I gotten this grossly wrong?

If not, how is the issuance of swaps not criminal fraud? Why was it permitted/encouraged to get to this point?

The issue isn’t the swaps themselves; it’s that the various parties to them were not required to hold sufficient capital to meet their obligations. It’s not criminal fraud specifically because it’s not illegal. The industry should be more regulated, but it should not be killed off altogether.

Is this a meaningful distinction? Are there swaps that were backed by sufficient capital?

I’m no expert in criminal law (and know even less about finances!:)). But it seems to me that they were selling something of entirely illusory value. Wouldn’t I commit a crime if I sold you an amulet guaranteeing to protect you from misfortune?

Ah, but when the price of the asset collapses, as it did when the housing bubble burst, the asset no longer covers the loan.

Writing insurance that you can’t cover certainly skates the edges of financial fraud. (Although, to be fair, any insurance company can fail given enough bad luck. The only alternative is to have infinite capital.)

The justification for not instituting a capital requirement for credit default swaps is that the buyers are large and presumably sophisticated financial institutions themselves. It’s not as if Joe Sixpack, or even Joe Cabernet Sauvignon, is wandering in off the street and buying a credit swap. Large institutions ought to be capable of investigating counter-party default risk on their own, without regulatory help.

As we’ve seen, however, this has not proven to be the case. Size and sophistication are not guarantees against stupidity. And when large buyers and sellers are stupid, innocent people get hurt. I’m not averse to defining the writing of swaps, without adequate capital, as fraud.

Yeah, but there is a salable asset to cover at least a portion of the debt. I’m not averse to banks losing money in times of economic downturns, because they lent money gambling on continued increases in RE prices. I haven’t heard anyone suggest that the banks - or property owners - should pay back the profits they made over the preceding decades.

In many areas, RE prices are adjusting down - not (in my inexpert opinion) collapsing. If RE prices completely collapse in an area, then it suggests to me that a whole bunch of folks - builders, land speculators, lenders, and borrowers - all grossly erred in their assessment/gamble of what that particular market could support. And the areas facing the steepest drops in RE prices seem to be many of the same ones that had the steepest past increases.

Yeah - I never had much sympathy for the insurers who expressed astonishment that a hurricane might actually cause damage in Florida that they might be expected to pay off, followed by what impressed me as the rewriting of the rules after-the-fact. :rolleyes:

There’s no reason why there can’t be, and there probably are a few out there that are fine. But since they’re not required to be disclosed,

Do you seriously think that a magic amulet is analogous to a derivative security?

Florida’s insurance regulations are fucked up beyond belief, so the situation is a little more complicated than you suggest.

I’m not that knowledgeable about the issue, but I’ve been hearing from a number of sources that the real problem is a lack of a secondary market for credit swaps. Without those, nobody really knows how to value them.

But as far as having assets on reseve to back obligations fully, that goes against the very definition of what a “bank” is.

Florida regulates property insurance pricing. Insurers were not allowed to charge a fair price for hurricane risk.

Well…you are correct that banks should not need 100% assets to back all their obligations but then CDS were monstrously out of control. The SEC estimated that worldwide there were $58 TRILLION (:eek:) in outstanding contracts.

Read that number again then consider the entire world’s GDP is something like $65 trillion for some perspective. According to the SEC the CDS market, “…is completely lacking in transparency and completely unregulated.” (cite)

Do you really need to look further for a problem?

There were a number of factors that contributed the crisis, swaps being one of them, but ultimately it was all our own greed that made the situation go out of control. The swaps were good instruments in the sense that it created money transactions, i.e., it got money and the economy moving. The swaps are based on real estate assets, which were booming for some time now. Everyone knew that it was at least on the high cycle, if not an actual bubble, but no one did anything about it, thinking that they could get out when things got bad. In essence, people were timing the market. When the bubble burst, people lost confidence in these assets rapidly, so fast that institutions couldn’t get out of them unless they wanted to through a fire sale.

How did then everything get so bad? I argue that Fannie Mae and Freddie Mac, while not the sole cause, were huge enough to distort the unregulated market and exasperate the problem. They were either buying up paper, or they were guaranteeing the loans. The market saw what they were doing, knowing full well that the government would not let them fail (or gambling on that knowledge). So, they continued the practice of either buying and selling to each other, or to the GSEs or to both. Little did they know that the GSEs were also selling to each other, thus also further distorting the market.

People knew that these things were risky, in some sense. The government tried to regulate it, but who wants to kill the golden goose? People were getting home ownership, politicians had feathers in their caps, the market was moving, and people were making money. My feelings are that even if they tried to regulate, the damage would already have been done, because people started defaulting on these loans. The regulation would have stopped the GSEs from their market distorting behavior, and might have provided transparency in the markets, but they probably wouldn’t have done nothing to stop the real estate bubble from popping. Bubbles are artificial by nature, and without an extraneous component they will pop – too quickly for most people to do anything about it (see e.g. tulips, silver, tech stocks, real estate).

Now, the current problem is that markets aren’t moving because there is a lack of faith in these instruments because no one knows how to value them. Banks, people, institutions already have too much money tied up into these things and might be content to let it play out, but in the meantime markets slow down and possibly freeze (or recession comes into play). If these swaps as well as the CDOs/MBSs/derivatives/whathaveyou can get moving, the market can start to return to normal.

I intentionally chose an extreme analogy - but please educate me why it is invalid.
As I see it, one is a worthless guarantee of protection against undesireable occurrances. The other is a nifty piece of jewlery!

Seriously - both someone going to a fortuneteller, and the buyers of worthless derivative securities - should know better. But my understanding is that if I give a gypsy my life’s savings for a magic potion and then have second thoughts about the wisdom of that transaction (or the efficacy of the potion), the gypsy can face criminal prosecution.

Can you explain to a non-finance expert why these “swaps” are anything other than a complete fabrication, where industry insiders simply collude to share risk on paper, with the desire of artificially inflating the value of something or another?

And I readily acknowledge that I know less about insurance than I do about financials. So I retract my comment about Florida insurance and hurricanes.

Thanks for the very clear, concise explanation. It sheds a little light on a very complex situation - which I feel is poorly explained in the mass media I’ve encountered.

This kinda confuses me. I’ve always been way on the conservative side of personal finance. I own my home and both of my cars, have never carried a credit card balance. Generally been a tad slow to get into or out of any market swing.

But it has seemed to me for a long time that much of our financial system was based on the hope that things would just keep going up, while discounting the possibility of a downturn. Seemed like a house of cards based on little more than optimism, and a desire to make short-term goals.

I had equal disdain for folks who over-leveraged themselves to buy a house/car/TV, as for institutions that over-leveraged themselves for whatever reason. But now it seems folks are acting as tho these aggressive borrowers did nothing wrong. I don’t understand it.

I like to play poker and gambling on the golf course - but I always go in knowing my maximum burn. And if I lose my stake, I have no one but myself (and lady luck) to blame. Exactly how does the group belief that good times will continue - at least until I get to make my profit - terribly different than gambling?

This isn’t an inaccurate way to look at things. If you have one of these securities, and it’s performing, and now you have a guarantee on it, which is also performing, and everyone else is doing it, why wouldn’t you go along with it, too? Or, another way to look at it, what if tomorrow, the government started printing on all currency, “You can use this for your financial transactions, but we’re (the gov’t) done backing it.” That’s sort of what happened (though in my last example, there would be a world-wide collapse, possibly a Mad Max type dystopia.) People in the financial system hedge against downturns, or there are those that completely thrive off of it (the shorters), it’s just that in this case, one side heavily outnumbered the other. Things are balancing out now the other way.

No, they probably didn’t. As long as they have cash flow, they are ok. Debt can be managed responsibly, even if the people using it are using for irresponsible things (hookers and blow). That’s the beauty of credit. People are already forecasting a similar problem with credit cards. However, I think they have a different model as those interest rates are way high and they do take into account massive default (at least that’s what my friends in credit risk finance tell me).

In some sense, yes, it is gambling. But, people who do this for a living have hedges and have way more information than I know what to look for. Finance is risky, make no bones about it. The economy will have downturns, otherwise, we would all be robots. The way you live, i.e. super-responsible, is good for you, but there is little risk for you to capitalize (i.e. profit from risk-taking) because you take little, if any risk. If everyone were like you, we would not have the modern economy we have today, and I dare say, none of the modern conveniences we have today, either.

Ah, but there’s the rub. These folk/institutions act as tho their cash flow will continue uninterrupted, unless it increases.

I’m curious, what exactly would we have to do without, if the SOP were not to assume quite as much risk as seems prevalent these past couple of decades? Because I have long suspected that folks/institutions engage in unsustainable practices primarily to increase the acquisition of consumer goods and disposables - which is not something I’m excessively interested in.

And it is fine with me if a whole bunch of folk wish to mortgage their future in the hopes that happy times will never end. But I start getting a tad miffed when things go south and I end up picking up a good portion of the tab for their high living.

When Paulson was at Goldman he fought for swaps. Swaps are designed to be be opaque. They were intended to keep outsiders from the dirty work they were doing. Paulson also fought to have margins go from 14 to 1 to 40 to 1.They just had to do it to compete,don’t you know. They sold swaps they knew they could not back if something went wrong. They did it anyway and made billions. Paulson is worth about 750 mill and now he is our savior. I do not trust him at all. He sold like a traveling medicine show.
There are a lot of economists I would rather see in charge than that thief. Many warned us about what they were doing. Yet we go to the guy who sold this bill of goods to fix it.

Dinsdale, you can read some good background on what credit default swaps are, and why institutions write them, in this thread. mazinger_z seems to be discussing mortgage-backed securities, not swaps.

Thanks for the link.

True, I am, but the mechanics of what I say still hold true, particularly to the underlying failure (i.e. housing bubble), because that’s where this discussion is going to go anyway, since a better understanding of why CDSs are good or bad involves a discussion as to how they are now an issue.

Can you explain the relationship between the amount of CDS contracts outstanding vis a vis the size of the world economy, and why one needs to be constrained by the other?

Are you actually interested in learning anything, or do you just want to bitch about stuff you don’t understand?