The Wall St. Bookies

In order to understand the present economic crisis, more needs to be explained as to what the Wall St. “financial wizards” were up to.

First, let’s begin with the simple example of betting at the race track. You pick a horse that you think will win. The owner of the horse bets to win. You also bet to win even though you don’t own the horse. This is known as a side bet. You can make the bet at the track or off the track through a bookie. In either case there is money to back up the bet so if you win you will be paid.

Now on Wall St. a side bet is called a derivative. It is a financial investment that also does not require that you own the investment. For example, you can bet on interest rates going up or down, a stock index going up or down or whether a mortgage owner will default on his mortgage. These are all side bets that do not require that you own the investment. Betting on mortgage defaults were called “credit default swaps” (CDS) and it was these bets that caused the crisis. “Swaps” were sold by investment banks, were unregulated by law and no money was required to back them. Credit default swaps were actually insurance policies that protected the investor in the event the bet went bad. But why would it go bad? Housing prices continued to go up. No one could lose. Anyway you weren’t really buying protection because you were just placing a side bet. And remember you did not have to own the investment. So the three big investment banks i.e. Bear Stearns, Lehman Bros and AIG accepted bets that they could not pay off when the mortgage market went south and, as a result, those investment banks, the largest on Wall St., failed. It was “illegal gambling” that had been made legal by Congress in the year 2000. The bank lobbyists managed to persuade Congress with argument and large amounts of cash to pass a bill that removed derivatives and credit default swaps from regulation.

You see, a conventional insurance company that conforms to established standards by law has to set aside sufficient funds to pay off losses. So the “insurance” that the banks were selling weren’t insurance but rather another side bet, the credit default swap. It was a swap because you were swapping the default risk to a supposed insurer. But when the bubble burst there was no money to pay the loser. It was bye-bye baby. Now it’s in the US taxpayer’s lap. Unfortunately the whole world is suffering because of Wall St. greed.

One particular company should take the major blame and it has been brought to its knees. It is AIG, the largest insurance company in the world with offices all over the world. The former CEO, the man who built the company, was responsible for the move from insurance to credit default swaps making it possible to credit endless risk with no regulation. As a result, the loss to the company was $100 billion and the destruction of the corporation. The Feds are still pouring our money into it to save it. One economist calls it “lemon socialism”, i.e. losses are socialized and profits are privatized.

References:

The Baseline Scenario
Krugman, Paul
Wikipedia