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Saturday, November 29, 2008

Housing caused a Financial Problem, Greed and Stupidity made it a Crisis

There are derivatives and derivatives, most are clever instruments that are extremely efficient in generating leverage and spreading risk. It is in the way in which some of them were used that created the financial crisis.
Credit Default Swaps CDF’s:
Stupidity is issuing Credit Default Swaps insurance without setting aside any reserves.
Greed is accepting fees and payments for them without doing anything to legitimize their existence.
Stupidity is entirely relying on ratings and still not setting aside reserves to cover the risk of defaults.
Greed is allowing parties unrelated to a transaction to place side bets on defaults in order to receive fees and payments.
As a result of not setting aside reserves more CDF’s were issued than the issuers could possibly cover.
The taxpayers are now funding the liabilities of the issuers of these CDF’s (AIG and others) because the insurers were too greedy for fees and too stupid to set aside reserves when they should and could have.

Collateralized Debt Obligations CDO’s:
Stupidity is not balancing a portfolio by combining low risk/low interest CDO’s with high risk/high interest CDO’s.
Greed is having only high risk/high interest CDO’s to maximize returns without regard to the potential exposure of being wiped out.
As a result of this greed and stupidity the banks are holding worthless high risk/high interest CDO’s that have caused them to be greatly over leveraged and unable to lend.
The taxpayers are now funding the Banks that were overexposed to these worthless CDO’s because the banks were too greedy and too stupid to maintain a balanced portfolio of low risk/ low interest CDO’s.
So instead of behaving like rational prudent human beings, the management or guardians of our financial system were driven by greed and stupidity. Instead of treating one of the greatest inventions of our time, derivatives, responsibly and with care to expand credit and the economy, they instead turned them into a lethal weapon that changed a simple financial problem into a global nightmare.


What are Collateralized Debt Obligations, CDO’s ?

The instruments or Derivatives that were used to bundle mortgages issued by banks to homeowners are called Collateralized Debt Obligations (CDO’s).
These CDO’s were resold to other financial institutions to finance additional lending or issue more mortgages.
Each CDO was divided into roughly three slices or coupons. Coupon#1 was the safest guaranteed/low risk and thus carried a relatively low interest rate e.g. 5%, Coupon #2 was not entirely covered, held more risk but carried a higher interest rate e.g. 7% and the Coupon #3 was high risk and thus carried the highest 11% to 13% interest rate.
In case of any default or shortfall, holders of Coupon #1were the first to get paid and any surplus went first to coupon #2 and last to Coupon #3. Therefore, if any trouble or shortfall occurred the first coupon holders to get wiped out were those holding Coupon #3.
One of two things happened Coupons #1 and #2 were easily sold to prudent investors and the banks got stuck with coupon #3 or the banks were so greedy that they held on to coupon #3 because it had the greatest payout even though it carried the highest risk.

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