Another derivative instrument that was invented to justify AAA rating were Credit Default Swaps (CDS). CDS are like the insurance i.e. you buy a CDO and if you are worried about defaults, you could buy insurance for it – a CDS. In some cases, The contract with a CDS issuer stipulated that you’d get some money every time a CDO you bought lost value. But unlike regular insurance a) CDS weren’t regulated, so the insurer didn’t have to satisfy any capital requirements to sell a CDS b) CDS just referenced a CDO, they weren’t tied to it. I.e. you could buy a CDS referencing a particular CDO even if you don’t own a CDO. In fact many people could buy a CDS referencing the same CDO. It was a little like 10 people being able to buy insurance on your house. This way if your house burns, or even loses its value on the market, the buyer of this “insurance” will get paid, but this person will not be the one losing a house. This made CDS perfect vehicle for speculation or even short raids: if you believe real estate will go down you can buy a lot of CDS to make money; if you want stocks of a particular bank to go down, you buy a lot of CDS for CDOs held by this bank. Just the act of buying a lot of CDS will drive the value of CDOs held by the bank down and cause this bank to experience losses. (if it is known that a 100 of people bought insurance on your house, the value of your house will probably drop) A total amount of sold CDS greatly exceeded the number of CDOs held by banks demonstrating that CDS were used for speculation rather than insurance.

All banks are required to maintain a certain minimum ratio between the amount of money they can lend and the amount of capital they have. Normally this ratio is around 1/10. Simple bank operations involve taking our deposits, putting about 10% in reserve, lending 90% and making money on the spread. In 1999 the government repealed the Glass-Steagal act that separated lending business from investment. This was what allowed banks to invest in CDOs to begin with. But the value of CDOs a bank had counted against the bank’s capital requirements. The question was – how to estimate this value e.g. using a model, using potential cash flows while holding this papers for maturity i.e. until the loans are repaid. In 2007, SEC decided to value these securities based on the mark-to-market rule i.e. based on the amount of money you could get for these CDOs on the open market. But… as the values of CDOs started to drop, banks had to right off the losses and to put more money in reserve leaving less money for lending. Every quarter banks had to report paper losses in CDOs market value as real losses. This caused banks to sell the CDOs driving the value of CDOs even lower. Even CDOs that were based on investment grade corporate bonds lost their value. This amplified the losses exponentially since the losses in the value of CDOs greatly exceeded the actual losses in mortgages.

To make matters even worse, in 2004 the SEC in its infinite wisdom agreed to exempt 5 major investment banks – Lehman Brothers, Bear Stearns, Goldman Sachs, Morgan Stanley and Meryl Lynch from leveraging limits i.e. they could keep even less money in reserve and invest more and more money the borrow (including our deposit money) into CDOs. As a result, companies like Lehman Brothers and Bear Stearns were leveraged 30 or 40 to 1. I.e. for every $1 they had in reserve, $30 or $40 were given out as loans. As loan losses mounted, the value of CDOs dropped – in part because of real losses, in part because other banks were selling them and nobody wanted them any more, and in part because of short sellers’ speculating on Credit Default Swaps, companies like Lehman didn’t have enough money in reserve to do business.

After Lehman went out of business, AIG had to pay for a lot of Credit Default Swaps that insured CDOs sold by Lehman. Not only didn’t they have enough money, their credit rating was cut which means they had to have additional collateral on its debt and had difficulties getting more loans… Here goes AIG.

All these companies having problems put money market funds in jeopardy. Since money market mutual funds aren’t insured as banks’ money market account, they can lose value. Some of these funds were invested in CDOs. The panic “run on banks” started with more and more people withdrawing money from the money market funds. But money market funds are vital for business – a lot of businesses keep money in these funds (as well as some of the retirement money and our 401Ks). So the threat to money market funds was a huge problem. Additionally, people with large deposits in banks started withdrawing money from banks.

Normally when a bank doesn’t have money at hand to pay depositors, it borrows from another bank, then repays from payments it gets on loans. But since a) banks needed more money in reserve had less money to lend b) no bank knew what another bank might have on its balance sheet, so banks were afraid to lose money c) by now there were simply fewer large banks, the lending stopped.All lending – to other banks, to businesses, etc. Shipping companies for example, that normally don’t get paid until they deliver the goods, couldn’t get short term loans to pay their crew so that the goods could get delivered, even good solid shipping companies with stellar rating. This is what made this problem so serious – with no lending even to good businesses, with the potential losses in money market funds which are vital for business, without intervention the whole financial system could have collapsed. We may dislike the bailouts, but without them the situation may well have been much worse.

This is in summary. I might have missed a few details or the order, but this is basically what happened.

Sherin
The Money Maniac