Wednesday, September 17, 2008

McCain: My guy Gramm caused this problem, now let us fix it

We were talking yesterday about AIG, its collapse, and why the mortgage crisis would hurt insurance companies, and I had no idea. Since then I've heard an excellent interview on Fresh Air and done some reading on the topic, and I think I have a bit of an answer. I may be missing some of the details, but it looks pretty damning for McCain and his economic plans.

To understand this we need to go back to a pretty ugly time, a time back in December, 2000, right after that thug Scalia and his henchmen on the Supreme Court assigned us Bush as our Resident. The federal budget was going through Congress, and Phil Gramm, McCain's biggest economic advisor, called up a bill that had been considered dead, the Commodity Futures Modernization Act, and muscled it into the budget bill, which then passed, right around midnight before the Congress went home for Christmas.

It didn't actually deregulate anything, it just prohibited the federal government from regulating a new, and little-known financial instrument called a swap. You may never have heard of a swap, but the swaps are what made the saps at AIG go down.

Now just keep that little bit of history in your mind for a while. Time goes on, the real estate market goes crazy, and people with money burning a hole in their pockets figure that a way to make tons more money is to bet on the following two propositions: real estate prices will always go up, and people who don't have the ability to pay their mortgages will somehow pay them. This bet leads banks and fly-by-night mortgage outfits to start lending out tons of money, even more than the house is worth, and even to people who have bad credit, their income doesn't meet standard underwriting standards, and so on. They then bundle up a whole bunch of these mortgages and sell them on the secondary market in the form of various kinds of securities. I guess the idea is that even if some of the mortgages don't perform, they will be bundled together with a bunch of other very profitable mortgages, so it's a safe bet. (Would you lend the price of a house to someone who doesn't have the money to pay it back? Me neither, but maybe that's why we're not smart enough to run Countrywide or these big banks.)

But, it's not really a safe bet, because it's not safe enough to get reasonably prudent investors to buy them. The risk is too much. However, we've known for a long time how to get people to invest their money in something when they think the risk of losing it all would be too great. It's called insurance. You wouldn't spend $10,000 or 20,000 on a car, or $100,000 or $200,000 on a house, if you thought that you would just be wiped out if the car or the house were destroyed and you were just out the money. Some people won't even spend $1,000 or $2,000 on a vacation without buying insurance on it.

So they figured out that they can just insure this risk too. That's what a swap is. They created an instrument called a credit default swap, in which Investor A pays a premium to Company B, and Company B promises Investor A that if one of the borrowers fails to pay their mortgage, Company B will step in and pay Investor A their investment. Company B gets their money, Investor A gets to make the investment and to receive the income that the investment is going to generate, and it's all possible because of the swap. That's what AIG was selling.

So what, you say? We have insurance for all kinds of things, and all kinds of bad things happen without insurance companies going out of business. People get into car crashes, trees fall on houses, vacations get rained out, and the insurance companies just pay off the policy holder and move on. How do they do it? There's a one-word answer: regulation. Your state government won't let me to call myself a car insurance company, and start collecting car insurance premiums, unless I can prove that I have enough money on hand to pay off the claims. Homeowners' insurance, the same thing.

But now we go back to Phil Gramm, and his midnight Christmas present to the money men. The law he wrote (oh yes, and if I think back to 2000, I'm pretty sure John McCain was in the Senate that year; there's the experience thing) said that these credit default swaps cannot be regulated. The government can't stop me from selling credit default swaps, even if I'm just a guy sitting in my basement in Montpelier, and it can't make me prove that I have enough money to pay off the claims.

And that's where we are today. Property values stop going up. A bunch of those mortgagors (they're the borrower--remember, "Mortgagee rhymes with Simon Legree") reach into their pocket and come up empty, so they default on their mortgages. The banks have to foreclose, and the people who own the mortgage-backed securities start looking around for someone to cover their losses, and who's standing their with their face hanging out? AIG, which sold them these credit default swaps, these promises that if the mortgages didn't perform, they'd be good for the money.

Only because of Phil Gramm, John McCain, and the other guys who voted for Gramm's bill, nobody ever made AIG set the money aside in case the loss they were insuring should happen.

And now, whose economic ideas are in the head of John McCain, the candidate who admits he doesn't know anything about the economy?

Right, Phil Gramm's.

So tell me, how much sense does it make to turn the economy over to McCain and Gramm?


Anonymous Tom McC said...

So that's not entirely how I understand the particular AIG mess and the one that seems to be causing most of the problems, although I confess I haven't read closely enough to be sure that I've understood correctly.

I believ that AIG had tons of "super-senior" mortgage-backed securities on their books. The superseniors are ones that are structured in such a way as to have virtually no risk of non-payment, becuase some huge percentage of the pool of mortgages represented by the securities would have to default first.

So AIG, like lots of banks and some insurers, decided to load up on these securities. No risk, right? Well, not no risk exactly, but virtually no credit risk. But it came to pass, with all the problems in the housing and mortgage markets, that nobody wanted to buy even the super senior tranches anymore.

This creates an accounting problem: how much are these securities worth? the banks needed to establish a market value for these securities, and if they were less than what was on the books, the bank (or AIG) would have to take a loss. And boy did they.

Again, I could be wrong about their direct exposure to defaulted mortgages and defaulted mortgage-backed securities, but that's what I think is going on.

September 19, 2008 10:52 PM  
Anonymous Tom McC said...

Of course, that doesn't take away from your central point, that McCain and his friends have spent the past several years trying to free the financial sector from any supervision, and now the joke's on everybody. Even the banks I think are going to have to take a big hit. I wish some of it would come out of the hides of the overcompensated wizards running these places, but life is rarely that satisfying.

September 19, 2008 10:54 PM  
Blogger lindaw said...

Thank you for this explanation of Gramm-swaps. I have heard of them but did not know how they connected to Phil Gramm. Is he still McCain's financial advisor?

September 27, 2008 10:52 AM  

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