Mortgage companies under investigation by the FBI
In a new development concerning the economic crisis surrounding the mortgage industry, FOX News is reporting the FBI is investigating mortgage finance companies Fannie Mae and Freddie Mac, along with Insurer American International Group (AIG) and Lehman Brothers. While I am not a vindictive person, I believe this investigation is a good thing, if it is conducted fairly and openly.
As the economy’s downward spiral continues, spurred on by more and more bad news from Wall Street, it’s pretty clear where all of this started. Mortgage companies saw a chance to make more money by providing loans to people with questionable credit and they jumped at the chance. Then they took out what basically amounts to insurance against these bad loans, thinking they were hedging their bets and couldn’t lose. These hedge bets, as I like to call them, are labeled credit default swaps and from the news I have been hearing and reading, they are one of the main problems with our financial system today. Wikipedia describes them this way.
Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity.
Credit default swaps have been used extensively to speculate on a company’s credit rating. According to Wikipedia:
Credit default swaps give a speculator a way to profit from changes in a company’s credit quality. A protection seller in a credit default swap effectively has an unfunded exposure to the underlying cash bond or reference entity, with a value equal to the notional amount of the CDS contract.
For example, if a company has been having problems, it may be possible to buy the company’s outstanding debt (usually bonds) at a discounted price. If the company has $1 million worth of bonds outstanding, it might be possible to buy the debt for $900,000 from another party if that party is concerned that the company will not repay its debt. If the company does in fact repay the debt, you would receive the entire $1 million and make a profit of $100,000. Alternatively, one could enter into a credit default swap with the other investor, by selling credit protection and receiving a premium of $100,000. If the company does not default, one would make a profit of $100,000 without having invested anything.
As I was driving home tonight, I was listening to Fresh Air on NPR and Terry Gross’ interview with New York Times columnist, Gretchen Morgenson and she did a very good job of showing exactly what credit default swaps are, what they are being used for, and how they are very much related to the economic crisis we are in right now. Betwen the Fresh Air broadcast and a recent column written by Gretchen Morgenson, I now look at the crisis we are in with a little different light shed on it. Take a few minutes to read the article and listen to the interview, but be careful. You might be surprised at what you learn. In her column, Gretchen Morgenson makes some statements that are very bold, but true.
Take, for example, the rescue on Tuesday of the American International Group, once the world’s largest insurance company. It was pretty breathtaking. Since when do insurance companies, whose business models seem to consist of taking in premiums and stonewalling claims, deserve rescues from beleaguered taxpayers?
Answer: Ever since the world became so intertwined that the failure of one company can topple a host of others. And ever since credit default swaps, those unregulated derivative contracts that allow investors to bet on a debt issuer’s financial prospects, loomed so big on balance sheets that they now drive every bailout decision.
It seems to me these credit default swaps are at the very heart of the economic troubles our country is facing today.
In reading and trying to understand what has been going on with the big companies on Wall Street, one tendency seems to prevail as more and more of the crisis is brought to light. The management of these companies thought they could just continue to make bad loan and investment decisions and cover their bets by speculating in these credit default swaps. This practice resulted in the bailout and bankruptcy dance we have been seeing the last few weeks, with the companies going belly up and the people who were actually in charge of running them going scot free, with a large severance package to boot. In my opinion, the FBI should prosecute these people to the fullest extent of the law. Their greed is the main perpetuating factor that has driven these companies to the brink and over the edge and with them, our entire financial system. It’s a shame, but that’s what greed does.
That’s my take!
Larry
