What Started The Recession

Dec 29, 08 What Started The Recession
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This is a huge question that I have avoided posting on because of its esoteric nature.  I have pondered the question of what started the recession for awhile.  When you attempt to unravel the mystery of the greatest economic collapse in 80 years, much too often, all you encounter are time lines and events with little to no context.

Delving into the complex nature of  globally interconnected  “wheels within wheels” is time consuming and frustrating.  At best, you can draw out words and examples that may provide a hazy backdrop from which you can draw a few inferences.  At worst, you run smack dab into an impenetrable wall of information and numbers that appear to be indecipherable.

However, as a committed student of the past is prologue school of thought, I believe that it is essential to understand the root causes of the financial collapse in order to prevent future recessions.  Thus, this is the first in series of posts attempting understand and explain the root causes of the current recession.  Today, we discuss credit default swaps.

1.)  Understanding Credit Default Swaps

Credit default swaps, or CDS, are the elephants in the room.  Although the total value of the credit default swap market is worth upwards of $45 trillion, (wrap your head around that number) it is a relatively simple scheme.  Credit default swaps are basically bets on whether a security will go into default because of certain financial events.

CDS are what funded the housing bubble that eventually burst.  Rich Newman’s article does a wonderful job of explaining credit default swaps in layman’s terms.  Even though the problems inherent with credit default swaps and financial derivatives became readily apparent after Enron’s collapse, the government still did not choose to regulate these transactions.

2.)  Why So Serious

Believe it or not, this $45 trillion dollar market is completely unregulated.  CDS were created in 1997 by JP Morgan in order shift risk to third parties.  In essence, this allowed companies such as AIG and Lehman Brothers to leverage risk and write it off their books.

Senator Phil Gramm, who is a classic bad guy, snuck the Trojan Horse of deregulation inside the Commodity Futures Modernization of Act of 2000.  Buried within 11,000 pages of an omnibus spending bill and rushed through the House and Senate right before the Christmas holiday, Senator Gramm navigated the bill past all relevant committees, votes, and oversight right into law.

A Graph By Scott Pollack

A Graph By Scott Pollack

3.)  Why Credit Default Swaps Are So Dangerous

Since 2001, the CDS market has grown exponentially.  Between 2001-2007, the CDS market increased by $44 trillion dollars.  Credit default swaps are so dangerous because the buyers are not sure that the sellers will be able to pay them if a series of financial events occur.

Considering the economic conditions that exist right now, the likelihood that more companies are going to fold is apparent. Many economists believe that the inital government bailout of the financial sector was designed to prop up the companies that were heavily invested in CDS.

Imagine if an insurance company had to pay out a large number of policies at one time.  Traditionally, the rate of incidents leading to paid claims is low.  Thus, the company decided to invest much of their capital in risky financial schemes that they lost money on.

Yet, instead of acknowledging their losses, they used complex financial schemes to hide debt and stave off insolvency.  Now imagine that the buyers of CDS call in over $20-30 trillion dollars of debt at one time.  We are talking about Mad Max territory here.

4.)  Fool Me Once…

There are some economists that believe all of this hand-wringing is premature.  Personally, I feel like we are risking our financial markets for Monopoly money.  When you are tossing around such astronomical numbers, the consequences become surreal.  Some economists believe that the market is too big to fail.  They want a regulation free economy.

In their minds, the numbers make sense and rational self-interest will prevent the market from failing.  They were wrong.  Now that CDS are penetrating into the general marketplace of ideas, these same individuals are telling us not to worry.

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