Lust for Leverage

As America continues to struggle with the single most dangerous economic crisis to occur since the invention of television, television news operations have been unforgivably lame and late in telling in a cogent and compelling way, the story of how and why this has happened to us. Lots of stories about how afraid and worried people are, but not much about the how and why. Perhaps this is because the underlying subject is economics, and it's hard to make "the dismal science" seem sexy, or even violent enough for TV. I understand that part. Even my wife, who is very smart, loving and nurturing, gets a look on her face that usually only dentists see when I try to explain the newest things I have learned about Credit Derivatives to her.

But I know it can be done, and I know the story is important. Because if we don't fix this problem, or if we fix it the wrong way, we are all doomed. Our economy will crater and we will end up having to live on tubers, nuts and grass like our distant ancestors. You know, the ones Gov. Palin doesn't believe in.

So I have a helpful suggestion for the networks. Since all you need in order to bring in a big audience for a TV show is a good title, call this one: "Lust for Leverage." Because that is after all, what caused the collapse. And people like to hear stories about lust. And money.

Now I know that there has been an endless parade of talking heads on the Fox News Channel explaining how this has all the fault of Barney Frank and those awful poor people who wanted to live indoors. But even a cursory glance at some numbers will tell you that this just ain't so.

The total value of outstanding sub-prime loans in this country is about $1.3 TRILLION. Fewer than 20% of those debtors are in default, or behind in their payments. This means that even if all those homeowners in default, never paid another dime, and every single one of those houses covered by all those loans and the land that they were on somehow suddenly just disappeared, the total loss could not be more than $260 BILLION.

So even if those careless indoor loving poor people and their enabler Barney Frank really were the root cause of this mess, and that impossible scenario actually happened, we could have totally eliminated that problem by merely paying off every single sub-prime mortgage in the country that is in default, for a total amount that is far smaller than the $700 BILLION Congress has alloted for the historic bailout.

But of course that is not the case, and all those houses and all the land that they are on are are still there and have some value. And most of those homeowners could make some kind of payments, so the real cost to fix that part is far less than $260 BILLION. So, there must have been something else, something big, at work here. And I am here to tell you what it is. Lust. Lust for leverage. By the big dogs.

While the total value of all those sub-prime mortgages is about $1.3 TRILLION, and the total value of all the Corporate Bonds in this country is about $5 TRILLION, the total value of Credit Default Swaps based on those debts is about $50 TRILLION. And this is where the real problem lies.

What are Credit Default Swaps you ask? They started out as a form of insurance on Corporate Bonds. But they quickly morphed into a form of gambling that Sky Masterson would love. Remember him? He was the character in the musical "Guys and Dolls" who sang "Luck Be a Lady Tonight." He loved gambling so much, he would wager on which sugar cube a fly would land on first. Credit Default Swaps morphed from a reasonable form of risk management insurance, into the same kind of gambling that bets on sugar loving flies. High flying Wall Street Sky Mastersons could buy and sell these totally unregulated "insurance polices" to speculate. That means bet on a hunch. They could even buy "insurance" on bonds they didn't even own. That is like you buying an insurance policy on my house, betting that I am such a dope, I will burn my own house down. Your only downside risk is the premium you pay, but if you win, you win an amount that is equal to the worth of my house. This is not about managing risk, or about capital formation so jobs can be created or new factories built. This is more like roulette. And it's all about leverage.

Because, unlike actual insurance, which is regulated, so If a company, like AIG sold a $100 million insurance policy, it would need to have a $100 million in assets available so it could pay off the policy in case of a claim. Credit Default Swaps are totally unregulated, so sellers of these policies can take a big gamble and write 10 times as many policies and get 10 times as much in the way of premiums as they have in assets and thus leverage by the 10 the power of their money.

But it also meant that they had put bets out there that were worth 10 times the amount of chips they had to pay off on a loss. Even that wasn't enough for the big dogs. They went to the SEC and pressured that poor nebbish in charge to raise the ceiling on leverage in general from about 10 to 1, up to about 30 - 1. That meant that you could bet a million dollars on your favorite sugar cube, even if you only had $33,000 in chips. Under those conditions, a few bad bets, and things get really ugly really fast. Now go back up a few paragraphs and consider those numbers -- $1.3 TRILLION in sub-prime mortgages, $5 TRILLION in corporates debt, $50 TRILLION in gambling debts.

Of course there are more factors involved than just Credit Default Swaps. It's like "Who Shot J.R.?" as you learn about the contributory roles played by Credit Rating Agencies, Bond Insurers, Liquidity Banks, predatory and deceptive lending practices, Commercial Paper, and CDO's with their unsavory Tranches (which sounds like something that might be cured by Amoxycillin but is actually just a big slice of a big bundle of mortgages). Learn about this stuff and I promise you that the next time someone comes up to you and tries to tell you that this mess is all the fault of Barney Frank, Fannie Mae, Freddie Mac and the irresponsible poor, you are certifiably ready to say to them: "Shut up you stupid dope."

Sadly, I didn't learn all this from television, which I think should be helping me learn this because they could use pictures and do a show-and-tell which would make it easier for my little ADD'd brain to follow. I learned about this because I have been listening to radio. There has been a great series of stories on NPR's "This American Life" and "Planet Money." I listen to these podcasts on my iPod when I make my yearly visits to the gym. I highly recommend them. Start with the "This American Life" episode titled: "The Giant Pool of Money " available here.

Then try "Another Frightening Show About the Economy" which you can download for $0.95 here.

Subscribe to the "Planet Money" podcast, but make sure to listen to their archieved episode "A Tale of Intertwined Misery" here.

If this doesn't thrill you because it is just radio and doesn't have pictures, consider listening to it as you stand outside your house and watch its value plumet. It might make the whole thing seem pretty engaging.