It's Like A Weed, Man... (The Mortgage Meltdown, Part Four of Seven)

[* The series as it unfolds:

1. You Unmitigated Bastards
2. What The Fuck Are Fannie Mae And Freddie Mac, Anyway?
3. Community Organizing
4. It's Like A Weed, Man
5. A House Built Upon The Sand...
6. And Like That House, Down It Goes
7. None Of You Is Fit To Lead

*]

An update before we begin: As of now, the bailout is DOA. The House voted it down 228-205; there will no doubt be another bill quietly circulating to do the same thing in a few days. I will keep you posted.

Thanks to Mounting pressure from the Clinton Administration and ACORN, the secondary mortgage market, and sales of mortgage-backed securities, absolutely exploded during the late 1990's and the first years of the new millennium.

Nothing seemed to stop it; in fact, events just seemed to conspire to make the situation worse. In the wake of 9/11, an effort by the Federal Reserve to stimulate the economy and avoid recession - a drop in the prime rate - was disastrous. The prime rate is the interest rate on loans made between the Fed and banks; the Fed dropped this rate to the lowest in decades, and the housing market took off explosively. FNMA quickly became even more of a powerhouse, with FHLMC right behind.

It was also during this time that the MBS-derivatives market, formerly merely a sideline of the secondary mortgage market, expanded into a full-fledged tertiary market of its own; this would later prove devastating at home and abroad.

Trading in derivatives is the Wall Street equivalent of Atlantic City. A trader places an option - essentially a bet - on a specific security, saying that it will rise, or fall, in value in a certain time period. By doing so, using a minuscule percentage of the cost of the future trade (this is called leveraging,) the buyer retains what amounts to "first dibs" on that security at the expected future price.

When the time rolls around, the trader can then sell their right to buy the security to banks, foreign governments, what have you, for more than the cost of the derivative itself.

To make things more interesting, the trader can also reserve the right to sell at a given price, and the price bought or sold at can be the current price, or the future estimated price, or any other number they can convince someone to agree with.

To get even MORE creative, a single trader can take out multiple derivatives from a single security; hedging their bets against any eventuality. For example, let's say a bank issues a "bond" based on the future estimated value of 10,000 home mortgage loans. A trader - without even buying the bonds themselves, and with very little money - can buy derivatives allowing him to sell those bonds at current prices in 6 months or a year in case it goes down; buy them at the NEW price in six months or a year in case it goes down; sell at the new price six months or a year off in case it goes up; and buy at the CURRENT price in a year if it goes up, all at once, on the same bonds he doesn't own, with money he doesn't have.

Then, for fun and profit, he can turn around and sell those derivatives, separately or together, to any buyer he can find, for vast sums of money; the only funds the initial trader risks are the leverage funds he's used to create the derivatives in the first place, a tiny fraction of the value of the derivatives themselves.

This is why the values of the actual mortgages at risk here can be $250 billion, but the derivatives can be worth over 60 TRILLION DOLLARS.

And FNMA and FHLMC were blithely selling MBS derivatives - not just domestically, but to foreign banks and governments.

The flaw in this practice is NOT the trading of the derivatives themselves; it is, simply, that all too often investors - even banks and governments - count the chickens before they hatch; it is a frightfully common practice (this is the accounting practice, for example, that brought down Enron a few years ago,) to carry derivatives as assets at their EXPECTED future value.

Just like many banks have been counting as assets many, many mortgage loans - at the expected value of those loans upon repayment.

In the case, specifically, of the subprime mortgage meltdown, the derivatives in question are called "Credit Default Swaps," which is a fancy term for a bet on whether the borrowers will bother to repay the loan, or not. In the U.S., the CDS market has a valuation of trillions and trillions of dollars; this is because - basically - the speculators making these bets convinced the banks to take their bets - without a bottom on the liability the banks would hold if the mortgage market crashed. Which leaves the banks holding trillions of dollars in debt to private investors, which is not offset by any actual asset.

This, in fact, is the underlying mechanic by which the crash happened; as more and more defaults and foreclosures started to roll in, banks which had counted on their mortgage portfolios for future value started to go under when it was discovered that their piggy banks were empty, and simultaneously, securities backed by those mortgages became worthless paper - and that made the Credit Default Swaps placed on those securities worth trillions that the banks couldn't repay...

And the first solid signs that this was happening came along in 2003.

[* As promised, here is the information you'll need to contact your Congressional Representatives and Senators about this mess, if you are so inspired. I hope you will. I hope you're furious. I hope you're as furious as I am. I hope you tell them so at great length. Here's the info; enjoy.

U.S. House Of Representatives Member Directory By State

U.S. Senate Member Directory By State

And while I'm at it, the president's email address - I hope he gets a ton of viagra ads - is president@whitehouse.gov, and the Veep is vice_president@whitehouse.gov - so use them wisely and OFTEN. *]