Credit Crisis 101

If you are watching your portfolio plummet and wondering what is happening, this post might help you understand with better clarity why it seems your money is being flushed down the toilet.  The 3 combined podcasts run about 100 minutes, I’ve summarized the key points and some choice quotes. However, I highly recommend you downloading them yourself to listen to. (If you have a Zune or don’t use iTunes, please close your browser and jump off a cliff)

60 Minutes (iTunes link, 42 minutes)
– What went wrong with the risk models

“You can’t model human behavior with math”

– What is a credit default swap (CDS) 

“It is an insurance contract, but they’ve been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a ‘swap,’ which by virtue of federal law is deregulated,” 

– The CDS market is around USD 50-60 trillion dollars

Radioeconomics.com (iTunes link, 34 minutes) – The guest is Barry Ritholtz (from The Big Picture blog which is one of the best blogs covering the financial crisis)

– The Commodity Futures Trading Act of 2000 exempted any derivatives instrument (such as CDS) from being regulated
– The CDS market went from USD 2 trillion to USD 50-60 trillion in just several years
– Ratings agencies (Moody’s, S&P and Fitch) were rating most mortgage backed commerical paper as “triple A” investment grade
– Housing sales peaked in 2005 and housing prices peaked in 2006
– Why in 2004, were 5 investments banks exempted from the Net Capitalization rule?
– The ban on short sales in financial stocks is stupid

This American Life (iTunes link, 1 hour)

Part 1 – Commericial Paper Market
– The commerical paper market (one of the largest markets) locked up after “breaking the buck” occured with the Reserve Fund

Part 2 – CDS’s
– Satyajit Das talks about the market originally being used for insurance and soon turned into gambling. (He has a great book, that I reviewed a while back)
– Great analogy of using CDS’s for fire home protection
– CDS’s are traded via over-the-counter (OTC) between two private parties in an unregulated market
– USD 5 trillion in Bonds and USD 60 trillion in CDS  – a 12x leverage

Part 3 – CDS’s traded in an unregulated market

After listening to all 3 podcasts it’s clear, there is no quick fix to the problem.  The Fed stepped in on Tuesday and announced a Commercial Paper Funding Facility and the DJIA still got slammed over 500 points down. 

The two largest financial markets: commercial paper and CDS are unregulated and I’m sure the market participants like it that way. With regulation and transparency, you have to fight for business and lower your prices, look at the US brokerage model.  Once the US brokerage model was littered with companies offering rock bottom services, the industry looked towards new markets – CDS.

The size of the world stock market is estimated at about USD 60.9 trillion  at the end of 2007.  The size of the CDS market is between USD 50-60 trillion. Shouldn’t both be regulated the same way based on their size and importance?

The ONLY thing that is going to continue to rise is the US National Debt…USD 10 trillion and counting…