At the bottom of the inverted financial pyramid are overvalued land, wood structures, dry walls and granite countertops - i.e. cheaply over-build houses.
These were sold to people who could only afford them with mortgages that had unrealistic starting conditions and on the premise that housing prices would continue to rise forever.
These mortgages were bundled, sliced and diced into Mortgage Backed Securities and sold to investors. Home equity loans, car-loans and credit card debt were converted to Asset Backed Securities and sold off.
On top of these MBS/ABS papers some geniuses constructed an additional financial layer.
These were insurance contracts that covered against the default of ABS, MBS and various types of bonds. These insurance contracts, Credit Default Swaps, are totally unregulated private agreements. They were widely created and dealt with when the risk of default of the underlying papers was assumed to be low.
Some of the insurers who issued these CDS never had the capital to back all the policies they wrote. In a competitive environment they offered too low premiums to insure against default risks.
Some insurers partly insured themselves via reinsurance. When they sold a CDS on a bond issue of some $10 million they went to other insurers and bought themselves CDS, let's say $5 million or perhaps even for $20 million. The re-insurers partly re-insured themselves again by buying CDS elsewhere.
Some people simply betted on a change in the default risk of some bonds. They did not even own the MBS or bond in question, but bought or sold insurance against the default of a specific MBS or bond anyway. Some may have bought total insurance from different insurers in a way that a default of the MBS would pay them ten times the nominal value of said MBS.
Imagine you could have ten fire insurances on your home that would each pay out the full value of your house if it burns down. That would probably give you some very hot ideas.
That is exactly the reason why fire insurance regulation prevents such a case. But CDS are unregulated, their originators are unregulated and there is no settlement mechanism for them other than the private contracts between the parties.
The original size of the mortgages going into default are probably $300-500 billion. The total mortgage origination in the last years were a few trillion dollars. These and additionally credit card loans and auto loans that were converted to Asset Backed Securities in a volume of about $6 trillion.
But on top of these $6 trillion of MBS/ABS and bonds insurances, re-insurances and re-re-insurances were written with an estimated total nominal value of some $65+ trillion. The real number is unknown, but it is bigger than the whole worlds yearly GDP.
Now the housing bubble busted. There was simply too much supply created to sustain ever rising prices. Without rising house prices a lot of homeowners had to default on their mortgages.
With the mortgages going into foreclosure, the MBS and other asset backed papers where suddenly less worth than expected. This triggered credit insurance events. People who had bought the Credit Default Swaps suddenly demanded money from their insurers.
It turns out that these insurers, or their re-insurers, or whoever meanwhile carries the now negative side of the CDS in question are out of money and the insurance agreements are worthless. The worlds biggest insurer, AIG, was nationalized because it had written too much credit insurance for too low prices.
The big danger now are not defaulting homeowners. The big danger are not Asset Backed Securities that might lose some value.
The big danger is the pyramid of credit insurances that is certain to come down and that will take with it at least half of the existing finance infrastructure.
Banks, hedge funds, pension funds, municipals and others who bought insurance will find that it is worthless. Banks, hedge funds an others who sold insurances will find that they will have to pay out more than their total capital.
We currently see a credit-freeze because nobody wants to lend to anybody as it is impossible to know how much credit insurance the other party has written or how much it depends on their validity. You do not lend to anyone who might already be bust.
That is the situation we are in and it shows why the Paulson plan is utter crap and nothing but a huge robbery.
The Paulson plan would not help at the bottom of the inverted pyramid, the housing market, and not at the top, in the CDS market.
Paulson knows that the crash of the CDS market is inevitable. His plan is an attempt to let the taxpayer pay for the stabilization of the middle of the pyramid in the hope that the big crash will come only after the election (and in the hope that the loot might help Paulson's beloved Goldman Sachs to survive.)
There is only way to avert the crash.
Declare all CDS contracts, worldwide, as null and void. There is precedence for this:
During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision.
The maze of the value and ownership of $65+ trillion of financial credit insurance contracts has frozen the credit markets. Nobody is lending to anybody else because the value of the counterparty is in doubt.
Those $65 trillion reasons for the credit market freeze will never go away without a huge crash that then will have worth consequences than the 1929 stock market crash. The only way to eliminate these reasons is internationally concerted action to declare the legal obligations of all CDS' null and void.
At the same time:
Sunday, March 15, 2009
(ht Daily Kos) The so-called credit default swaps were fraudulent wagers that should be declared null and void as gambling debts, and therefore unenforcable. In fact, Congress acted in 2000--during the Clinton administration, thanks to help from the likes of Senate Finance Committee Chairman Chris Dodd--to exempt such wagers from existing state gambling law. The obvious solution is to rescind that 2000 legislation and treat credit default swap debt as illegal gambling (which it clearly was, given the results). As explained by Moon of Alabama, Sept. 21, 2008, there is a precedent from the Great Depression era: