SOWELL: The left's coming economic overreach

There are some fundamental questions that noone has seemed to ask about the subprime chaos. 1. How many loans were defaulted on? 2. What was the total amount of those loans? 3. What was the amount that triggered the collapse? 4. Were they all defaults or were there bad investments thrown in too? 5. Who made their fortunes and got out before the crash? 6. Who will be the greatest losers if it continues to crash? It seems that the ESG's, the corporations, the government in conjunction with the media has learned to manipulate fear pretty well. It started with Y2K, the Tobbacco Trials, Global Warming, the $4.00 a gallon oil crisis and now the $700 billion bailout. Is this really a crisis or just a way to increase value, grab profits and then bailout leaving the U.S. taxpayers with the tab?

The $700 billion bailout plan just stinks to high heaven. It was made in the heat of an election year with little critical review or rational thought. Now, we got Nancy Pelosi proposing another $300 billion "stimulus" package (read "goodies and handouts to Democrats' lobbyists, special interests, and supporters"). Where do these people think this money comes from? A huge gaggle of geese laying thousands of golden eggs in the Treasury? The economy will never be truly "sound" until the federal government gets its spending under control, something is done to control exploding entitlement spending, the tax system is modified to encourage business growth, and the federal government reduces regulation of businesses.

Total amount of subprimes looks to be about $600 Billion. The default rate on subprimes looks around 9% from the last #'s I saw at the end of 2007. Total defaults is probably between 100-200 Billion. Hard to say. But the actual defaults were never the real problem. The problem are the derivitves tied to the subprime loans and the leverage used on top of these assets. As the value of homes declined the value of the derivitives declined, often very precipitously due to the conditions built into the instruments. e.g. the devaluation may not happen until home values falls a specified %. Since home prices don't have a liquid market to determine their value every day the mark to market process for these derivitives is a nightmare. To make it worse mortgages are bundled into packages of mortgages which are broken into interest paying and principle paying tranches. Most are still being paid but within each tranche can be a mortgage that isn't being paid. Effectivly devaluing the securities of hundreds of paying mortgages. If you've leveraged a devaluing security to the tune of 10 or 20 to 1 and you MUST maintain at least a 5% capitalization ratio you either need to sell off your loans or get more capitalization. Some firms couldn't do either fast enough and imploded. It appears right now that the money for the bail out is being used to shore up the balance sheets of banks across the globe. The credit default swap market is $60 Trillion dollars and that isn't the end of the derivitive market, with no clearing or regulation. It's going to take a long time to unwind this mess.

"If the meaning of words can be changed to suit political convenience, then discussions become an exercise in futility." Agreed, kind of like how so many folks on these pages have been labeling Obama's tax policy "socialist" and "marxist".

It sounds like kc knows a great deal about this. What do you recommend be done about it? Would prohibiting or restricting derivatives keep this from happening again? If I understand correctly, derivatives do not have any intrinsic value and do not seem to serve any useful purpose other than to be Wall Street's version of gambling.

The "intrinsic" value of a derivative is the amount by which it is "in the money" i.e. using the example of a call option on a stock, intrinsic value would be the difference between the 'strike' price + cost of the option, and the underlying stock's current market price. Credit derivatives allow investors to hedge credit risk. The underlying securities (bonds/loans etc.) are limited in supply, and therefore can be illiquid. Before credit derivatives existed, investors seeking to reduce risk could only do so by selling the bond/loan. Now they can either sell the instrument, or purchase default insurance. Since the derivative is only a contract, not a security, in theory there is an unlimited supply. However, in allowing investors to hedge credit risk, they create another kind of risk--counterprarty risk. This became a huge problem when some of the big counterparties (Bear Stearns/Lehman/AIG) ran into trouble. One of the suggested solutions is to make credit derivatives exchange traded, so that your counterparty is the exchange (capitalized by all participating members) rather than just one investment bank.

"Agreed, kind of like how so many folks on these pages have been labeling Obama's tax policy "socialist" and "marxist"." so what exactly is a socialist and why is Obama's tax policies not socialist? I don't know if there is a standard definition of socialism, though Michael Newman's Socialism: A Very Short Introduction, via Wikipedia, puts it that "all socialists advocate the creation of an egalitarian society, in which wealth and power are distributed more evenly, although there is considerable disagreement among socialists over how, and to what extent this could be achieved" Now that sounds a lot like what Obama has been saying. But to Mr. Sowell's excellent point, it sounds much better if we just say its "progressive" - gives everyone a lot hope when we can pretend these policies haven't been tried over and over and over...

jhm is correct. There needs to be an exchange for derivatives similar to the CBOE where at least the trades can clear and be regulated. Another problem is that it appers to me that AIG (and they're not along) did virtually no underwriting of Credit Default Swaps (CDSS). They say otherwise but a $1 trillion company of sterling reputation lays in ruins due to there financial divisions positions in CDSS. Another problem is that the risk models being used by banks and investment firms to evaluate risk were based on past experiences. They are faulty when it comes to unexpected events. This is what happened to First Capital Strategists that shook the options market 8 years ago but no one learned. Another is that options and derivatives are being used for raw gambling by investemnt firms, banks and hedge funds for their own accounts. Options were designed to help business' dependent on commodities to better manage and predict their expenses. This is now only the smallest percent of actual option trades. The amounts of money flowing through the CBOE is so immense it now can distort the price of commodities. e.g. the price of oil was distorted by a factor of 2X by commodities speculators. When Paulson/Bernanke went to the CBOE back in Aug. and limited the ability to speculate in oil futures the price began to slowly come down. I don't like what the gov't is doing and don't want more regulations. You have no idea how many there are already are and have no wish to be drowned in anymore but only the gov't has the resources to unwind this mess and that always comes with a price. usually more gov't intererence.

The issue with the bailout is, why are we still keeping the ESG's? They are the contractors for this mess. They built the whole thing on a foundation of clay, without caissons. There was NO risk analysis on the CRA. There was only Bill Clinton, Barney Frank and Chris Dodd the promoters of this mess. (Sounds an awful lot like White Water doesn' it) If the foundation is no good, all of those "derivatives" aren't going to support the floors above it. Eventually a crack in the foundation will bring the whole bloody thing down. Apparently that crack was 9%. Now we are trying to put the caissons in and we are using the same inspectors (Frank and Dodd). It's no wonder the stock market doesn't believe in Obama and the Democrat led Congress. Those derivatives are gone and we still have the same idiots in charge. This is another Gray Davis moment and I'm not sure we have elected an Arnold Schwartzeneggar.

The foundations of Fannie Mae and Freddie Mc aeren't necessarily clay. Both organizations existed for a long time and were very successful. They supplied an enormous amount of liquidity that wasn't being supplied by the private sector. This liquidity created alot of wealth in the country and raised the standard of living across the entire country. It is unlikely a private firm could have or will in the future serve the same function as these two entities. That said, the oversight of Fannie and Freddie was nothing short of criminally irresponsable. The lowering of underwriting standards was also criminally irresponsible. That the democratic leadership didn't forsee this is as pathetic an excuse imaginable. However, It seems to me that given the confluence of events, massive use of CDSS, obscene abuse of leverage, low interest rates (which allows the abuse of leverage), massive deficets (which squeezed the credit buyers into mortgages) and a housing bubble that was going to pop sooner or later some part of our credit system was going to break. The stressors were just too great. Imho the fact that it broke in the mortgage market has made the problem harder to resolve and more harmful due to the way mortgage securities are packaged and sold. P.S. The derivatives are still with us. They are not going anywhere. They serve too many functions and make too much money to ever go away.