Credit Default Swaps — Now I Get It

I *thought* I understood what credit default swaps (CDS) were all about and the role they played in the collapse of our financial markets. But thanks to a terrific interview by Terry Gross, it’s finally really clicked me. On a recent edition of Fresh Air, Frank Partnoy did a great job of explaining it.

I knew that CDSs are essentially bets placed on so-called securitized mortgages. Specifically, a CDS is like a short sale. It’s a bet that a mortgage or (more accurately) a portion of a bundle of mortgages will default and not be paid back.   The underwriter of the CDS (an AIG for example) is essentially betting against you and has to pay you if the loans are not repaid. It’s obviously a lot more complex than that, since why would you buy something from a company that only made money when your investment turned out not to be a good one. (Why? It’s like placing a bet with a bookie. There’s supposed to be another gambler on the other side. If not, the bookie has to make good, paying for his risk out of the difference in the spreads.)

But here’s the important new insight I learned from Partnoy. These really are bets and the reason they’ve brought down our econoy is that there’s no limit to the number of bets that can be placed on a single underlying mortgage or traunch. As a simplistic example, for a $300,000 mortgage AIG can sell as many bets as it wants. Since the bets aren’t backed by the mortgage itself, let alone the collateral (the real estate), there could be tens of millions of dollars riding on that single mortgage. It’s not just the kind of leverage we’re used to in which you borrow money in order to make ore investments. No, these aren’t “investments* — they’re *bets*. And just like in Las Vegas, the amount that can be bet on something isn’t limited by the value of that thing. IOW, all of these bailouts are in order to cover the losses of bookies and to make sure that those who gambled get their payoffs.

Partnoy also explains how it came to be that Bill Clinton signed the deregulation that got us into this mess in December of 2000. It’s fascinating in a sick and twisted way. I actually look forward to learning more as more books are published over the coming years.

Lexus Service Turns Sleazy

You know those “dealer options” offered when you buy a car? Things like rust-proofing and paint sealant? They’re totally unnecessary, of course, but they’re a significant revenue source for the dealers and the salespeople. They’re pitched as last-minute impulse-buy items, appealing to your fears and desire to get out the door.

I’ve owned or leased four Lexus cars, the current one being a 13-year old environmentally incorrect honkin’ V8 LS400 cruiser. (Our other car is a Prius.) Great cars. Until now I’ve had most maintenance other than oil changes, batteries and tires done at the local Lexus dealership. They’re expensive, but the service is good, fast, courteous and generally honest. Last week a radiator hose broke and I had to have the car towed to the dealership: a $13.40 part plus $145.00 for labor. Okay, that’s a lot of labor to replace a hose, but I’m okay with it.

But when when the service rep called after the initial inspection, he also pitched three other items. The latter two were described as “dealer-recommended items.”

  • Replace the valve-cover gaskets.
  • Annual “de-carbonizing”. [Flash video]
  • Power-steering flush. [Flash video]

So the impulse/ripoff options have now made their way to Lexus service departments. Leaky valve-cover gaskets are to be expected on a 13-year old engine, and they’re not much of a problem. A little bit of oil oozes out and possibly drips onto the exhaust manifold, but at $900+ I can wait. Okay, thanks for noticing but I’ll pass. No harm in suggesting this one. But it’s those last two items that annoy me. Of course injectors need to be cleaned, but I’d be surprised if that isn’t covered by regular Lexus maintenance, which is very thorough. Same for the power-steering system.

Watch the Flash videos. Notice anything unusual? First, they’re not Lexus branded. Hmmm. Second, look at the URL. They’re from a site called Liqqid Express, which offers the headline “Featuring Online Menu Selling for the Service Department.” Another hmmm. Clearly, this is all about selling not service. Each of these services was quoted to me in the $100 range.

I complained to the service director who replied in email “…Both of those services are of value to our customers; that is why every Lexus dealer in the [San Francisco] bay area offers these services…There are many services that are good ideas for your car that are not in the manual. Lexus puts the minimum requirements in the owner’s manual for maintenance that is due on these cars…”

I don’t know if it’s still the case, but Lexus (corporate) used to be extremely fussy about quality dealerships and service departments. The survey they send out after every service appointment can (or could) cause a lot of grief for the dealership. I plan to voice my concerns to Lexus when I receive my next survey. If, as the local service director says, this is something that is going on all over the bay area, I wonder if it’s approved or at least sanctioned by corporate Lexus. I’ll be interested in their response.

In any case, I plan to look for another shop to perform maintenance in the future.

Listen to that Nobel-Winning Guy

I’m a huge Paul Krugman fan, and today’s column (The Market Mystique) may be one of his most important.

Even during the “go-go years,” the bull market of the 1960s, finance and insurance together accounted for less than 4 percent of G.D.P…On the eve of the current crisis, finance and insurance accounted for 8 percent of G.D.P., more than twice their share in the 1960s.

Obama’s team is composed of the wrong people focused on the wrong task. Rather than protect “the economy” they’re trying to protect the financial services industry because that’s where they came from and what they know. It’s a case of the Innovator’s Dilemma: they’re trying to change a system from the inside. It won’t work.

If you don’t believe it’s the same old people, just read Congress Passes Wide-Ranging Bill Easing Bank Laws from the NY TImes nearly ten years ago. [Thanks, Warren.] It’s spooky.

“Today [November 1999] Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century,” Treasury Secretary Lawrence H. Summers said. ”This historic legislation will better enable American companies to compete in the new economy.”

Lawrence H. Summers is now Director of Obama’s Economic Council.

As surprisingly few experts have said — indeed, Obama himself has hinted at — we need to shrink the financial services industry. As a society we need to devalue the institutionalized gambling (highly leveraged risk taking) and we need to make it less attractive to make money by playing with money as opposed to creating real value. That’s not easy to do, of course, but one way is as a byproduct of regulation. It’s a governor; a throttle. If we make it harder for people to make money by placing big bets with our money, fewer people will do so. Krugman says:

But the underlying vision remains that of a financial system more or less the same as it was two years ago, albeit somewhat tamed by new rules.

As another example of where our government is focused, consider interest rates. An illiquid bank can borrow money from the Fed at less than 1%. But that bank is allowed to charge you and me, who are likely better credit risks than the bank itself, more than 20%. U.S. credit-card debt now exceeds $1 trillion. If the Congress really wants to fix the economy by helping people repay their mortgages and student loans, why don’t they address these usury practices? Could it be because they’re trying to protect our financial institutions rather than the people? Surprisingly, I find myself agreeing with many conservatives who are against all these bailouts. Maybe we should just let the whole thing collapse and make a fresh start of it all. It might be the better decision in the long run. And it might happen anyway, exacerbated by the loss of $2+ trillion in bailouts and stimulus.

Audible.com Joins SpokenWord.org

Over the next hour we’ll be adding virtually the entire audiobook catalog (close to 40,000 titles) from Audible.com to SpokenWord.org. You can listen to free MP3 previews on SpokenWord.org and if you like what you hear, you can click through to Audible.com’s site to purchase the complete audiobook.

Why did we decide to include programs that are only available with usage restrictions or DRM (digital-resource management) from sources such as Audible.com? Two reasons: (1) We want to be a source for all spoken-word recordings; and (2) We receive affiliate-program commissions from vendors, which helps us bring you SpokenWord.org for free. We recognize that the inclusion of fee/DRM content is controversial and we’re trying to do so with full transparency.

Before launching this feature we discussed it at length internally. We also surveyed the members of The Conversations Network, 89% of whom told us they wanted us to include commercial/DRM programs so long as we made it clear what was free and what wasn’t and so long as commercial/DRM programs didn’t become a majority of the site. If you believe our presentation of these programs is in appropriate, please join our discussion. We’re always trying to improve the content and presentation.