It my seem strange to anyone who has followed the debate over the causes of the 2008 housing bubble collapse and the resulting financial crisis that triggered the “Great Recession,” but it took until 2015 for economists to publish a research paper in the Journal of Finance that shows credit default swaps (a/k/a CDS) used by large investment banks to prop up their subprime mortgage deriviatives scam were directly linked to the 2007-2008 Financial Crisis and housing bubble collapse. Two economists at the University of Texas, Dr. Harold H. Zhang Dr. Feng Zhao, working with “global asset management firm TCW” looked at over 9 Million securitized mortgage instruments (also known as mortgage backed securities or collateral debt obligations) on the secondary market by investment bankers from 2003 – 2007. Their statistical analysis of these investments showed that the use of credit default swaps increased the demand for these mortgage backed investments, leading the initial lenders to lower their standards in order to generate more mortgages to meet this demand, which led to – surprise – higher default rates:
The researchers found that the presence of credit default swaps further stimulated the strong demand for mortgage-backed securities, which led to lax lending standards in the mortgage origination market and encouraged predatory lending and borrowing practices. Lenders increasingly offered subprime mortgages, which inevitably drove much higher mortgage default rates. […]
[L]oans originated with CDS coverage had a much higher likelihood of becoming delinquent than loans originated without CDS coverage. The researchers also found that commercial banks allocated the riskiest subprime loans to mortgage pools with CDS contracts.
“If you look at home insurance, health insurance, life insurance, it’s a much regulated industry,” Zhang said. “But with credit default swap there is no regulation. No one really knows how many policies have been issued or how many are outstanding. There should be a centralized clearing house collecting all this information.”
Credit default swaps or CDS, for those unfamiliar with them, are essentially insurance contracts for fixed income financial investments. They were frequently used by investment bankers who sold derivative securities comprised of packages of sub-prime mortgages (i.e., collateral debt instruments, CDOs or mortgage backed securities) during the years of the housing bubble. The idea was that should the underlying mortgages included in the collateral debt obligations default, the credit default swaps would protect investors against any losses.
The problem? Unlike most other areas of insurance, credit default swaps were not regulated, and because they were not regulated, they were subject to abuse by the large financial entities that sold them as part of supposedly AAA rated investments.
“If you look at home insurance, health insurance, life insurance, it’s a much regulated industry,” Zhang said. “But with credit default swap there is no regulation. No one really knows how many policies have been issued or how many are outstanding. There should be a centralized clearing house collecting all this information.”
Zhao said the study may have policy implications.
In a 2011 congressional hearing, SEC Commissioner Luis Aguilar spoke about how it became clear after the financial crisis that firms were creating financial products, selling them and then making bets against them.
“The U.S. Securities and Exchange Commission has been tackling conflicts of interest in securitization deals with a long list of financial crisis cases settled by the SEC and various subprime market players,” Zhao said. “Our study is especially relevant as it provides the first empirical evidence in academic research to such claim pertaining to the usage of CDS.”
Again, these abuses of credit default swaps sold as insurance for sub-prime mortgage-backed securities is not new information to anyone in the financial industry. It’s not the financial press or regulators charging lack of institutional control and regulations led to the 2008 crisis. These claims are now supported by economists who finally studied CDS. Their research demonstrated a direct statistically significant link between their use with subprime mortgage-backed securities and the increased rate of mortgage defaults that triggered the greatest economic crisis since the Great Depression.
These same economists also verified that firms who offered mortgage-backed securities insured by CDS sold the riskiest mortgage securities as safe investments to pension funds, mutual fund managers and other large institutional investors. In other words, the use of unregulated CDS by the largest financial firms led to more and riskier loan generation and less scrutiny of these financial instruments:
Poor quality loans were originated by lenders, and then were repackaged, securitized and sold to investors. The loans were no longer on the lenders’ books, so they had less incentive to monitor the borrowers. The investors relied on their insurance policy—the CDS—and also neglected to monitor the borrowers.
“That’s how the credit default swaps created more hazard issues and actually exacerbated the financial crisis, because it encouraged origination of poor quality loans,” Zhang said.
Everyone from the mortgage originators, to the commercial banks, to the large investment bankers and those who purchased these increasingly risky mortgage backed securities failed to properly assess the risk and monitor the danger. And once it became apparent to many of the Big Banks who offered these subprime mortgage securities that they were complete crap, many of those same firms turned right around and bet against the very securities they told their buyers were safe and risk free. Case in point: Goldman Sachs.
In 2006 and 2007, Goldman Sachs Group peddled more than $40 billion in securities backed by at least 200,000 risky home mortgages, but never told the buyers it was secretly betting that a sharp drop in U.S. housing prices would send the value of those securities plummeting.
Goldman’s sales and its clandestine wagers, completed at the brink of the housing market meltdown, enabled the nation’s premier investment bank to pass most of its potential losses to others before a flood of mortgage defaults staggered the U.S. and global economies.
Only later did investors discover that what Goldman had promoted as triple-A rated investments were closer to junk.
Now, pension funds, insurance companies, labor unions and foreign financial institutions that bought those dicey mortgage securities are facing large losses, and a five-month McClatchy investigation has found that Goldman’s failure to disclose that it made secret, exotic bets on an imminent housing crash may have violated securities laws.
The same firms that are whining about the pitifully weak regulatory schemes that were put in place after the fact. The same firms who benefited from government bailouts in the United States and Europe, and continue to be among the most profitable companies in the world. The same firms who “own Congress,” continue to invest heavily in the campaigns of both Republican and Democratic elected officials and continue to receive preferential treatment at the expense of ordinary taxpayers and individual depositors.
So, the next time your libertarian/conservative/Republican friends go on about how if big government would only allowed the invisible hand of the market to operate freely all our economic problems would be solved by the sparkly free enterprise unicorns, just tell them our federal government already tried that approach and real economists have shown that it failed miserably.
