Many are wondering how the current crisis in the US financial and mortgage markets suddenly erupted recently despite strong economic growth over the preceding 3-4 years. This article attempts to provide some answers.

To understand the phenomenon, let’s go back to 1933 when the US Congress enacted the Glass-Steagall Act following the famous Wall Street crash. The Glass-Steagall Act separated the functions of commercial banks from those of stockbrokerage houses and regulated the way banks could loan out mortgages. In essence, through this Act, the government limited the risk inherent in repayment of mortgage loans.

In 1990s, the Congress passed the Gramm-Leach-Bliley Act (GLBA) which rolled back the Glass-Steagall Act and largely deregulated the banking industry, allowing banks to merge with securities firms. The GLBA was followed up by an amendment into an omnibus appropriations bill which deregulated the trading of financial instruments and allowed banks and brokers to trade mortgages as if they were stocks and bonds.

What followed in the wake of such deregulation was that sub-prime mortgages (essentially, loans that have less room to tolerate financial difficulties of the borrower thus increasing the chances of late payments and defaults) became routine, and the trading of sub-prime mortgages in bulk became a widespread practice on Wall Street up to the present day.

In the early 1990s, in order to hedge their loan risks, some US banks devised a derivative instrument called the credit default swap (CDS). A credit default swap is, essentially, an insurance contract between a protection buyer (such as creditors of loans and bonds who might seek insurance to guarantee that the debts they are owed are repaid) and a protection seller (such as an insurance provider) covering the loan or bond.

A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced loan. Typically, the insurance is for five years. CDS’s are bilateral contracts, meaning they are private contracts between two parties and subject only to the collateral and margin agreed to by contract.

They are traded over-the-counter, usually by telephone. They are also subject to re-sale to another party willing to enter into another contract. Fundamentally, this kind of derivative serves a real purpose – as a hedging device.

Frighteningly, however, CDS’s are subject to “counterparty risk”, thus if the party providing the insurance protection – once it has collected its upfront payment and premiums – doesn’t have the finances to pay the insured buyer in the case of a default event affecting the referenced loan or if the “insurer” goes bankrupt, the buyer is not covered.

The premium payments are gone, as is the insurance against default. More frighteningly, CDS’s are not standardised instruments either. In fact, they technically aren’t true securities in the classic sense of the word in that they’re not transparent, aren’t traded on any exchange, aren’t subject to present US securities laws, and aren’t regulated. They are, however, all at risk, and current estimate of their value is $62 trillion.

What happened is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (including sub-prime mortgage-backed securities), but didn’t actually own the underlying credits, now had a means by which to speculate on them.

Here’s an example of such a speculative activity: If you think XYZ Corp. is in trouble, and won’t be able to pay back its bondholders, you can speculate by buying, and paying premiums for, CDS’s derived from their bonds, which will pay you the full face amount of the bonds if they do actually default.

If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means you’d essentially be speculating that the bonds would not default. You’re hoping that you’ll collect, and keep, all the premiums, and never have to pay off on the insurance. It’s pure speculation.

To understand the mechanism of CDS’s better, think of a situation where one is allowed to insure your house by seeking protection through paying insurance premiums to someone else entirely not connected to your house, so that if your house is devastated in an earthquake or terrorist act, he gets paid its value. I’m speculating on an event. I’m making a bet.

The bad news is that there are even worse bets out there. There are CDS’s written on sub-prime mortgage securities. It’s bad enough that these sub-prime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value; what’s worse is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn’t, default!

The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.

And this is only where the story begins. What is happening in both the stock and credit markets is a direct result of what’s playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because – and only because – the trillions of dollars of CDS’s on its books would be wiped out.

All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions of dollars in losses that they have been carrying at higher values because they could say that they were insured for those losses.

The counterparty risk that all Bear’s trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option. The Fed had to bail out Bear Stearns.

The same thing has happened to AIG. Make no mistake about it, there’s nothing wrong with AIG’s insurance subsidiaries – absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate (LIBOR) on that $85 billion loan!

What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities.

As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn’t have. In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.

Unfortunately, there’s more bad news in store. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. The US may be entering a period of global economic depression, essentially due to the inability of the regulators and the US government to arrest reckless speculation.