(Taken from Raghu-nomics Volume 7)
“Lehman is our case in point. Lehman’s $800 billion in securities comprised of a host of duplicate copies all issued against the same real estate assets. Let’s say Lehman held equal portions of these 7 securities (as we used in our auto example above). We now have 7 of these policies issued against the same car (real estate). Here’s what it means. We could pay off Lehman’s entire liability with just 1/7th the cost. Just $60 billion would have covered the full $800 billion of Lehman’s securities. This $60 billion would retire all of Lehman’s other remaining $740 billion in outstanding liabilities. Why? Because there were 7 policies issued against the same real estate loan. Pay off 1/7, you paid-off the whole thing. The best part is that you would still have $60 billion of debt free real estate assets left over.”
- Credit Default Swaps: settled for 1/7th their total.
Credit Default Swaps or CDS is a new industry that billed itself as the insurance policy against investment risk. It’s like buying a home out in the forest and getting fire insurance in the likely event that there is a fire. The concept of risk free investing in high risk investments can sound incredulous – as our securities meltdown showed us. Raghu-nomics provides a demonstration in the next Chapter how feasible this actually can be. In short, an industry wide approach to collectively pooling the premiums to pay off small market disruptions (rather than paying out for a foreclosure) would be profitable and simple. We use the example of this 2% liability of the real estate markets of 07 to show how this would work. At the height of the market, there were five CDS per home mortgage. Say that each charged a 3% premium. 3% premium on 5 different policies equals 15%. The real estate market only had a total liability of just 2%. It would have only taken 2% to have written-off all the liability of the housing industry. The CDS insurance industry could pocket 8% to 13% in profit a year – assuming they needed to write-off 2% a year. More details in later chapters.
The point here is that Wall Street recognized that Credit Default Swaps: CDS, would place multiple policies (bets) against the same asset. They failed to see who this multiplication could be used to offset the liabilities (as insurance is supposed to do). Nor did they realized the importance of tracking these policies to their specific, home loan. Had this direct correlation been in place, much of the securities meltdown would have been avoided. The industry would have been able to accurately identify which securities held that 2% of the liability (as discussed in section 1). All other securities would then have traded (near) full price. Again, it’s simply an accounting issue and one that had no previous precedent to work from. Raghu-nomics hopes to change that.
There is an even larger issue. These CDS were really a duplicate policy against the same asset. Leveraged financing created trillions more with a whole other set of duplicate securities against these same assets as well. A host of portfolios and companies had securities that were now filled with different versions of securities all issued against the same asset. Paying off that asset should have automatically retired all its counterparts. Here’s another way of saying this: you should have been able to write off much of that portfolio by simply paying off a small part of it.
Our favorite example is Lehman Brothers. The first chapter gave the example of the airport rental company wherein there are 5 different insurance policies on it and two loans for a total of 7 sets of ‘securities’ against that same car: the American Express card coverage, the $12 a day insurance policy, the Commercial Driver’s License policy, the auto companies policy and the banks policy. The bank and rental company reflect an additional loan on the same car as well.
Here’s our point: If a portfolio happened to be made of these 7 different securities, it could be written off by simply paying just 1/7th (one seventh) of that amount. Pay off the car (of our example) and you not only get the car fully paid, but you also have the other 7 liabilities paid-off as well. (For example, the US has $65 trillion in CDS plus $12 trillion in real estate loans, plus derivatives worth trillions more in ‘leverage debt.’ All of this was issued against this same $12 trillion in home loans. Those loans only had 2% of net liabilities.)
Lehman is our case in point. Lehman’s $800 billion in securities comprised of a host of duplicate copies all issued against the same real estate assets. Let’s say Lehman held equal portions of these 7 securities (as we used in our auto example above). We now have 7 of these policies issued against the same car (real estate). Here’s what it means. We could pay off Lehman’s entire liability with just 1/7the the cost. Just $60 billion would have covered the full $800 billion of Lehman’s securities. This $60 billion would retire all of Lehman’s other remaining $740 billion in outstanding liabilities. Why? Because there were 7 policies issued against the same real estate loan. Pay off 1/7, you paid-off the whole thing. The best part is that you would still have $60 billion of debt free real estate assets left over.
Here’s how this would translate over to the housing issue. You would get to have the homeowner pay you back for the payout you just made to pay off your portfolio. It would equal about the same amount the investor/refinancer just paid. You would recoup about 100% of your pay out. The payout would be for just a third to a fifth of the portfolios original total liability. We could have written off much of these securities with just a fraction of the portfolios total liability while getting to have a hard asset to show for it. This would be possible if we tracked these assets. This opportunity was lost due to poor accounting. This makes the 3rd Accounting Mistake.
Part 1 & 2 of 7
Part 3 of 7http://quadrust.com/article/section-3-of-7-securitize-mortgages
Part 4 of 7
Part 5 of 7
Part 6 of 7
Part 7 of 7: