Bob Cropf

Obama to announce foreclosure plan

In economics, Obama, stimulus on February 17, 2009 at 12:11 PM

Tomorrow in Phoenix, AZ, President Obama is expected to unveil his plan to help the country’s homeowners who are struggling with foreclosures. His plan is expected to cost between $50 and $100 billion. The tide of foreclosures is threatening to swamp the economy. RealtyTrac is a private firm tracking foreclosures around the country. They provide some of the best data of national foreclosure trends (you have to be a subscriber to see some of the data.) However, a recent NPR report raises some questions about undercounting hard-hit rural areas.

The issue is more complicated than just foreclosures. As the website, Bankaholic, the securitization of the failed mortgages is really at the heart of the problem. At the heart of the securitization problem are the so-called toxic derivatives, which the Bankaholic site describes. A big example of the suspect financial instruments that brought us to our current mess are the credit default swaps (CDS). The following is from the Bankaholic site.

What are CDS
Let’s say you just bought a shiny new sports car for $100k. You can buy insurance on the car by paying an insurance company $500 a year. The insurance company promises to buy you a new sports car if you total your car.

The insurance is like a CDS, except CDSs insure corporate bonds in the event that a corporation goes bust.

However, with a CDS, you can buy insurance even if you don’t own the bond; this is called speculation. When you buy a CDS w/o owning the underlying bond, you are essentially betting that the corporation will go bankrupt. This is like buying car insurance for your friends shiny new Ferrari, hoping to collect in the event that he crashes. Some hedge funds even allegedly speculate in CDS while sabotaging their underlying corporate stocks to increase the chances of bankruptcy. This is the equivalent of cutting the brakes on your friend’s Ferrari.

  1. Though I am not sure I would be ready for all of the fall-out that might ensue, I think that there is a powerful argument to be made for the government to declare all CDS purchased by someone who does not own the bond they were insuring to be NULL&VOID. I know it is a LOT of money, far more money then is actually involved in the securities themselves because multiple entities would by CDS on a single security but
    (1) It isn’t actually lost to the CDS purchaser unless the security actually failed… so they *should not* have counted this money in their balance sheets
    (2) It was bordering on maleficence to have spent money in this way… there is really no good faith reason to do so… insure against your own losses, sure, insure against someone else’s losses incentivizes sabotage like nothing else.

    Didn’t some government regulator (Born?) suggest back in the 1990s that you shouldn’t be allowed buy CDS on bonds you don’t own because of the perverse incentives it sets up. If I remember correctly Summers or Rubin shot her down, but it could have been another issue entirely.

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