15
Oct
08

A flat out special purpose vehicle

As a person with a general interest in economics but not a detailed understanding of its complexity and depth I was interested to observe the Tony Jones interview of economist WIll Hutton, located here.

An excerpt:

TONY JONES: Yes, well, you’ve written the most complete account that I’ve seen of how it went bust in the first place; how this credit derivative market developed and why so many financial managers put their trust in us. Tell us how it all started.

WILL HUTTON: Well, how long have you got? I think everyone watching will probably understand the idea of a bond, you know, you issue a bond, a company or Government issues a bond and you make 1,000 pounds in profits and you’ll pay a small fraction of those profits to servicing the bond.

Fine, we all understand that. It’s a very established principle. Securitisation did something different.

It said okay, let’s take part of your profit stream, it could be interest from payments on a port facility you own, it could be a football stadium, it could be some mortgage payments you’re receiving from some tenants.

Let’s take all those and let’s hypothecate them, to what was called in the jargon a special purpose vehicle, and then let’s flog it to investors all around the world.

And to give them some guarantee that this very risky piece of paper is worth the paper it’s written on, let’s take out an insurance contract called a credit default.

But it was more than a credit default, it was called a credit default swap because you would swap the insurance policy to another buyer if you chose.

Now what makes this so interesting is that if for any reason any of those mortgage payments don’t come in like you’re expecting; if the traffic in the port facility goes down a bit, if the revenues from that football stadium just contract a bit, suddenly, wow, there’s less money coming in to pay the interest on that bond.

And you start to … and the value of it starts to fall, and then you want to collect on the insurance policy but you’ve swapped the insurance policy to somebody else and they may in turn have swapped it to somebody else and somebody else and somebody else.

So nobody in the system knows what the value of these securities actually are really, where the losses are going to pop up and suddenly, over the last two, three, four weeks, the entire world system has just frozen in fear.

And people only … and banks will lend to each other just for the night or they’ll borrow from a Central Bank.

And you can’t lend working capital to a business or a 25-year mortgage if you, the bank, are just borrowing off the Central Bank or borrowing off another bank overnight you just can’t do it.
So credit has just stopped in its tracks and if something hadn’t happened, we would have confronted a worldwide meltdown, a worldwide depression.

An overview of media reports of economists suggests somewhere between a mild recession to a deep recession in the United States with permeating effects throughout the world.  Australia appears much safer to cope with this than many other countries.  Consistency across media does not always produce an accurate result.  The complexity of the issue, the lack of information and the lack of oversight and regulation is concerning.

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