Monday, September 22, 2008

Soaring Cost of Protection Ended Wall Street's Run

The five big investment houses on Wall Street are no more. Two merged, one failed, and all are now under a more regulated commercial bank status. What happened this past week that accelerated the crisis? Why did storied Wall Street flee the benefits of free markets for the protection of more regulated financial waters?

Piecing together stories from across the financial world with information from Lehman Brothers' annual reports, I believe the cost of credit "peace of mind" became prohibitive. It happened virtually overnight.

The risk of unregulated mortgage backed securities can be covered by a derivative investment known as credit default swaps, also unregulated. Think of them as "Mafia protection money." When the neighborhood is good, the cost of protection is cheap. But as the block becomes more dangerous, the price of protection increases to cover the higher risk.

That happened recently. The Wall Street Journal reported:

In the past week, a jump in the value of credit-default swaps tied to Morgan Stanley and Goldman Sachs Group Inc. set off similar concerns at both firms. On Thursday morning, swap sellers were charging buyers more than $900,000 annually to insure $10 million of Morgan Stanley's obligations from default over five years, a price typically associated with highly risky or distressed companies. The prices had doubled from Monday and tripled from the week before. On Friday, after the SEC announced its short-selling curbs, the cost fell to $560,000.

The five year cost of protection decreased from 45% to 28% after Uncle Sam took action! For the investor to come out whole, annual interest rates would need to increase over 5% overnight. That would kill credit.

Yet, no one wants to buy uninsured or uncovered credit in today's market. Without credit default swaps, the mortgage backed securities can't move.

The Wall Street Mafia protection market went flippy-floppy the last week or so. Why the surprise? The big investment houses trade derivatives off balance sheet. Lehman had almost $740 billion in those instruments, more than all of the company's assets. A seize up in trading derivatives could take out Lehman overnight.

I believe the reckoning came in credit derivatives. Their collapse took out storied financial firms and locked up the credit markets. Of course, President Bush and Treasury Chief Hank Paulson don't want to tell the American public the truth, Wall Street failed from gambling and Mafia like protection schemes.

But that's why we're bailing out firms holding "mortgage security related products" to the tune of $1 trillion or more. I'm concerned about the taxpayer backstopping asset backed mortgage securities. I'll be livid if I'm paying for credit default swaps. What happens on Wall Street should stay on Wall Street....

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