As a young twenty something ingenue at JP Morgan Chase, Blythe Masters was the inventor of the Credit Default Swap (CDS), the financial instrument responsible for almost destroying the global financial system in 2008. Warren Buffett called CDSs “financial weapons of mass destruction.” But exactly what are CDSs and how did they function to almost bring down the entire global banking system? CDSs came about from JP Morgan Chase, Goldman Sachs and other large banks’ desire to offload risk and thereby strengthen their balance sheets. They would then be in a position to do more deals due to the fact that they would not have to keep so much collateral on their books to back up their deals. If a loan or bet went south, someone else would be responsible for paying off on the insurance policy, not them. Thus they could increase their profits by doing more and more trades without having to worry about paying off on any of them if anything went awry. That would be some other institution’s responsibility. A CDS was an insurance policy. Furthermore, you wouldn’t even have to be directly involved as a party or counterparty. You could purchase a “naked” CDS. This is like betting on a horse that you don’t own and have no financial stake in or responsibility for.
When the big banks entered the subprime loan market, their problem was “how do we get the rating agencies such as Moody’s and Standard and Poor’s to rate these securities as anything other than trash and make them more attractive to investors?” First, the subprime loans were bundled together and securitized creating Collateralized Debt Obligations (CDOs). Then they were sold off in tranches (slices) to investors. Blythe Masters’ invention circa 1996 enabled them to be rated AAA. How they did it was this. The rating agencies might want to have rated the CDOs BBB or CCC, but the banks said to them “How about if we throw in some insurance that these mortgages won’t default? Will that raise the credit rating of this worthless junk?” Sure enough the rating agencies said. So part of the package became a CDS which effectively guaranteed the CDO and got it rated AAA. Investors ate up the product never bothering to look at the underlying worthless mortgages. A AAA rating was good enough for them. After all how could they go wrong with a AAA rated investment product? Then as soon as the deal was done, JP Morgan Chase traded off the CDS to someone else like AIG, for instance. No regulator or anyone else ever bothered to ask if AIG had the assets to back up the risk it had taken on and JP Morgan was free to go on and make other trades and deals since the need to back up any of these deals had just been transferred to some other institution. Without a lot of risk weighing down their balance sheets the big banks were free to make more deals, more trades and higher profits.
Insurance companies are the most highly regulated companies on the planet since it is important to know that an insurance company has the assets to back up the policies it writes. However, no one bothered to check if CDSs, which are essentially insurance products, were backed up by anything and this is what in a nutshell caused the financial deluge of 2008. And the regulatory atmosphere during the Bush administration was that no regulation was good regulation. When subprime mortgages went belly up, the investors tried to redeem their CDSs only to find out that the institutions who had pledged to make them whole didn’t have the assets to do so. This is what caused Bear Stearns to throw itself at Tim Geithner’s and Ben Bernanke’s feet in March of 2008 and beg for mercy. They engineered a takeover of Bear by JP Morgan Chase and to sweeten the deal they gave JP Morgan $30 billion. So they said in effect ‘here take $30 billion and Bear Stearns and problem solved’. But the problem was not solved. Treasury Secretary Henry Paulson, a free market guy, was upset that Bear wasn’t allowed to go bankrupt because of ‘moral hazard’. He thought that banks that had gotten themselves in trouble shouldn’t come begging to the government to save them. Moral hazard meant that you had to suffer the consequences of your own decisions even if that meant going bankrupt. You couldn’t expect the government to bail you out. Unfortunately, this concept ended up being applied more to average citizens than to the big financial institutions.
What happened next was that Lehman, which also had a large portfolio of CDSs came crying to the government. Paulson said, “No bailout. You guys are on your own.” and Lehman promptly went bankrupt. But the dominoes did not stop falling there. AIG had a humungus portfolio of CDSs with not a prayer of a chance of backing them up. The dominoes were falling and the regulators in the government had hardly a clue as to what was happening. Why didn’t they know anything or have a plan for dealing with the ensuing catastrophe? Because the CDS market was a dark market. They weren’t traded on an exchange. Each deal was a private deal between a party and a counterparty with no one else having a clue as to what was going on. Thus trillions of CDSs accumulated on the books of financial institutions without anyone knowing the total amount or whether or not the institutions were in a position to pay them off if need be.
Here’s an example of a dark market. Say you’re selling a used car. You’d like to get as much as you can for it and your counterparty would like to pay the least. You, being a used car dealer, and your counterparty being an unsophisticated rube, who do you think is going to get the better end of the deal? The dealer of course. Before the era of Kelly’s Blue Book there was a dark market in used car dealing. With the advent of Kelly’s Blue Book, the market is no longer dark since the counterparty can look up the value of a used car and know about what he should pay. Similarly, Wall Street traders racked up huge profits because their counterparties didn’t know they were being screwed. That is why they don’t want CDSs traded on an exchange or any light cast on their activities. It would cut down on the Wall Street trader’s profits.
After Lehman failed, the crisis got even worse. So Geithner and Bernanke got together, much to Paulson’s chagrin, and said fuck moral hazard, we have to bail out AIG to save the system, and they did to the tune of $180 billion which came as did the $30 billion for Bear Stearns from the Federal Reserve Bank. Note that this all happened during the Bush administration long before Geithner became Treasury Secretary under Obama. Who engineered the takeover of the banks by the government? Who was the big socialist here? Bush and Paulson, free market guys, not Obama. Obama wasn’t even in office yet. The next thing was that Bernanke said he could not keep on doing this. Paulson would have to go to the US Congress and demand money for future bailouts, and the result of this was the TARP, the Troubled Asset Relief Program, to the tune of $700 billion. Paulson, the free market guy who believed in letting the chips fall where they may, stuffed $125 billion down the throats of the big banks whether they liked it or not. Many of them did not want to accept the money.
Later after Geithner became Treasury Secretary under Obama, he argued that investors should not have to take the least bit of a haircut. All their bets should be paid off in full. The casino’s integrity would have to be preserved at any and all costs or no one would ever bet there again. Quel horreur! So what that amounted to was that if you placed a bet that Lehman was going down and you bought a naked CDS and then sure enough Lehman went down, Geithner argued that that investor should be paid in full regardless of how little he paid to place his bet in the first place or when he placed the bet! Geithner totally pussyfooted around the big banks, but of course people who were being foreclosed on got absolutely no relief whatsoever. Main Street which suffered the most from the banking crisis was left to go it alone (remember moral hazard?) while the banks were being stuffed with cash. No banker had to take a cut in salary or miss a bonus. Wall Street got bailed out. Main Street got sold out. Bankers weren’t forced to write down mortgage principles or lower mortgage interest rates. Any writedowns were strictly voluntary so bankers for the most part ignored them. In the final analysis foreclosures were far more profitable. Investors could buy up foreclosed properties on the cheap paying cash and make a killing when prices went up again.
And with all the fuss over TARP, and unbeknownst to the general public, Bernanke’s Federal Reserve was still stuffing the banks with cash. A lawsuit by Bloomberg News forced the Fed to reveal that it had given $7.7 trillion to banks all over the world to prevent the looming crisis. No wonder the banks recovered so quickly! This made TARP trivial by comparison. A lot of these bets that were paid in full were on naked CDSs. Anyone could buy a CDS not just a party or counterparty to the original loan, and since these markets were dark, no one knows how many insiders walked off with billions when they knew which way the wind was blowing or how little they paid to place their bets in the first place. Such a one was John Paulson, no relation to the Treasury Secretary. He made $4 billion on one bet. He had Goldman Sachs design a CDO which both he and Goldman knew would fail. Then Paulson bet against it. Goldman’s traders enthusiastically talked it up to their clients, er uh, muppets who bought it. Goldman itself bet against its own product. Long story short Paulson made $4 billion which Geithner, of course, demanded that he be paid in toto – no haircut for this sleazy bastard. Now Paulson is using his billions under the Citizens United ruling of the Supreme Court to donate millions to defeat President Obama and promote right wing policies and politicians. You can thank Tim Geithner for insisting on no haircut for Paulson. Ironically, it was Obama’s Treasury Secretary’s policies that enabled Paulson to pocket the big bucks which he is using to defeat Geithner’s boss!
So what about Blythe Masters who created the CDS when she was a young and pretty twenty something. Her career has gone onward and upward. She still works for JP Morgan Chase. She’s the current head of the Global Commodities Department and resides in New York City. She takes no blame for her creation of the Credit Default Swap. She blames the parties and counterparties who made inappropriate use of it. It’s their fault not hers. It’s faulty execution not the fault of the product itself. She goes blithely along with her life. Masters is Board Chair of the NY Affiliate of the breast cancer charity, Susan G. Komen for the Cure, and a member of the Board of Directors of the National Dance Institute.
John Lawrence writes at Will Blog for Food /
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