Credit Default Swaps and the Bagdad Banker
Once upon a time in Iraq a Bagdad banker and a goat trader traveled a great distance to a small desert village. They drank tea with village chiefs and made themselves known as benefactors to the village: The goat trader offered to buy goats and the banker offered to lend money. The goat trader first offered to buy goats at $10 a goat. The price was good and the villagers sold him a few goats. After a number of days, the trader offered $20. No one paid much attention to the rumor, “Enchala.” One cleaver fellow, however, bought a goat from his neighbor for $12, betting that the rumor might be true, and indeed made $8 dollars on the trade a couple of days later.
Sure enough in a few days the goat trader was buying goats for $20, and the word got around. The villagers bought goats from the Bedouins and sold them in the city. A new rumor soon spread whispering $30. Conventional wisdom now confirmed that goat prices were going up. Villagers begin buying and selling goats among themselves in anticipation of rising prices.
The banker began lending goat money at 10% with penalties for default or lost goats. Speculators took out loans to buy goats in anticipation of higher prices. First time buyers clamored for this sure thing. Goats were traded between villages. There were few problems.
Business was good. Optimism grew. The banker made many loans to anxious buyers in anticipation of higher prices. The trader sold most of his goats back to into the goat market – always at a profit. They borrowed from one another. They traded off their valuables to buy as many goats as they could.
As it came to pass, the banker left for Bagdad carrying all the money and all the goat mortgages, leaving behind the rumor that goats were going to $50. Thus begins another part of the story.
This banker, let’s call him Aman, had many relatives and many connections of a shrewder sort -- but none so outrageous as his cousin who was in fact in the protection and kidnapping business. Together over tea they talked about the goat revenue and the profitable opportunities that goats might offer. The banker considered selling the goat paper to Bagdad banks, but the image of a goat mortgage looked like something less than a prime security.
The cousin commented, “Make it look like a new legitimate enterprise, and the Americans will subsidize it, no questions asked. Another thing, in our family business, we found that we could sell protection more than once on the same individual. Why can’t you sell the goat paper multiple times? After all, the mortgage is just a promise. There is no substance.”
“The trick would be in getting the paper back in order to sell it again.”
“Guarantee the payment. Ha, trade one promise for another. Ah, sell the bank insurance on the mortgage payment in exchange for the paper. The bank would need to make payments for that guarantee. Then do the same thing all over again. That guarantee will make the goat mortgage look better, and your promise may look better than the goat owner’s.”
“Those guarantees amount to insurance. We have a broker’s license. Just for the sake of argument, let’s suppose that we registered as an insurance company as well. The Americans will love it. They worship insurance.
“Now you are talking about my business,” replied the cousin. Our family has sold protection for seven hundred years. It’s the same thing as insurance, just a bit rougher and not regulated. I like the idea, but the Americans regulate insurance. We need another name.”
“But, if we call ourselves an insurance company, the Americans will surely subsidize our operation. They are throwing money at the wall.”
“Let us work together cousin. Between us we can do this.”
“Praise be my cousin I am honored. I must confess that was my hope.”
“You are family Amed, and I do think we have something here, so yes let us prosper. We will start an insurance company, a brokerage company and along with your bank we will own all three under a holding company, but we don’t sell insurance; we sell protection.”
"Let us instead of insurance swap a guarantee of payment by our insurance company for the original loan papers. This is the key. If we can swap credit default insurance for the mortgage papers, everything falls into place. We will call this new paper “Credit Default Swaps.” There is no limit to how many times we can sell the same goat mortgages and the CDSs”
“Good, the loans and the swaps are both worthless, but with the mortgage papers in our vault, we can sell them again and again”
“We’ll call these “Hedge Funds” and sell shares in the funds as well. It’s like printing money. And to think, they sent Bernie Madoff to jail.”
“I don’t see why not, and we can guarantee the loan payments with more insurance swaps. That way we get the money for the loans, the money for the guarantees and by swapping out the paper we do the same thing all over again.”
“How many times do you think we can sell these same notes?”
“I don’t think there is any limit, so long as goat prices hold. Our trader will have to keep buying goats.”
“How many goats are there in Iraq?”
“As many goats as there are stars in the sky cousin; praise be...”
“What criminal charges do we face?”
"Let’s just say there is no specific law against it, but if goat prices go south we may need to leave town in a hurry.”
“So, the money will have to be transferred to a safe place.”
“Praise be – that sub-prime goat paper holds for a while.”
“Since the Americans came everything is deregulated and privatized, the rules have changed. Before you could not be an insurance company and an investment broker at the same time, but not anymore”
“If we license ourselves as both, we will look even more legitimate.”
“Yes and there will be three money streams, one from selling the goats, one from selling the goat mortgages and one from insuring them.”
“I started out as a banker. I think we need to keep banking in the equation.”
“And that’s how we manipulate the money. It uses to be that you could not be a bank and a brokerage house at the same time, much less an insurance company. Now there is no need to explain; one hand shakes the other.”
“We can use our bank to transfer assets from one enterprise to the other. “In case someone wants their money back?”
“Small problems can just disappear; arrangements can be made.”
“What about bigger problems? The securities regulations are still in effect and there are regulators who will not disappear. We could spend a lot of time explaining and documenting”
“Not if we avoid regulated securities. There are many regulations that are exempt from regulation. There are off the balance sheet investment pools. In London they call these Dark Pools where large institutions trade off the record.”
“Our related companies can backstop each other’s claims. We can reinsure each other as well to make the financials look all the better.”
“That is true cousin, and the securities regulators do not know what the bank is doing and the banking regulators do not know what the broker is doing.”
“Yes, and if there is anything to hide when the banking regulator comes calling, we just move it across the hall to the other office."
“We will be big soon enough. There are many instruments that are exempt. In fact those not specifically designated are not regulated. Legislators are happy to see these unregulated instruments because it helps them hide their own under the table revenue stream.”
“We are getting ahead of ourselves cousin. I have only a bombed out bank and a broker’s license and a hand full of goat mortgages.”
“That will not be a problem. Our cash flow will help us build a blinding image.”
And it came to pass that the partnership thrived. The goat prices held for a while. The cousins built a huge aluminum and glass office building. They named their enterprise AIG, Arabian, Investment Group, and even sponsored a soccer team. They paid themselves multi million dollar bonuses and became community leaders and philanthropists.
Nevertheless, as all things end, goat prices collapsed, and foreclosure was a problem. Would the government bail them out? Were they too big to fail? As it turned out they paid themselves yet more multi million dollar bonuses – draining all the assets – and disappeared into the desert, like the Red Shadow.
Sure enough in a few days the goat trader was buying goats for $20, and the word got around. The villagers bought goats from the Bedouins and sold them in the city. A new rumor soon spread whispering $30. Conventional wisdom now confirmed that goat prices were going up. Villagers begin buying and selling goats among themselves in anticipation of rising prices.
The banker began lending goat money at 10% with penalties for default or lost goats. Speculators took out loans to buy goats in anticipation of higher prices. First time buyers clamored for this sure thing. Goats were traded between villages. There were few problems.
Business was good. Optimism grew. The banker made many loans to anxious buyers in anticipation of higher prices. The trader sold most of his goats back to into the goat market – always at a profit. They borrowed from one another. They traded off their valuables to buy as many goats as they could.
As it came to pass, the banker left for Bagdad carrying all the money and all the goat mortgages, leaving behind the rumor that goats were going to $50. Thus begins another part of the story.
This banker, let’s call him Aman, had many relatives and many connections of a shrewder sort -- but none so outrageous as his cousin who was in fact in the protection and kidnapping business. Together over tea they talked about the goat revenue and the profitable opportunities that goats might offer. The banker considered selling the goat paper to Bagdad banks, but the image of a goat mortgage looked like something less than a prime security.
The cousin commented, “Make it look like a new legitimate enterprise, and the Americans will subsidize it, no questions asked. Another thing, in our family business, we found that we could sell protection more than once on the same individual. Why can’t you sell the goat paper multiple times? After all, the mortgage is just a promise. There is no substance.”
“The trick would be in getting the paper back in order to sell it again.”
“Guarantee the payment. Ha, trade one promise for another. Ah, sell the bank insurance on the mortgage payment in exchange for the paper. The bank would need to make payments for that guarantee. Then do the same thing all over again. That guarantee will make the goat mortgage look better, and your promise may look better than the goat owner’s.”
“Those guarantees amount to insurance. We have a broker’s license. Just for the sake of argument, let’s suppose that we registered as an insurance company as well. The Americans will love it. They worship insurance.
“Now you are talking about my business,” replied the cousin. Our family has sold protection for seven hundred years. It’s the same thing as insurance, just a bit rougher and not regulated. I like the idea, but the Americans regulate insurance. We need another name.”
“But, if we call ourselves an insurance company, the Americans will surely subsidize our operation. They are throwing money at the wall.”
“Let us work together cousin. Between us we can do this.”
“Praise be my cousin I am honored. I must confess that was my hope.”
“You are family Amed, and I do think we have something here, so yes let us prosper. We will start an insurance company, a brokerage company and along with your bank we will own all three under a holding company, but we don’t sell insurance; we sell protection.”
"Let us instead of insurance swap a guarantee of payment by our insurance company for the original loan papers. This is the key. If we can swap credit default insurance for the mortgage papers, everything falls into place. We will call this new paper “Credit Default Swaps.” There is no limit to how many times we can sell the same goat mortgages and the CDSs”
“Good, the loans and the swaps are both worthless, but with the mortgage papers in our vault, we can sell them again and again”
“We’ll call these “Hedge Funds” and sell shares in the funds as well. It’s like printing money. And to think, they sent Bernie Madoff to jail.”
“I don’t see why not, and we can guarantee the loan payments with more insurance swaps. That way we get the money for the loans, the money for the guarantees and by swapping out the paper we do the same thing all over again.”
“How many times do you think we can sell these same notes?”
“I don’t think there is any limit, so long as goat prices hold. Our trader will have to keep buying goats.”
“How many goats are there in Iraq?”
“As many goats as there are stars in the sky cousin; praise be...”
“What criminal charges do we face?”
"Let’s just say there is no specific law against it, but if goat prices go south we may need to leave town in a hurry.”
“So, the money will have to be transferred to a safe place.”
“Praise be – that sub-prime goat paper holds for a while.”
“Since the Americans came everything is deregulated and privatized, the rules have changed. Before you could not be an insurance company and an investment broker at the same time, but not anymore”
“If we license ourselves as both, we will look even more legitimate.”
“Yes and there will be three money streams, one from selling the goats, one from selling the goat mortgages and one from insuring them.”
“I started out as a banker. I think we need to keep banking in the equation.”
“And that’s how we manipulate the money. It uses to be that you could not be a bank and a brokerage house at the same time, much less an insurance company. Now there is no need to explain; one hand shakes the other.”
“We can use our bank to transfer assets from one enterprise to the other. “In case someone wants their money back?”
“Small problems can just disappear; arrangements can be made.”
“What about bigger problems? The securities regulations are still in effect and there are regulators who will not disappear. We could spend a lot of time explaining and documenting”
“Not if we avoid regulated securities. There are many regulations that are exempt from regulation. There are off the balance sheet investment pools. In London they call these Dark Pools where large institutions trade off the record.”
“Our related companies can backstop each other’s claims. We can reinsure each other as well to make the financials look all the better.”
“That is true cousin, and the securities regulators do not know what the bank is doing and the banking regulators do not know what the broker is doing.”
“Yes, and if there is anything to hide when the banking regulator comes calling, we just move it across the hall to the other office."
“We will be big soon enough. There are many instruments that are exempt. In fact those not specifically designated are not regulated. Legislators are happy to see these unregulated instruments because it helps them hide their own under the table revenue stream.”
“We are getting ahead of ourselves cousin. I have only a bombed out bank and a broker’s license and a hand full of goat mortgages.”
“That will not be a problem. Our cash flow will help us build a blinding image.”
And it came to pass that the partnership thrived. The goat prices held for a while. The cousins built a huge aluminum and glass office building. They named their enterprise AIG, Arabian, Investment Group, and even sponsored a soccer team. They paid themselves multi million dollar bonuses and became community leaders and philanthropists.
Nevertheless, as all things end, goat prices collapsed, and foreclosure was a problem. Would the government bail them out? Were they too big to fail? As it turned out they paid themselves yet more multi million dollar bonuses – draining all the assets – and disappeared into the desert, like the Red Shadow.
Labels: Economics
posted by Clancy Hughes | 2/09/2010 11:39:00 AM
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