Things have really changed in this country since 1948 when Harry Truman was President. That year, 56% of profits in the U.S. economy came as a result of manufacturing. And, at that time, 8.3% of profits came from the financial sector. Now let’s fast forward to 2007 – the year the financial collapse of our economy began – and see how things have changed. In 2007, manufacturing produced 10% of profits, while the financial sector produced 26% of profits. I have never understood how our political leaders could sit back and allow our nation to lose manufacturing jobs in mass to foreign countries.

As we have mentioned in previous issues, there has been lots of speculation on the probable causes for the collapse of our economic system. I will mention one of the theories here. Prior to 2007, few of us had any idea what Credit Default Swaps – the complex financial instruments that pushed the global economy to the edge of depression – actually were. Credit Default Swaps (CDS) weren’t even around before the early 1990s. CDSs ballooned in the 2000s and there was a reason. These CDSs took off after a 250-page amendment – written by Wall Street lawyers and sponsored by none other than Senator Phil Gramm – was quietly tacked onto an appropriations bill as Congress was adjourning for Christmas in 2000. One provision in the amendment exempted CDSs from regulation and while that in itself was a bad thing, it went virtually unnoticed. I suspect the timing of this event was more than just a random coincidence.

In the 1980s, mortgage lenders began bundling and selling mortgages. Buyers of those securitized mortgages bought Credit Default Swaps as insurance policies in the event the bundled mortgages were to default. Because the insurance swaps were unregulated, there was no way of knowing whether the insurer could pay off in the event of default. There was one thing that was certain, however, and that was a good number of bundled mortgages were subprime loans.

There is a term labeled “Naked Default Swaps,” in which a party who doesn’t own a security buys a policy on it, betting on it, either to fail or succeed. The bet was that either the security would be okay or would not be okay. Then Wall Street would come in and sell them what amounted to an insurance policy of sorts made on that bet. If that sounds weird and complicated, I can tell you it is.

When the nation’s financial system collapsed in 2008, an estimated $62.2 trillion in CDS value was hanging out there – a figure equivalent to the gross domestic product of the entire world in 2008. Because CDSs are unregulated, there was no way of knowing what capital reserves backed them. An estimated 80% of that $62.2 trillion was in “naked swaps,” directional bets in which the parties own no interest in the securities they were insuring. And 80% of all Credit Default Swaps were traded by the nation’s five biggest investment banks – their losses backed by the FDIC and the U.S. Treasury. If anybody believes that there is no need for stronger regulation of our financial institutions, the above information should change their mind. There is no telling how much fraud has been committed, and the lack of regulation made it extremely easy.

You will recall that in mid-April, the SEC charged investment banker Goldman-Sachs with using credit default swaps to defraud its clients of $1 billion. It was alleged that Goldman bundled mortgages that were calculated to lose value, sold them to clients, and then purchased credit default swaps on the securitized mortgages. When the value of the “synthetic collateralized debt obligation” packages that Goldman sold their clients went in the tank, Goldman cashed in on the swaps, collecting billions of dollars. It was reported that Goldman Sachs used a separate entity (Abacus 2007-AC1). If this sounds familiar, you might remember the Enron story to sell the investment packages the SEC alleges were designed to fail.

According to an article in the New York Times, reporting on Goldman’s dealings, seven of the Abacus deals were insured by Credit Default Swaps purchased from AIG. You will recall that the federal government bailed AIG out with an initial $180 billion in TARP funding.

Source: New York Times