A Look At Wall Street's Shadow Market

60 Minutes: How Some Arcane Wall Street Financial Instruments Magnified Economic Crisis

(CBS)  They are private and largely undisclosed contracts that mortgage investors entered into to protect themselves against losses if the investments went bad. And they are part of a huge unregulated market that has already helped bring down three of the largest firms on Wall Street, and still threaten the ones that are left.

Before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they are much simpler than they sound. "A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails," he explains.

"It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," Greenberger adds.

"So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy?" Kroft asks.

"A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument," Greenberger says.

But he says there was a big problem. "The problem was that if it were insurance, or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap, and not insurance, there was no requirement that adequate capital reserves be put to the side."

"Now, who was selling these credit default swaps?" Kroft asks.

"Bear Sterns was selling them, Lehman Brothers was selling them, AIG was selling them. You know, the names we hear that are in trouble, Citigroup was selling them," Greenberger says.

"These investment banks were not only selling the securities that turned out to be terrible investments, they were selling insurance on them?" Kroft asks.

"Well, it made it easier to sell the terrible investments if you could convince the buyer that not only were they gonna get the investment, but insurance," Greenberger explains.

But when homeowners began defaulting on their mortgages, and Wall Street's high-risk mortgage backed securities also began to fail, the big investment houses and insurance companies who sold the credit default swaps hadn't set aside the money they needed to pay off their obligations.

Bear Stearns was the first to go under, selling itself to J.P. Morgan for pennies on the dollar. Then, Lehman Brothers declared bankruptcy. And when AIG, the nation's largest insurer, couldn't cover its bad debts, the government stepped in with an $85 billion rescue.

Asked what role the credit default swaps play in this financial disaster, Frank Partnoy tells Kroft, "They were the centerpiece, really. That's why the banks lost all the money. They lost all the money based on those side bets, based on the mortgages."

[north45]

I like the transcript of the videos, speakers are identified and I can look up exact quotes.

These comments are not a real blog. In real life I''m 45north not north45 (rules). The rule against html is a constraint.

[notassmartas]

Well, now it is mathematicians and physicists who are the *bad* guys. If so, one wonders why there were no well paying jobs in math and physics for them and they had to work in the corporate world of finance?

[tracysmom39]

Who sets the million dollar ceo bonus. The stock holders certainly cannot agree that golden parachutes should be given to a ceo who has departed after damaging the company. Is it a I''ll scratch your back, if you scratch my back amoung upper management.

[nkhunt]

Re Your story on October 5 on "...Wall Street''s Shaddow Marrket." The thrust of your story was that the current economic crisis was caused entirely by Wall Street malfeasance. You failed to mention that the federal government was complicit in this fiasco. You cetainly knew that. Are you so enamored with liberal politicians, that you have lost your journalistic integrity?

[hur451]

This segment should be shown as a psa on every station in the country to expose this mess ,it should also be shown to the senate and congress. Mr. Kroft an excellent report.

[babooph]

Keep the Somali pix in the news-it portends the USA future with the BUSH legacy.

[deanhix]

The problem lies not with the fat cats. Some might have taken advantage but the problem lie with Fannie/Freddy. lending instutions were required by Fanny/Freddy to carry subprime housing loans. their strong arms were Acron and liberials in congress

[deanhix]

The 2005 reregulation bill of freddie mae offered by john mccain was killed in senste by dem, it takes 60 votes to pass bills. all dems voted against and all rep voted for. there are only 49 rep in senate.

[johnb92711]

This is why I tell people to have at least 3 to 4 months (or more) of food on your shelves. Buy only what you use anyway, so you don''t waste money. If things get alot worst, you''ll be ready. Prices could go up alot more or even shortages. It does not hurt to have extra food. You don''t want to be dependent on someone else for your next meal. This also buys you some time. If nothing happens, so what, you don''t go shopping for awhile. You''ve saved money. If things do get worst, you''re ready and you have something to trade with.

[bobnjersey]

[john mccain tried to stop this mess in 2005 and his bill was blocked by the liberals in the senste including obama. 60 minutes removed my comments. CBS is in the tank for obama]
[Posted by deanhix at 11:07 AM : Oct 07, 2008]

did john mccain resist the lobbying efforts of wall street to keep the credit default swaps from remaining unregulated ... being the man of deregulation that he so proudly used to state?

what party controlled congress when mccain called for legislation to control freddie/fannie? why didn''t the republicans push the limits thru?

[epicflux]

The CEO of that derivatives company was hilarious blaming the underlining securities.

The metaphor in my mind is like a gambling addict trying to explain to his therapist & family that it''s not his bets that are losing him money, but the horses he''s betting on. It''s a skewed logic that only an addict could understand.

"If only the horses would win, I would win, CAN''T YOU SEE!"

[maine11111]

Bilical times people, can everyone say ONE WORLD GOVERNMENT!!!!!

[pakaal]

"These complex financial instruments were actually designed by mathematicians and physicists, who used algorithms and computer models to reconstitute the unreliable loans in a way that was supposed to eliminate most of the risk."

The start of that sentence should include "mathematicians and physicists _working for financial houses_" and end with "eliminate most of the risk to themselves _and the corporations they worked for_."

And judging by some of the hundreds of millions being paid out to the execs who are now leaving the burning buildings cash in hand, it looks like they did their jobs well.

[suriko]

I am so angry. Just where is the $60 Trillion dollars or is it all just worthless paper too? I''ll join the class action suit. I''ve worked hard all my life and I want justice for the American people. Don''t forget to VOTE...

[onedayatatim]

Is it just me or does anyone else wish they could slap the smirk off of ISDA''s CEO, Robert Pickel? I would love to see that association investigated.

[onedayatatim]

onedayatatim

[cbsisafraid]

Why was there no mention of JP Morgan in the 60 minutes story? They are the largest holder of derivatives.
$80 Trillion or so in notional value according to the government agency that monitors banks

http://www.occ.treas.gov/deriv/deriv.htm
Where did you see $80 trillion?
The tables are in "millions" and JP shows
total Derivatives of $83,436,951,000.

[deanhix]

If you want to know what happened see the video "no Money" on youtube.com/themouthpeace

[deanhix]

I posted a comment about the basic cause of this being the social engineering of fannie mae. john mccain tried to stop this mess in 2005 and his bill was blocked by the liberals in the senste including obama. 60 minutes removed my comments. CBS is in the tank for obama

[julietteg]

Do I, as an Americal citizen, have the right to file criminal charges against those who took such incredible risk with the economy resulting in the current situation and/or do we have the right, as the American people, to file a class action lawsuit against the same? If any of them had a conscience, and obviously none do, they would return the money - it just didn''t disappear.