The Bet That Blew Up Wall Street

Steve Kroft On Credit Default Swaps And Their Central Role In The Unfolding Economic Crisis

(CBS)  This story was first published on Oct. 26, 2008. It was updated on Aug. 27, 2009.

Anyone with more than a casual interest in why their 401(k) has tanked over the past year knows that it's because of the global credit crisis. It was triggered by the collapse of the housing market in the United States and magnified worldwide by the sale of complicated investments that Warren Buffett once labeled financial weapons of mass destruction.

They are called credit derivatives or credit default swaps.

As correspondent Steve Kroft first reported last fall, they are essentially side bets on the performance of the U.S. mortgage markets and some of the biggest financial institutions in the world - a form of legalized gambling that allows you to wager on financial outcomes without ever having to actually buy the stocks and bonds and mortgages.

It would have been illegal during most of the 20th century under the gaming laws, but in 2000, Congress gave Wall Street an exemption and it has turned out to be a very bad idea.

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While Congress and the rest of the country scratched their heads trying to figure out how we got into this mess, 60 Minutes decided to go to Frank Partnoy, a law professor at the University of San Diego, who has written a couple of books on the subject.

Ask to explain what a derivative is, Partnoy says, "A derivative is a financial instrument whose value is based on something else. It's basically a side bet."

Think of it for a moment as a football game. Every week, the New York Giants take the field with hopes of getting back to the Super Bowl. If they do, they will get more money and glory for the team and its owners. They have a direct investment in the game. But the people in the stands may also have a financial stake in the ouctome, in the form of a bet with a friend or a bookie.

"We could call that a derivative. It's a side bet. We don't own the teams. But we have a bet based on the outcome. And a lot of derivatives are bets based on the outcome of games of a sort. Not football games, but games in the markets," Partnoy explains.

Partnoy says the bet was whether interest rates were going to go up or down. "And the new bet that arose over the last several years is a bet based on whether people will default on their mortgages."

And that was the bet that blew up Wall Street. The TNT was the collapse of the housing market and the failure of complicated mortgage securities that the big investment houses created and sold around the world.

But the rocket fuel was the trillions of dollars in side bets on those mortgage securities, called "credit default swaps." They were essentially private insurance contracts that paid off if the investment went bad, but you didn't have to actually own the investment to collect on the insurance.

When 60 Minutes last spoke with Eric Dinallo, he was insurance superintendent for the state of New York. He says credit default swaps were totally unregulated and the big banks and investment houses that sold them didn't have to set aside any money to cover potential losses and pay off their bets.

"As the market began to seize up and as the market for the underlying obligations began to perform poorly, everybody wanted to get paid, had a right to get paid on those credit default swaps. And there was no 'there' there. There was no money behind the commitments. And people came up short. And so that's to a large extent what happened to Bear Sterns, Lehman Brothers, and the holding company of AIG," he explains.

In other words, three of the nation's largest financial institutions had made more bad bets than they could afford to pay off. Bear Stearns was sold to J.P. Morgan for pennies on the dollar, Lehman Brothers was allowed to go belly up, and AIG, considered too big to let fail, is on life support thanks to a $180 billion investment by U.S. taxpayers.

"It's legalized gambling. It was illegal gambling. And we made it legal gambling…with absolutely no regulatory controls. Zero, as far as I can tell," Dinallo says.

"I mean it sounds a little like a bookie operation," Kroft comments.

"Yes, and it used to be illegal. It was very illegal 100 years ago," Dinallo says.

[Mom-O-Truth]

I call it Financial cannibalism of capitalism. Perfectly planned in 2000 executed in all details to cash in right before the election n 2008. Those who played the American citizens MUST be prosecuted and their money taken just like Madoff. A history example must be set with sever punishments by the current Obama administration.

[BarbaraAnnJackson]

Certain mortgage companies align with shrewd foreclosure lawyers to
benefit from unlawfully seized & unlawfully flipped properties --mostly by use of names mortgage companies that LACK STANDING or are DEFUNCT. Successful frauds enable these companies to file FALSE form 1099-A's with the IRS, as well as to file fraudulent Bankruptcy Court "Lift Automatic Stay Motions." The potential fraud being committed on the IRS via deliberate sham foreclosures will be worse than the S&L debacle.

News reports about foreclosures which court judges VOIDED will help
raise awareness so that thousands of people will not UNLAWFULLY become HOMELESS due to ILLEGAL FORECLOSURES. See foreclosure fraud proof @
*http://www.lawgrace.org/2008/08/08/my-august-8-2008-statement-to-the-louisiana-secretary-of-state-office-of-financial-institutions-concerning-wells-fargo-irs-and-mortgage-frauds-sham-foreclosures-and-judicial-collusion-and-national-app/

*http://www.lawgrace.org/2008/09/14/lehman-brothers%E2%80%99-mortgage-troubles-nationally-evidence-of-foreclosure-fraud-deception-and-conspiracy-with-wells-fargo-deceptive-judicial-filings/.

[resolue1]

I saw the show for the first time this evening as well and I've since read through many viewers comments, some of which were quite enlightening. My ultimate conclusion is that we cannot count on any of our representatives to represent us. Clinton could and should have vetoed it, Christmas or not. His total disregard for the possible outcome goes hand-in-hand with his reputation as a bad loser.
That it passed unanimously is even more disconcerting since certainly the democrats still sitting could and should have voted against it. One can only conclude that a lot of those people made a lot of money on those deals. I wish we could get the names of members of congress who did business with those companies that made a killing in CDS. Greed is non-partisan. Everyone is guilty, and the more you have, the more you want. I'm sure that they would all defend it as good business judgement. In the end you must look out for yourself- as Voltaire said- il faut cultiver son propre jardin. It's too easy though, to let the liars and fleecers off the hook so I agree with the fellow who wrote in last year and suggested that we tax the living daylights out of everyone making over $250,000 a year, with a seering 50% bracket for people over say $500,000. That's how it was before Reagan when we were a real country. While I'd like to see an end to the capital gains tax for my own obvious reasons, we should probably tighten that one up and make sure there aren't any loopholes. If these guys and gals ( Since Pelosi's husband is/was? a hedgefund manager) are going to get rich on our sweat- then let them pay for it- fully fund Medicare, fully fund Medicaid, give the money back to the states to pay for the pensions and rebuild our schools & highways. Make them pay- Make them pay- they can afford it.

[tank82]

Very good story, glad to see some information like this coming out about what happened. Steve good job but you stop short and end up on the wrong road. We need to stop blaming everything on the government regulation or de-regulation as the case maybe. You came so close to getting to what I want to know.

You made the comparison of these instruments to side bets but stop there. Let?s continue with this comparison, in a bet there is always a winner and a loser. We know who the losers are; the company?s issuing these policies. Here?s the problem Bookies, Casino?s and Race tracks are the one ?issuing? bets and they are usually pretty profitable. So why did the issuer of these policies get burned so badly.

At best it was horrible business management by multiple companies. At worst it was insider trading on steroids. I hate to sound like a conspiracy nut but the big bounces paid to these companies management sure seem to point to a payment for a job well done. Then other companies giving mortgages to anyone that could rub to nickels together. It is hard to believe so many companies did so many seemingly stupid things all at the same time. Then add in that regulators relaxed the laws after being illegal for over a 100 years and ensuring that states could not regulate it.

This is the story I want investigated and reported on. Who all gained from this and were they involved in any part of what caused it.

In my opinion groups of greedy people who would do this is a greater threat to the USA than any foreign terrorist organization. If evidence is found this occurred, could law enforcement use the terrorism laws to aid in the criminal investigation of this financial terrorism?

[mybuisness]

I wish congress would demand a review of the hedge funds which profited so handsomley from these CDS and reveal all the notable people of vested interest who profited on all this.

[kamirika]

Would someone out there share their wisdom and tell me what piece of legislation made this all possible and who introduced the piece to begin with?

[gusron]

Unfortunately, most of comments show that the authors don''t understand the roots of the current crises. Those authors have been brainwashed with the myths of the "American dream," freedom and the superiority of the capitalist system.

That system needs a deep revision toward the "capitalism with the human face" - Do you remember- "...human face"?

Otherwise, it is, and it would remain a jungle, that is no better than communism!

[gusron]

Unfortunately, most of comments show that the authors don''t understand the roots of the current crises. Those authors have been brainwashed with the myths of the "American dream," freedom and the superiority of the capitalist system.

The system needs a deep revision toward the "capitalism with the human face" - Do you remember- "...human face"? Otherwise, it is, and it would be a jungle, that is no better than communism!

[sonnung]

Either Clinton didn''t know the Enron loophole was in there, or he was going to benefit from it. Either way it led to this. If he didn''t know, then he is kicking himself now for not seeing it and yelling at his former advisers as well. If he did benefit from it, then he can try to sleep with the knowledge that his involvement is causing the rise in homelessness and poverty in our great nation.... Reps and Dems on both sides approved this bill and might not have known about it. And Bush vetoed the Bill that would close the loophole? What the.... Bush also vetoed every measure against the NSA until telecom was allowed immunity. he loves us so much. thanx b.

[djlny]

Hey Mom O, if we redistribute the wealth of those who understood the risks properly and invested accordingly and distribute it to others, why not redistribute the wealth of those homeowners that bought low too. Since we are out of equity on our own homes we can start cashing out our neighbors equity and keep those carts moving over at Walmart.