The Bet That Blew Up Wall Street

waltky · 10-29-2008, 03:03 PM

Steve Kroft's 60 Minutes story on derivatives and their part in the financial meltdown...

The Bet That Blew Up Wall Street
Oct. 26, 2008 - Credit Default Swaps And Their Central Role In The Unfolding Economic Crisis

Quote:

The world's financial system teetered on the edge again last week, and anyone with more than a passing interest in their shrinking 401(k) knows it's because of a global credit crisis. It began with the collapse of the U.S. housing market and has been magnified worldwide by what Warren Buffet once called "financial weapons of mass destruction." They are called credit derivatives or credit default swaps, and 60 Minutes did a story on the multi-trillion dollar market three weeks ago. But there's a lot more to tell.

As Steve Kroft reports, essentially they are side bets on the performance of the U.S. mortgage markets and the solvency on some of the biggest financial institutions in the world. It's 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, but eight years ago 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.

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waltky · 11-04-2008, 03:27 AM

Warren Buffett gonna be in trouble?...

Judge: Loss in AIG scheme tops $500 million
Mon., Nov. 3, 2008 - Ruling means five former insurance execs may face up to life in prison

Quote:

A federal judge has ruled that shareholders of American International Group Inc. lost more than $500 million as a result of a scheme to manipulate the financial statements of the world's largest insurance company. The ruling Friday by Judge Christopher Droney means five former insurance executives convicted of the scheme could face up to life in prison under advisory sentencing guidelines. Four former executives of General Re Corp. and a former executive of AIG were convicted in February of conspiracy, securities fraud, mail fraud and making false statements to the Securities and Exchange Commission.

Prosecutors filed court papers citing a study by its expert, concluding the fraud-related losses to AIG shareholders totaled $1.2 billion to $1.4 billion. They cited another methodology by the expert that put the losses at $544 million to $597 million, but said either method is reasonable. Droney rejected the higher estimate, but said the lower range was reasonable. That finding and a determination that the fraud affected more than 250 victims will increase the advisory guideline sentence range. The guideline range and a sentencing date have not been set yet.

The defendants challenged the estimate, saying there was no loss to investors. The defendants are Christopher Garand, Ronald Ferguson, Elizabeth Monrad, Robert Graham and Christian Milton. Ferguson has said in court papers that he anticipated the government will advocate a loss amount that leads to a recommendation for life in prison. But prosecutors made no such recommendation, simply concluding that the defendants should receive a "substantial" prison sentence. A report by the probation department recommended sentences of 14 years to more than 17 years for each defendant.

Prosecutors said the defendants participated in a scheme in which AIG paid Gen Re as part of a secret side agreement to take out reinsurance policies with AIG in 2000 and 2001, propping up its stock price and inflating reserves by $500 million. Reinsurance policies are backups purchased by insurance companies to completely or partly insure the risk they have assumed for their customers. General Re is part of Berkshire Hathaway Inc., which is led by billionaire investor Warren Buffett of Omaha, Nebraska.

Judge: Loss in AIG scheme tops $500 million - U.S. business