Posts Tagged ‘banks’

This recession: The death of the market system? Or the consequences of deception?

January 21, 2010

Capitalism, many people criticize it.

Nothing sums up these arguments better to me than a sign I saw being held by someone at an anti capitalist march. The sign read “Get rid of capitalism…. Replace it with something nicer.”

 What else is there?

Nowadays, there is no way to go, other than capitalism. Any country which does “well” without capitalism is the exception rather than the rule. Sure, you can point to China, an economic powerhouse, but I would not consider a country where human rights activists have their email accounts hacked a country which is doing “well.”

Capitalism is taking a lot of the flak for this recession… But I would suggest it, like many markets that fail, is the fault of the people inside it, rather than the concept itself.

My belief is that this entire mess that we are in is largely, although not solely down to something called Collateralized Debt Obligations (CDOs). Now, you will have a credit rating, you may or may not be aware of what this is. Your bank will lend to you at varying rates depending on your credit rating.

Now, a CDO is thousands of your mortgages put together. Basically, a CDO made out of AAA (safest) credit ratings would give you the lowest rate of return because it had a low risk, but at the same time was very reliable. One filled with CCC credit ratings would give you a much higher reward, if it didn’t collapse. This would be the reward for the risk that you took on.

 Now, let’s say I get 10,000 mortgages that I want to sell. I have a few AAA mortgages, but also a load of CCC ones that I want to get rid of. I pile them together in one big CDO. Next, I need to take it to the credit raters. A good example of this would be Standard and Poors. They take a look at my CDO and then brand it with a rating of its own.

HERE is where the problem lies.

Standard and Poors would be working on a commission, a AAA CDO is worth more than a CCC one, so they would have a clear incentive to give it that AAA rating. This means that a CDO might be given an AAA rating, when in fact; it should actually have a C rating for example

. This means that investors (banks) are paying a high price…. For a high risk, an unreliable one. AAA CDOs were seen as a sure bet. The thing is, a lot of the time, banks would combine CDOs and then pass them on, again and again. It was pass the bomb on a billion dollar scale…. This though, is why deception played a huge part, but so did greed.

 The people who are referred to as NINJAS (No Income No Job no Assets) were now having money lent to them… Why? Because, and this is where the CDOs kick in again…. If I was to lend you a load of money, I wouldn’t need to worry about if you could pay it, for all I care you could default on your mortgage in a month, by the time you stopped being able to pay, I would have sold your mortgage on and made my profit.

So, what do we need? Well, better regulation would surely pave the way. People at the Financial Services Authority are paid peanuts to work there compared to the CDO traders. Both would need to be of similar intelligence to do the job, so why would you want to take the FSA route when you could earn ten times as much?

 Furthermore, very few people understood how these CDOs worked, all people knew was that they made you very rich. They were actually devised by rocket scientists… Surely better regulation of financial products would have been helpful.

Capitalism isn’t dead, but the morals of the train of capitalism should be watched more closely, or the train could end up crashing…. Again…