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Fox Hunting: Lucy, You have Some ‘Splaining to Do

January 20, 2011

growing up watching the TV show, I Love Lucy, I loved when Ricky would say to Lucy, ” Lucy, you have some ‘splaining to do.” It was funny and an apt comment to her often hairbrained schemes and his resulting consternation. These days, it is Wall Street banking firms doing the ‘splaining and as the days and weeks go by, more and more is revealed as to how deep the systemic problems are that precipitated the 2008 Global Economic crash. The revelations not only show what was going on then, but what continues to go on now.

I saw the documentary film, Inside Job, this last fall and i would highly recommend it to every single person who shows any interest in what the heck has been happening within our financial sector. It is a must see for economic students and investors.

Where are we at today?

The financial regulation of the Volcker Rule looks to be making some ground in spite of many financial institutions trying to ‘hedge’ their way around it and Republicans branding it as a jobs killer. What they want is business as usual.

MarketWatch reported Tuesday, January 18th:

The regulators released a study on the Volcker Rule, named after its author, former Federal Reserve Chairman Paul Volcker. The rule is intended to limit big insured banks’ speculative investments in the wake of a financial crisis that took the economy to the brink.

At a meeting on Tuesday, the newly formed Financial Stability Oversight Council, which comprises banking and securities regulators including the Federal Reserve, approved the release of the study. They will consider the study as they write rules, which are due in nine months. Read the study:

Volcker Final Study on Regulations

The study said firms could be required to perform quantitative analysis to identify prohibited proprietary trading. Inventory, turnover, revenue and holding periods would all be considered.

The statute seeks to be explicit about what types of proprietary trading will be permitted, but the section is open to interpretation by bank regulators. A key issue for regulators is whether they can identify whether a bank made a trade on behalf of a customer, which is permissible, or for its own account, which is not.

Love that word, explicit, for that refers to clear disclosure by the financial banks and institutions of HOW investors money is being invested… in what financial instruments: stocks, bonds, credit default swaps, mortgage backed securities, equities, metals, etc. The main target are the complex derivatives that were used like casino chips and largely contributed to the financial meltdown: Credit Default Swaps, Mortgage Backed Securities, and Collateralized Debt Obligations.

What are they?

A Credit Default Swap (CDS) is a swap contract and agreement in which the protection buyer of the CDS makes a series of payments (often referred to as the CDS “fee” or “spread”) to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) experiences a credit event. It is a form of reverse trading.

In its simplest form, a credit default swap is a bilateral contract between the buyer and seller of protection. The CDS will refer to a “reference entity” or “reference obligor”, usually a corporation or government. The reference entity is not a party to the contract. The protection buyer makes quarterly premium payments—the “spread”—to the protection seller. If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction. A default is referred to as a “credit event” and include such events as failure to pay, restructuring and bankruptcy. Most CDSs are in the $10–$20 million range with maturities between one and 10 years.

The unregulated CDS market ballooned to $62 trillion in June of 2008. The crash reduced the market to $38 trillion by end of 2008. Some economists state the number in 2009 around $13 trillion.

Credit default swaps are not traded on an exchange and there is no required reporting of transactions to a government agency.

A Mortgage-backed Security (MBS) is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization. While a residential mortgage-backed security (RMBS) is secured by single-family or two to four family real estate, a commercial mortgage-backed security (CMBS) is secured by commercial and multifamily properties, such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites. A CMBS is usually structured as a different type of security than an RMBS.

Collateralized debt obligations (CDOs) are a type of structured asset-backed security. In simple terms, think of a CDO as a promise to pay cash flows to investors in a prescribed sequence, based on how much cash flow the CDO collects from the pool of bonds or other assets it owns. If cash collected by the CDO is insufficient to pay all of its investors, those in the lower layers (tranches) suffer losses first. CDO can be created as long as global investors are willing to provide the money to purchase the pool of bonds the CDO owns. CDO volume grew significantly between 2000-2006, then declined dramatically in the wake of the subprime mortgage crisis, which began in 2007. Many of the assets held by these CDO’s had been subprime mortgage-backed bonds. Global investors began to stop funding CDO’s in 2007, contributing to the collapse of certain structured investments held by major investment banks and the bankruptcy of several subprime lenders.

Want to know how they were misused? Track down Inside Job and you will know. You will be outraged. And you will then know that those politicians who support the bankers and continued unregulated trading are indeed, foxes in the hen house of government.

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