I don't know how...,
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and then we can start the bonfire:
Nell recommends Frank Partnoy's description of how the derivatives market contributed to the crisis. It's very good, in that it confirms my suspicions about the correlation between the astronomical growth in M3 credit money after 1995 and the invention of the credit default swap that year.
The way I guessed it worked: "purchasing insurance for money you create from nothing makes it safer for accounting to ignore and for you to create more money out of nothing".
The way Partnoy explains it worked:
The major banks recently had begun trading credit default swaps. Credit default swaps are like life insurance: one party pays a premium and receives a benefit upon death, except that as with Li's [Gaussian copula risk] model the death is not the death of a human being. Instead, the "death" that triggers payment is the default on some obligation, such as a corporate bond or mortgage loan.
Wall Street saw they could use credit default swaps to create an infinite amount of crap. They quickly engineered new repackaging transactions, using credit default swaps to clone risky subprime-mortgage-backed investments that, when pooled, generated more sky-high ratings. These new deals were known as "synthetic" CDOs, because they had been created artificially, through derivatives side bets. Instead of basing payoffs on subprime mortgage loans that actually existed in the real world, the banks created an Alice in Wonderland world and based payoffs on the multiple virtual realities that were down the rabbit hole.
If you were a homeowner with a risky subprime mortgage loan, CDO arrangers might put together a hundred side bets on whether you would default. Through credit default swaps, a hundred investors around the world could be exposed to the risk that you might not make your next monthly payments.
Soon, investors around the world were buying complex subprime-backed financial instruments: synthetic CDOs, structured investment vehicles, constant-proportion debt obligations, and even something called CDO-squareds (don't ask). The demand for these derivatives-backed investments was a tail wagging a very large dog.
Back when I worked at Morgan Stanley, credit default swaps did not even exist. Yet by 2008, the credit default swaps market had grown to $60 trillion. To put that number in perspective, the entire world's gross domestic product was $60 trillion.
That nominal face value is really panic inducing. Properly unwound and settled the cash value of these things supposedly becomes 3.3 trillion dollars, which should also be panic inducing if you figure the way things are going that's what we seem bound to pay out on them, on top of the 2-3 trillion dollars we seem bound to pay out for losses on the original mortgages.
What's (at least) 5-6 trillion dollars to keep a bunch of banks that aren't doing business in business? That's just two more terms of the Bush Administration in national debt. On the bright side, it has become almost impossible for me to account for how much money has been trucked out to the national money hole. There's tangles of hundred billion dollar tax breaks, laundering of mortgage backed paper through Freddie and Fannie since the bubble popped, the Federal Reserve alphabet soup (much of which is meant to do the business the banks are no longer doing but some of which is headed for hole), bank recapitalizations, share conversions, the latest plan to cover all this leveraging with even more leveraging, and massive amounts of government guarantees insuring we'll continue paying far into the future, all tied up into a giant international ball of cash and twine that we're supposed to hope is big enough to fill the national money hole once and for all. It could be ready to roll any month now, depending on the effective looting surtax above the base looting cost of the bailouts, and the size of our shovels.