We last left off with a red hot financial market in the mid 1980's being led by the fancy MBS (mortgage backed security) and CMO (collateralized mortgage obligation) securities running in tandem with a leveraged paradise known as the junk bond market.
The easy money and lavish lifestyles of the 1980's were not isolated to Wall Street.
Savings and loan (S&L or "thrifts") institutions across the nation were taking advantage of the newly implemented Tax Reform Act of 1986.
The new act was passed to update "old banking standards" and allow thrifts to take on more risk in order to better compete in the "complex financial markets" of the 1980's.
Thrifts ran with their new found freedom and grew like wild fire.
Some of the more aggressive ones were doubling in size every year with less than ethical lending practices.
All this easy money was making thrift executives very rich and further compounded the greed running rampant through the markets of the 80's.
The fun finally stopped when the "S&L Crisis" hit in the waning years of a decade best known for the King of Pop, mall bangs, and the chia pet.
During the crisis, thousands of thrifts failed, housing markets went south, the economy fell into a recession, and the US tax payer was left holding the bag to support a government bailout of the failing S&Ls (sound familiar?).
The details of the crisis are beyond the scope of our discussion, but suffice it to say that laxed lending standards and excessive leverage (using OPM...
other people's money), led to the then largest financial crisis since the Great Depression.
The go-go age of easy money and risky lending practices had come to an end...
for the time being.
The birth of the high tech sector gave rise to the 90's bull market and pulled the US economy out of its slump.
The technology boom ushered in one of the longest bull markets in US history as investors began to believe that "this time it was different" with a new age of development.
The tech heavy NASDAQ index grew almost 900% over the decade.
Technology was not only changing people's lives, but it was changing the makeup of the market as well.
At the beginning of the decade, technology related stocks made up only 7% of the broad S&P 500 index.
By the end of the decade they accounted for nearly 30% of the index.
During the heart of the technology led bull market, something known as the Asian Financial Crisis emerged in 1997 when Asian countries started defaulting on their debt.
The relatively young financial system in many Asian countries was weak and suffered from a lack of substantial governance.
The inadequate oversight and poor assessment of financial risk led to a dramatic currency devaluation for several Asian countries.
As the local currency became less and less valuable, it became impossible for companies and banks to pay off foreign debt (if a company is making money in a local currency that is rapidly devaluing and having to pay off debt in a stronger, foreign currency they are in deep kimshe).
The crisis resulted in a sharp decline to the growth of many Asian countries as businesses collapsed and millions of people fell below the poverty line.
Foreign investors were also impacted by the Asian Financial Crisis as a string of defaults on Asian debt left many lenders "up the creek without a paddle.
" To avoid repeating this precarious situation, the market brought forth a new product known as a credit default swap (CDS).
In its most basic form, a CDS is nothing more than an insurance agreement between two counterparties.
The purchaser of a CDS is looking to insure against catastrophic loss (other companies defaulting on debt that they own) in return for a small premium and the seller of the CDS is willing to take on additional risk in return for the premium.
When done in this manner, a CDS could be used as a way to hedge a portfolio of fixed income investments.
The agreement is similar to purchasing auto or home owner's insurance on one's car or property.
Unfortunately, that is where the similarities between insurance and a CDS stop.
Unlike insurance, CDS contracts are unregulated, which opens the door to a variety of subtle nuances.
First off, a CDS is a bilateral agreement between counterparties.
It is not an exchange traded product, it does not have a quoted market value, and in most cases, it is not accounted for on a company's financial statements.
Because of all these factors it is very difficult to pin down exactly how many CDS contracts are outstanding, how many offset each other (e.
g.
buy a CDS with counterparty A and sell a CDS on the same underlying security to counterparty B), and who has exposure to what.
Another major difference between the insurance business and the CDS marketplace is the collateral requirements for companies selling (writing) the contracts.
In the regulated insurance industry, companies are required to have a minimum amount of assets on hand in order to offset a portion of their outstanding liabilities.
In the CDS market place, no such regulation exists.
Under this "buyer beware" structure, it is possible for a very small counterparty to write large CDS contracts in order to collect bigger premiums knowing full well that they may not be able to make good on the claim if the underlying security ever defaulted.
The last major difference between purchasing insurance and a CDS is the fact that one does not need to own the underlying security in order to enter into a CDS.
This would be akin to someone taking home insurance out on their neighbor's house in hopes that something bad might happen to it so that they can collect on their contract.
When one enters into this type of agreement without having any exposure (financial risk) to the underlying asset, the CDS stops acting as a hedge (insurance) and becomes a speculative bet.
The CDS revolutionized the financial markets and how counterparties viewed risk.
The CDS industry was estimated to be in the "tens of billions of dollars" when it first started in the mid 90's and grew to an estimated value of over 55 trillion dollars today.
Risk became a commodity that could be purchased and sold by anyone with a phone, a pen, and a piece of paper (and connections to institutions with large fixed income exposure).
The catalyst behind the meteoric rise in the CDS market was still to come as our friends MBS and CMO came back to play during the US housing boom at the dawn of the 21st century.
But we are getting ahead of ourselves as we have not yet covered the bursting of the tech bubble and the aggressive monetary policy that led to largest housing bubble in US history.
Ciao, Frugal Franco
The easy money and lavish lifestyles of the 1980's were not isolated to Wall Street.
Savings and loan (S&L or "thrifts") institutions across the nation were taking advantage of the newly implemented Tax Reform Act of 1986.
The new act was passed to update "old banking standards" and allow thrifts to take on more risk in order to better compete in the "complex financial markets" of the 1980's.
Thrifts ran with their new found freedom and grew like wild fire.
Some of the more aggressive ones were doubling in size every year with less than ethical lending practices.
All this easy money was making thrift executives very rich and further compounded the greed running rampant through the markets of the 80's.
The fun finally stopped when the "S&L Crisis" hit in the waning years of a decade best known for the King of Pop, mall bangs, and the chia pet.
During the crisis, thousands of thrifts failed, housing markets went south, the economy fell into a recession, and the US tax payer was left holding the bag to support a government bailout of the failing S&Ls (sound familiar?).
The details of the crisis are beyond the scope of our discussion, but suffice it to say that laxed lending standards and excessive leverage (using OPM...
other people's money), led to the then largest financial crisis since the Great Depression.
The go-go age of easy money and risky lending practices had come to an end...
for the time being.
The birth of the high tech sector gave rise to the 90's bull market and pulled the US economy out of its slump.
The technology boom ushered in one of the longest bull markets in US history as investors began to believe that "this time it was different" with a new age of development.
The tech heavy NASDAQ index grew almost 900% over the decade.
Technology was not only changing people's lives, but it was changing the makeup of the market as well.
At the beginning of the decade, technology related stocks made up only 7% of the broad S&P 500 index.
By the end of the decade they accounted for nearly 30% of the index.
During the heart of the technology led bull market, something known as the Asian Financial Crisis emerged in 1997 when Asian countries started defaulting on their debt.
The relatively young financial system in many Asian countries was weak and suffered from a lack of substantial governance.
The inadequate oversight and poor assessment of financial risk led to a dramatic currency devaluation for several Asian countries.
As the local currency became less and less valuable, it became impossible for companies and banks to pay off foreign debt (if a company is making money in a local currency that is rapidly devaluing and having to pay off debt in a stronger, foreign currency they are in deep kimshe).
The crisis resulted in a sharp decline to the growth of many Asian countries as businesses collapsed and millions of people fell below the poverty line.
Foreign investors were also impacted by the Asian Financial Crisis as a string of defaults on Asian debt left many lenders "up the creek without a paddle.
" To avoid repeating this precarious situation, the market brought forth a new product known as a credit default swap (CDS).
In its most basic form, a CDS is nothing more than an insurance agreement between two counterparties.
The purchaser of a CDS is looking to insure against catastrophic loss (other companies defaulting on debt that they own) in return for a small premium and the seller of the CDS is willing to take on additional risk in return for the premium.
When done in this manner, a CDS could be used as a way to hedge a portfolio of fixed income investments.
The agreement is similar to purchasing auto or home owner's insurance on one's car or property.
Unfortunately, that is where the similarities between insurance and a CDS stop.
Unlike insurance, CDS contracts are unregulated, which opens the door to a variety of subtle nuances.
First off, a CDS is a bilateral agreement between counterparties.
It is not an exchange traded product, it does not have a quoted market value, and in most cases, it is not accounted for on a company's financial statements.
Because of all these factors it is very difficult to pin down exactly how many CDS contracts are outstanding, how many offset each other (e.
g.
buy a CDS with counterparty A and sell a CDS on the same underlying security to counterparty B), and who has exposure to what.
Another major difference between the insurance business and the CDS marketplace is the collateral requirements for companies selling (writing) the contracts.
In the regulated insurance industry, companies are required to have a minimum amount of assets on hand in order to offset a portion of their outstanding liabilities.
In the CDS market place, no such regulation exists.
Under this "buyer beware" structure, it is possible for a very small counterparty to write large CDS contracts in order to collect bigger premiums knowing full well that they may not be able to make good on the claim if the underlying security ever defaulted.
The last major difference between purchasing insurance and a CDS is the fact that one does not need to own the underlying security in order to enter into a CDS.
This would be akin to someone taking home insurance out on their neighbor's house in hopes that something bad might happen to it so that they can collect on their contract.
When one enters into this type of agreement without having any exposure (financial risk) to the underlying asset, the CDS stops acting as a hedge (insurance) and becomes a speculative bet.
The CDS revolutionized the financial markets and how counterparties viewed risk.
The CDS industry was estimated to be in the "tens of billions of dollars" when it first started in the mid 90's and grew to an estimated value of over 55 trillion dollars today.
Risk became a commodity that could be purchased and sold by anyone with a phone, a pen, and a piece of paper (and connections to institutions with large fixed income exposure).
The catalyst behind the meteoric rise in the CDS market was still to come as our friends MBS and CMO came back to play during the US housing boom at the dawn of the 21st century.
But we are getting ahead of ourselves as we have not yet covered the bursting of the tech bubble and the aggressive monetary policy that led to largest housing bubble in US history.
Ciao, Frugal Franco
Source...