(Continued)
What are mortgage derivatives?
Mortgage derivatives are pieces of paper which are created based on mortgages, or based on other pieces of paper which are directly or indirectly based on mortgages. This article gives a good explanation of several kinds of mortgage derivatives.
What does unregulated mean?
The trade in various kinds of pieces of paper are controlled, or "regulated" by particular "Regulatory Agencies", which are a part of the Executive Branch of government. For instance, the SEC regulates trade in stocks, bonds, and other "securities". They do this by issuing and enforcing a set of rules ("regulations"). Unregulated means that
either there is no agency with jurisdiction over the thing in question, or there is such an agency and it has chosen not to issue or enforce such rules.
What does under-regulated mean?
Sometimes, there is an agency with jurisdiction over the thing in question, but the rules or the enforcement (or both) are too weak to produce the necessary effect. We say then that the thing is under-regulated.
What does OTC mean?
Over The Counter. Effectively, buying it like you would goods at a store or from a web site.
So what happened?
The international economic problem was caused by the interactions of two classic bubbles involving money chasing money in unregulated and under-regulated pieces of paper. Each caused widespread effects, although the reasons differed.
The stage was set in 2001, when the Bush Administration ushered in a new era of financial deregulation. Lending practices of private lenders were deregulated to the point that the Administration went to court to keep the States from regulating them. Bundling loans was deregulated for everyone but the GSEs (Fannie Mae and Freddie Mac), allowing private companies to bundle whatever kinds of mortgages they chose to. And so on. And over the next seven years, regulations concerning business practices were eliminated, loosened, sidestepped, or ignored by a wide variety of government regulatory agencies.
The bubble that directly involved more institutions, and caused the more spectacular crash, centered on mortgage derivatives. These pieces of paper, often separated by several degrees from the mortgages themselves, were mostly unregulated. In the Lassez Faire environment promoted by the agencies of the Bush Administration, there was nothing to slow the heavily leveraged speculation and investment in these pieces of paper - even among supposedly regulated investors like banks. Money chased money, with little regard for the realities of the mortgages behind (often way behind) the pieces of paper, and the bubble swelled and spread. Even after a number of sources sounded alarms about those mortgages, the bubble continued to swell.
While that bubble was growing, a regulatory decision set another bubble on the fast track. In January, 2006, oil derivitives slipped their leash. These pieces of paper, already volatile due to events in the Middle East, the Gulf Hurricanes, and growing demand elsewhere benefitted from a ruling by the Bush administration's Commodity Futures Trading Commission (CFTC).
Up until that time, the primary exchange for trading those "paper barrels of oil" was the New York Merchantile Exchange (NYMEX). But NYMEX traders must keep records of all trades and report large trades to the CFTC, along with daily trading data noting price and volume information. In theory, the CFTC uses that data to track speculation and price manipulation.
The January 2006 CFTC ruling let the London Exchange (ICE) use its trading terminals in the United States to trade US crude oil futures on the ICE futures exchange in London. The traders on such unregulated OTC electronic exchanges don't have to keep the records required of NYMEX traders or file the “Large Trader Reports" with the CFTC, and such trades are exempt from routine CFTC oversight. On top of that, the CFTC issued another ruling that had the effect of allowing (in the words of Business Week) "unlimited speculation through a swaps loophole that exempted Wall Street investment banks like Goldman Sachs and Merrill Lynch from reporting requirements and limits on trading positions that are required of other investors to the oil derivative traders on Wall Street vis a vis the 'swaps' exemption." Money chased money, and the bubble was off and growing.
But this paper chase was a little different. Some of the oil related pieces of paper actually had the effect of setting the price per barrel of oil, and the frantic trade in the suddenly unencumbered and very profitable pieces of paper sent the price of oil (and oil derived products such as gasoline) skyrocketing.
By June of 2006, a committee of the US Senate issued a report outlining the situation and sounding an alarm about the effects of such speculation. The higher fuel prices quickly started to spread to other areas, such as food prices. As the bubble continued to grow, the effects became more severe. The rising costs and the (related) cutbacks in purchasing caused drops in employment. Families - even seemingly well to do families - who were already on the margin found themselves with little or no real income, and they started to default on their mortgages.
When the rate of mortgage defaults became high enough to catch the attention of the speculators and investors in the mortgage derivatives, that bubble popped. For each one of those mortgage defaults, as many as 20 different people and/or organizations had some sort of derivative pieces of paper that would be affected by the default. Concerned about that effect, they started trying to sell those pieces of paper. That drove their value down even more. People and organizations with political agendas started to point fingers at "predatory lenders", the CRA, and Fannie Mae/Freddie Mac, making often fallacious claims about their contributions to the problem, thereby increasing investor anxiety about anything related to mortgages.
By December of 2007, the side effects of the two bubbles drove the US into a recession. People cut back on optional purchases (such as new cars). By Fall of 2008, the oil bubble had started to deflate a little. The speculation-driven oil price had dropped from a high of about $160 per barrel to about $120 per barrel. The fuel prices, and the prices they drove up, were slower to drop.
Then the floor dropped out, and everything seemed to happen at once. Once solid financial organizations started to fail, due to their large investments in heavily leveraged mortgage derivatives. The banks among them stopped making most kinds of loans. Automobile companies, and others that depended on such loans for their customers, suffered massive losses as sales continued to drop.
When the first attempts by the (US) Federal government failed to stem the tide, the Administration proposed a massive bailout. It would get money from Congress to buy up a lot of the "bad" pieces of paper from the failing financial organizations (at a discount), and free the banks to start lending again. The failure of Congress to pass the bill that would fund that "bailout" caused a panic in financial circles, and a resounding crash in the markets for pieces of paper. Speculators and heavily leveraged investors, facing the dark downside of leverage, liquidated their investments to limit the damage and pay for their leveraged losses. The stock market plummeted, wiping out trillions of dollars of investments in days. The prices of "paper barrels of oil" dropped $20 per barrel in two days, then settled into a somewhat shallower long term decline (ultimately losing $100 per barrel from their earlier peak). The general public, hearing dire news and predictions from the political sources and the media, started to panic. Financial institutions faced bankruptcy.
A somewhat modified version of the "bailout" package passed the Congress and was signed by President Bush. But by then the damage was done. Tens of thousands more people were losing their jobs throughout the country, and the package was too little too late to stop it.
