Wednesday, September 24, 2008

Wall Street Bailout: Back to Basics

The financial crisis on Wall Street has led to an extraordinary Treasury Department proposal to avert major damage to the financial system and the economy. The press has broadly outlined that proposal focusing mainly on its $1 trillion price tag and the impending calamity that requires prompt action by the Congress. As the details of the plan emerge, critics have voiced objections to the lack of oversight by court or administrative agency as set out in Section 8 of the draft which states:

“Any determination of the Secretary with regard to any particular troubled asset pursuant to this Act shall be final, and shall not be set aside unless such determination is found to be arbitrary, capricious, an abuse of discretion, or not in accordance with the law.”
A report in Jurist discusses alternate proposals including Sen. Dodd’s proposed legislative changes which address transparency of the process, lack of court oversight and the absence of help for homeowners with troubled mortgages.

The current crisis presents challenges to policy makers and to most observers who may have little understanding of why it happened and what it means for everyday people. Understanding the crises requires knowledge of terms like subprime mortgages, mortgage backed securities, collateralized debt obligations, credit default swaps, short-selling, leveraging and other terms unfamiliar to most. Bloomberg Law helps define these terms:

Subprime Mortgage Loan: A first or second lien residential mortgage loan made to a borrower who has a history of delinquency or other credit problems.

Mortgage-Backed Security: A debt instrument with a pool of real estate loans as the underlying collateral. The mortgage payments of the individual real estate assets are used to pay interest and principal on the bonds.

Collateralized Debt Obligation: A structured debt security backed by a portfolio consisting of:
- Secured or unsecured senior or junior bonds issued by a variety of corporate or sovereign obligors.
- Secured or unsecured loans made to a variety of corporate commercial and industrial loan customers of one or more lending banks.

Credit Derivative: An OTC derivative designed to transfer credit risk from one party to another. By synthetically creating or eliminating credit exposures, they allow institutions to more effectively manage credit risks. Most credit derivatives entail two sources of credit exposure: one from the reference asset and the other from possible default by the counterparty to the transaction. Taking many forms, some of the more popular structures for credit derivative products include credit default swaps, total return swaps, and credit-linked notes.

Credit Default Swap: A credit derivative transaction in which two parties enter into an agreement, whereby one party pays the other a fixed periodic coupon for the specified life of the agreement. The other party makes no payments unless a credit event, relating to a predetermined reference asset, occurs. If such an event occurs, the party will then make a payment to the first party, and the swap will terminate. The size of the payment is usually linked to the decline in the reference asset's market value following the determination of the occurrence of a credit event.

Short Sale: Selling a security that the seller does not own but is committed to repurchase eventually. Investors use short sales to capitalize on an expected decline in the security's price.

The BLS Library collection has a number of books to help understand the basics of the crisis:

Subprime Mortgage Credit Derivatives by Laurie S. Goodman
Call # G2040.15 .S825 2008

Subprime Mortgages: America's Latest Boom and Bust by Edward M. Gramlich
Call # HG2040.5.U5 G73 2007

The Handbook of Mortgage-Backed Securities by Frank J. Fabozzi
Call # HG4655 .H36 2006

The Securitization Markets Handbook: Structures and Dynamics of Mortgage- and Asset-Backed Securities by Charles Austin Stone and Anne Zissu
Call # HG4655 .S76 2005

Introduction to Structured Finance by Frank J. Fabozzi
Call # HG4028.A84 F33 2006

Credit Derivatives: a Primer on Credit Risk, Modeling, and Instruments by George Chacko
Call # HG6024.A3 C739 2006

Prof. David Reiss has provided this useful bibliography:

Greed, Fraud and Ignorance: A Subprime Insider’s Look at the Mortgage Collapse by Richard Bitner (LTV Media 2008)

Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve by William Fleckenstein (McGraw-Hill 2008)

Subprime Mortgages: American's Latest Boom and Bust by Edward M. Gramlich (Urban Institute Press 2007)

The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash by Charles R. Morris (Public
Affairs 2008)

The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It by Robert J. Shiller (Princeton, forthcoming August 2008)

Financial Shock: A 360 Degree Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis by Mark Zandi (FT Press forthcoming 2008)

Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis by Paul Muolo and Mathew Padilla (Wiley 2008).

Prof. Reiss, Associate Dean Michael Gerber, Prof. Edward Janger and Prof. Roberta Karmel will lead the discussion in a Town Hall Meeting "Meltdown, Bailout and Transformation: A Week on Wall Street" on Thursday, Sept. 25, 4:00pm to 5:30pm in the Moot Court room on the 7th floor.

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