Op-Ed: 5 Questions for Federal Reserve Chairman Ben Bernanke

By Tom Kaufman and Christian Hudson

Originally published in the Santa Cruz Sentinel: 02/28/08

Congress is in a special position to make some news Wednesday and Thursday as Federal Reserve Chairman Ben Bernanke makes a return trip to Capitol Hill on the heels of new housing data showing foreclosures up 8% from last month and 57% from a year ago according to a RealtyTrac study - which is a foreclosure marketer.

There are lots of plans being circulated around Washington, some even sound like government backed bailouts for homeowners. That’s why Wednesday and Thursday really matter. It is a chance to hear Congress essentially ask the Fed, “well, what do YOU think should be done?”

If you caught our Sunday column, you know that we’re worried about something that is even bigger in sheer size than the subprime mortgage mess - namely credit default swaps . How big? U.S. banks are on the hook for multiple times more money than they are for subprime mortgages. They basically work like insurance where Wall Street covers each other should someone not pay up on a loan. The complication? Well, unlike insurance they aren’t required to report all their deals, so it is hard for people to know if the person that is covering them is really going to come through. So if we’ve wiped out on the mortgage wave, what happens on a wave multiple times bigger?

The Fed is legendarily obtuse in answering questions. But, unlike his predecessor, Mr. Bernanke has shown a willingness to let more light in, so we say let there be light! Fiat lux, Mr. Bernanke. Here’s what we’d like the Chairman to answer:

1) What does it mean in terms of risk to the market that U.S. banks have many times more the amount of exposure in credit default swaps as they do to subprime exposure?


2) Some of the competing subprime solutions suggest a government backed bailout for those homes now worth less than their mortgage - what are the risks of doing that and doesn’t that stiff those penny wise savers who waited to buy their first home once the market cooled off?


3) Most notably last time you were on the Hill - a little over a week ago - you did NOT take the opportunity to say there's a light at the end of the tunnel - that seems to imply that you haven't identified where that proverbial light is yet - is that fair?


4) One analyst in Fortune Magazine, Pimco’s Bill Gross, says there’s a liquidity crisis problem of the unregulated banking system. Is that right? Can you keep the financial derivatives excesses in check without more regulation?


5) Here's a scenario for you: Subprime mortgage debt causes defaults for institutions who call in their private hedged bets in the form of credit default swaps only to find them unable to pay up. This causes further indigestion and insecurity in the market place where institutional money is not willing to buy bonds, thus everyone from the swashbuckling real estate tycoon to the run of the mill school project can't raise capital. No capital means no construction, no construction means no jobs for an active workforce. This makes banks even more reluctant to hand out mortgages. The result? Continued decay and atrophy in the number of people who are in a position to buy homes causing home prices further fall pushing more homeowners into the category of shouldering a mortgage greater than the price of their home. Does that keep you awake at night?


Tom Kaufman is the Capital Markets Committee Chairman for the American College of Real Estate Lawyers and is a partner at Hunton and Williams LLP in Washington, D.C.

Christian Hudson is a former CNN Senior Producer now practicing finance and real estate law at Hunton and Williams LLP in Washington, D.C.

Op-Ed: The Next Step in the Subprime Tango?

By Tom Kaufman and Christian Hudson


Originally published in the Santa Cruz Sentinel: 02/24/2008

Everyone wants to know how bad is it going to get. More and more, the conventional wisdom seems to be it feels like the 1990-91 recession. Simply put, that analysis ignores evolution. You don't do business now the same way you did in 1990, and neither does Wall Street.

Consider 1990, just as Amazon.com wasn't part of the zeitgeist's lexicon, credit default swaps weren't a part of the financial sector's jargon.

Now doing business on the Internet is the cultural de rigueur, and so too are credit default swaps for Wall Street. You care about credit default swaps because they could be the next body blow to the market, your 401k, and the economy in general. Put it this way, the subprime market was about $1.3 trillion in 2007, while U.S. banks' involvement in credit default swaps was $5.5 trillion for that same year. Roughly four times as big. If you are a fan of numbers with snake-like tails of zeroes, then you will be intrigued to know that Getchen Morgenson's terrific reporting in the New York Times last weekend put the worldwide market for these kinds of deals at a whopping $45.5 trillion.

So, here's how it works. David gives Sam a loan. However, David is savvy and wants to make sure that if Sam doesn't pay him back, it won't be a total loss. Solution? David makes a deal with Melissa that he'll pay her a little bit every few months if she covers the loan should Sam turn out to be a deadbeat. As the Congressional Research Service wrote in their Feb. 11 report on Bond Insurers, such a deal is more or less like an insurance policy. The main difference between insurance and a swap is that a swap is a private agreement. Melissa can turn around and enter into another swap to protect herself where she pays a premium to me, and if David says pay up to her, she turns to me and I have to pay. The catch: she doesn't have to tell anyone about our agreement. But wait, it gets better. I can turn around and enter into yet another swap, this time with you and not tell anyone. That's what they mean when they say the swap market is unregulated. Now when David comes calling on Melissa, he has no idea that he's about to play Six Degrees of Kevin Bacon to get his money. David thought Melissa was his back-up plan, he didn't bargain on it being you. And if someone can't pay in that daisy chain? That's right, a domino effect where David is the loser.

The problem is that overexposure in subprime lending investments and other complex deals means many financial institutions now have a number of Sams on their hands. If those financial institutions make like David and call in their ace in the hole only to find it either not there or unable to pay, then how do you think investors will react? And what do you think that does to your 401K? Oh, and by the way, your 401k likely owns stock in David.

So let's return to the theory that this is just like 90-91 and compare then and now.

The Washington Post this week reported an increase in late credit-card payments and an increase in credit-card balances written off by banks. OK, sounds similar.

The latest data from the Mortgage Bankers Association indicates the highest delinquency rate on residential mortgage loans since 1986. Here, too, the data seems to track.

In fact, at first blush it tracks so well that when Federal Reserve Board Chairman Ben Bernanke was asked while testifying before a Senate committee whether we are currently mirroring the early 90s, he said, "... qualitatively, it's fairly similar to the recovery that followed the 90-91 recession, many of the same features." Bernanke went on to include a weak housing market as well.

What didn't get asked was key. Bernanke was not asked about the enormity of the credit default swap market and other yet not discussed complex derivatives that exist today as compared to the early '90s.


Thus, couldn't this end up as something of a nightmare scenario where the subprime mortgage hit was the first body blow and this is the later half of the one-two punch?

So we called the Fed. We got a very polite no comment.

Until Bernanke's next appearance, we'll hope for the best -- but keep your eyes peeled on the business section and on the cable news channels. Chances are you're gonna hear a lot more about those credit default swaps.

Tom Kaufman is the Capital Markets Committee Chairman for the American College of Real Estate Lawyers and is a partner at Hunton and Williams LLP in Washington, D.C.

Christian Hudson is a former CNN Senior Producer now practicing finance and real estate law at Hunton and Williams LLP in Washington, D.C.