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The Financial Mess is Worse Than You Think: Here’s Why Tarp is a Flop

Posted Sep 27, 2009 by Kris DiGiovanni

Updated Sep 27, 2009 at 04:58 PM

We are coming up on the one-year anniversary of the Troubled Assets Relief Program (TARP). According to some experts, it’s done its job; stabilized the economy, kept big banks from going under, has even turned a profit for the American taxpayer. 

But after the latest progress report from TARP officials, Elizabeth Warren, the Harvard Law professor and economist appointed to chair the congressional oversight committee, was highly critical of TARP activity so far.  She was especially disappointed in TARP’s failure to make progress on one of its main goals – buying toxic assets held by the banks.  Until there is a plan in place for disposing of these liabilities, she said ,

Toxic assets – it’s a term we’ve heard a lot about, although recently not so much.  What are they, and what’s the big deal about them? 

A few months ago, I read an article in Wired Magazine that explained them better than anything I’ve read to date, and now that I understand what’s going on a little better, I am scared – really scared. Let me attempt to explain.

One type of toxic asset is called Collateralized Debt Obligation (CDO). CDOs are groups of bonds, loans, and mortgages, both good ones and bad ones, all mixed together. They were invented around 1995 as a way for financial institutions to move debts off their balance sheets by selling them as collateral. From the beginning, however, there was a problem – how to figure out exactly what the CDOs were actually worth.

But then came mathematician David X. Li, who pioneered a formula, the Gaussian Copula Function, that provides a way to assess the relationship between the various types of loans in the CDOs, thus making it possible to assign a value. Since these securities were fairly new inventions, Li couldn’t rely on the traditional historic data to arrive at a valuation, so he used market data about the prices of companion securities known as Credit Default Swaps (CDSs)

CDSs are like insurance on CDOs.  Investors pay a premium to ensure the CDO retains its value.  If the CDO defaults, the insurer is liable for the entire cost of the CDO (the insured value).  As we all know, insurance is based on the small likelihood of something negative happening versus the larger likelihood things will continue to go well.  The financial world thought CDSs were a safe bet because a very large part of the debt that made up the CDOs was home mortgages, and houses had been steadily appreciating in value for years.

Ratings agencies like Moody’s relied on Li’s formula to rank the CDOs.  Li’s theory stated that the correlation of the components of any CDO was more important than the health or value of the individual debt instruments.  This assumption made it possible for a CDO to receive a higher rating than any of its individual components carried, and created a false sense of safety for those who invested in them.

Per the Wired article:

So how do we fix this mess?  We could cancel all the CDSs and let the firms holding them just go under, except for one thing – the CDSs provide the only mechanism for determining the value of the CDOs.  So we need them to stay.  The only way to find a way out of this craziness is for some other genius to come up with a method for valuing CDOs that doesn’t rely on CDSs. 

Is your head spinning yet?  I know mine is.  I’m also good and mad.  I’m mad at all the financial types who bought into an unproven “theory” from a math wunderkind and based our country’s financial future on it.  I’m angry at the greed that provoked the unrestricted and unregulated trading of financial instruments that were nothing more than a giant house of cards.  And I’m really P.O.’d that, Wall Street, the Banking industry, and the SEC are more occupied with handing out big bonuses and pointing fingers at each other than trying to undo the damage they’ve caused.

President Obama put them on notice in his recent speech, warning that much stricter regulation is coming.  But this is closing the barn door after the horse is not only gone, but has won the Kentucky Derby, retired, and begun pulling in exorbitant stud fees.  I sincerely hope that someone finds a way to solve the financial chaos caused by CDOs and CDS’ - but I’m not optimistic.