Think Twice Finance

The Subprime Mortgage Crisis: Part 8. Circular Jerkularity.

Circular Jerkularity is the technical term for a hitherto unheralded financing technique practiced by Rating Agencies, Insurers of Subprime Mortgage Conduits such as MBIA, and traders of Credit Default Swaps (CDS) that has recently been a source of consternation among Wall Street firms and their clientele.

As the term suggests, this is a three-way reciprocal cooperative effort, best explained by detailing the role of each participant.

The rating agencies grade the financial instruments insured by the Insurers, and priced by the traders of CDS’s. A financial instrument can improve its grade if it is insured by the insurers and protected from risk by an inexpensive CDS. The rating agencies also rate the Insurers. Their rating determines the value of the insurance provided. And the rating agencies rate the traders of CDSs. They therefore determine whether CDS traders can sell their products at a competitive price.

The Insurers provide financial guarantees that mortgage conduits will perform according to their terms. With a guarantee from a highly rated insurer, a rating agency will give a mortgage conduit a high grade. With a guarantee from a highly rated insurer, a CDS can be bought more cheaply by a Conduit. CDS’s themselves can be insured and their value enhanced as a result.

The credit default swaps protect holders of mortgage conduit liabilities with guarantees that they will not lose revenues from their investment if the rating agency changes its grade. Having a CDS attached encourages the rating agency to give the conduit a higher grade. And entering many highly rated CDS’s results in a high rating for the CDS trader. A CDS from a highly rated CDS trader encourages conduit insurers to charge less for their insurance. And an insurer protected from its risks by CDS’s can expect a higher rating and can buy CDS’s more cheaply.

Cooperation is a wonderful thing. Isn’t it? So what is everybody worrying about?