the next debt bubble?

September 24, 2006 6:39 PM

Plunging into the shadows:"In thinly traded, lightly regulated and untransparent markets, the bold can make an awful lot of money—and they can lose it on an even more extravagant scale... In today's caffeine-fuelled dealing rooms, a barely regulated private-equity group could very well borrow money from syndicates of private lenders, including hedge funds, to spend on taking public companies private. At each stage, risks can be converted into securities, sliced up, repackaged, sold on and sliced up again. The endless opportunities to write contracts on underlying debt instruments explains why the outstanding value of credit-derivatives contracts has rocketed to $26 trillion—$9 trillion more than six months ago, and seven times as much as in 2003."
posted by kliuless (27 comments total)

I'm quite unqualified to comment, but I've been following The Economist's coverage for the past month or so. Fascinating and frightening at the same time.
posted by shoepal at 7:50 PM on September 24, 2006

Warren Buffett bought an insurance company that had a bunch of derivatives contracts. He has nothing but bad things to say about them. I believe he called them 'financial weapons of mass destruction', though I could be confusing him with another analyst. He DEFINITELY does not like them. (and there's probably nobody alive that understands finance better than Warren Buffett.)

Some analysts I've read believe that a total collapse of the entire system is becoming more and more likely. The scale of these contracts, with their hidden knock-on effects, has become so large that they could have a domino effect and wipe out most of the world's major financial institutions.

A derivatives blowup happened in the 1990s, with Long Term Capital Management. The Fed orchestrated a gigantic bailout to save them; Greenspan said that he believed LTCM's failure had a 'less than 50% chance' of taking down the world financial system. That would appear to indicate he thought it was north of 40%....
posted by Malor at 8:04 PM on September 24, 2006

Greed is good....right?
posted by Thorzdad at 8:06 PM on September 24, 2006

This might be the most important thing I don't understand.
posted by Vindaloo at 8:06 PM on September 24, 2006

Count me in. I'll sign over my next two paychecks (you accept PayPal?)
posted by hal9k at 8:15 PM on September 24, 2006

here's kind of a backgrounder on credit derivatives; just like black-scholes opened up new frontiers in finance, so has the gaussian copula opened up new avenues/adventures in structured finance.

re: buffett, cf. munger
posted by kliuless at 8:20 PM on September 24, 2006

Investing in derivatives seems to be about as smart as taking stock-buying advice based on "pump and dump" scam/spam you receive in your inbox.
posted by clevershark at 8:23 PM on September 24, 2006

it doesn't matter whether we understand them or not ... the question is, do THEY understand them?

i'm getting a very uncomfortable feeling they don't
posted by pyramid termite at 10:03 PM on September 24, 2006

This reminds me of my macro econ prof. I pointed out one day that there wasn't enough gold or whatever to back the amounts of money he was talking about. He very cheerfully agreed. I compared the world economic system to a shared delusion. He agreed. I then asked what would happen if people realised this. He pumped his fist into the air, and happily shouted, "The Revolution!"

He didn't get tenure for some reason...
posted by QIbHom at 11:53 PM on September 24, 2006 [3 favorites]

This is pretty appropriate for metafilter, actually. The continued meta-ization of capital (perhaps I should use the word metastasis?), together with the fact that the global economy has taken a number of serious hard blows to the stomach (dotcom bust, 9/11, american auto crash, as listed in the lead article in this post) without really reacting, has got me a bit concerned lately too. I'm not sure what the remedy is.

Wherever there's a corner of finance where a group of companies can derive something to trade, they will do it, and the appetite for speculation is endless these days, it seems, since once you're far enough removed from reality, in an active and liquid market, you only need to speculate for a minute or two. The markets are fucked up and crazy in this age of computerized speculative realtime investment. I'm pretty sure there are no people—or at least very, very, very few people—who understand the entire thing anymore, although some simulation systems might. I'd like to make it a personal goal to get my head around the whole thing, but I'm not sure it's possible.

Unrelatedly and pointlessly, I get a little thrill whenever The Economist prints something I've been writing or thinking about for a while prior. It makes me feel plugged-in, or something. It's the only magazine I've convinced myself to subscribe to in years.
posted by blacklite at 12:33 AM on September 25, 2006

Malor: The company he bought was GenRe. At the time he said something along the lines of "I don't invest in things I don't understand" so he closed down the entire derivatives trading arm, GenRe Securities. However, LTCM wasn't a derivatives blowout - it was a straightforward debt default by Russia that precipitated the crisis there.

The transfer of credit risk around the financial system is a good thing and will undoubtably make system more, rather than less, able to withstand shocks. In particular, the ability of insurance companies to get involved in this market adds to stability.
posted by patricio at 3:54 AM on September 25, 2006

it doesn't matter whether we understand them or not ... the question is, do THEY understand them?

As part of my training I did a 6 month stint with the derivatives department of a Magic Circle law firm. The industry view seems to be that the big investment banks are likely modelling CDO/CDS risk with some degree of accuracy; the smaller banks less so. What, however, is going on behind the doors of the hedge funds is anyone's guess.

Frank Partnoy's book FIASCO is a fun place to start in looking at the derivatives world.

The transfer of credit risk around the financial system is a good thing and will undoubtably make system more, rather than less, able to withstand shocks.

That's an incredibly controvesial statement and I would shrink from presenting it as fact. I'm not a banker nor a quant so won't presume to rebut it but Satyajit Das who is, writing in Traders, Guns and Money doesn't agree.

The view from the City seems to be that there's a credit crunch just down the road. Rumour has it that some of the bulge bracket banks in London are busy hiring insolvency specilists at present. The systemic impact of such widespread investment in CDOs is presently unknown.
posted by dmt at 4:47 AM on September 25, 2006

caffeine-fuelled... Ummmm, right.
posted by gene_machine at 5:02 AM on September 25, 2006

dmt: I agree that the jury is out on the modelling of the derivatives, particularly in structured credit, and some market participants may have got it wrong but that's also the case in loan/debt market where you can misjudge the financial health of companies you are exposed to.

As for the financial system of a whole, perhaps I was little bullish, but Alan Greenspan thinks it's not that controversial a view (though there are risks):

As is generally acknowledged, the development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively.

dmt: are congrats due for qualification?
posted by patricio at 6:35 AM on September 25, 2006

Some analysts I've read believe that a total collapse of the entire system is becoming more and more likely. The scale of these contracts, with their hidden knock-on effects, has become so large that they could have a domino effect and wipe out most of the world's major financial institutions.

What does this mean? What will a 'wipe out' of most of the worlds major financial institutions mean to the average person?
posted by eas98 at 7:23 AM on September 25, 2006

The Greenspan comment referencing the measurement and management of risk is correct, and for the most part, the credit derivatives markets serve the same function as the commodities futures market...they allow investors in credit securities to put together hedging strategies in markets where clean hedges are often difficult to create. Just like in the commodities markets there are speculators feeding around the edges, but the vast majority of market participants are effectively risk neutral. With all that said, QIbHom makes an interesting an important observation...one of the biggest and least understood of the issues around credit and other derivatives is the ultimate liquidity of the underlying securities. Just like in the professor's gold example, many derivatives markets are based on underlying securities that are materially less liquid than the derivatives securities themselves...the issue is compounded in situations where the total outstanding size of the underlying security is just a fraction of the outstanding derivative contracts. The problems arise when there is a default on a derivatives contract that requires delivery of the underlying security...in most cases, the participants all just settle their trades for cash, but in an extreme case, the scramble for postions in the underlying could cause enough displacement in pricing to spill over into other securities or markets...the "revolution" referenced in QIbHom's post. The derivatives themselves are not inherently bad...but there is a pretty good argument that their unregulated growth is dangerous. Derivatives used in bank portfolios are monitored by the regulators, but the huge market in derivatives trading between the securities firms and the hedge funds is effectively the wild west. Keep your seat belt fastened...
posted by cyclopz at 7:24 AM on September 25, 2006

People worry a bit too much about the trillions and trillions notional amount of CDS outstanding.

A typical single-name CDS contract says that one counterparty (call him the insurer, although in most cases he's actually a bank) will pay the other counterparty (call him the policy holder) a certain in the event of a deafult on the referenced security ... but only upon presentation of the same face value amount of debt by the policy holder.

The vast majority of CDS policy holders don't own the face value they've insured, and, in fact, because the amount of insurance outstanding vastly exceeds the amount of underlying face value, it would be impossible for the full notional amout of the liability to be claimed against the insurers.

What this means is that when a default occurs, the insurers have two choices: either make their insureds fulfill their end of the contract fully (in which case most of the outstanding CDS expires worthless or near-worthless) or else settles with CDS holders at a fraction of the notional amount, waiving the requirement that the debt actually be turned over. The latter route is what has actually been followed in the few events of default in issuers with significant quantities of CDS outstanding (for example, CalPine).
posted by MattD at 7:29 AM on September 25, 2006

Or, a lot of what Cyclopz just said!

Speaking solely in my personal capacity, another reason to be less worried about CDS than other things is that the main people who are short CDS liability (i.e., with an obligation to pay) are the biggest and most risk-management-obsessed banks. Other (non-big-bank) investors remain quite heavily levered towards sustained high energy costs, sustained low spreads in fixed income and high multiples in equities, and a very soft landing for U.S. housing, and not necessarily with tremendous hedges stop-loss tools in place (e.g., Amaranth). I suspect the return of $20 barrels of oil and sub-$500k prices for 4 br/2.5 bath houses in nice suburbs of New York or San Francisco would roil the markets a lot worse than anything on the CDS side...
posted by MattD at 7:39 AM on September 25, 2006

This reminds me of my macro econ prof. I pointed out one day that there wasn't enough gold or whatever to back the amounts of money he was talking about. He very cheerfully agreed. I compared the world economic system to a shared delusion. He agreed. I then asked what would happen if people realised this. He pumped his fist into the air, and happily shouted, "The Revolution!"

Except by this logic, your economy gets stronger just by having more gold. Which, as the Spanish have proven, is not really the case. The fact that the economy is backed by intagibles (labour, etc) doesn't mean that it's not backed by something.
posted by GuyZero at 9:41 AM on September 25, 2006

The biggest reason for commodity money is to prevent abuse by politicians. As is, we print vast amounts of currency every year (we don't even have to actually PRINT it anymore, it's just numbers in a computer these days). The government uses that money to, in essence, extract value from the economy for free. This causes inflation.

Money backed by a commodity is a more stable medium of exchange. It doesn't matter what the commodity IS, as long as it takes real work to manufacture. You still get price swings and boom/bust cycles, but the generation of real wealth is able to continue at a higher rate of speed because vast amounts of the stuff isn't being invisibly removed from the economy by the government.

Money isn't wealth, directly. Wealth is surplus production. Money allows those surpluses to move around in the most efficient way, as long as the money supply isn't being abused by the government. There's no real need for managing the money supply... it's simply the most marketable commodity. Historically, that commodity was gold. But it could have been seashells or cow patties. You don't worry about regulating the soap supply. It regulates itself. The money supply will do precisely the same thing.

The reason the government wants to control it is for the ability to extract wealth from the economy, invisible to most of the participants. It gives the government (unearned) wealth and political power, by being able to manipulate the economy. THAT is the reason they insist so loudly that they need to control the money supply. It's not for your benefit, it's for theirs.

We've had a number of market blowups over the last ten years.... Mexico, LTCM, Turkey, Argentina.... it's NOT NORMAL for economies to just disintegrate like that. We are in a period of profound economic instability, brought about by fictional money that is being abused to an extroardinary degree. Derivatives are just a symptom of a much deeper problem.

Commodity money prevents currency speculation. Currency speculators are a gigantic parasite on the world economic system. In currency trades, for every winner, there is a loser. The winners are the big guys who are plugged into the political system; the losers are the little people who have no idea what's going on. It's farmers that go broke because their wheat is no longer worth what it cost to grow who pay for the limousines and mansions of the Wall Street crowd. Commodity-backed money kills economic parasites dead.

Measuring wealth with modern currency is like trying to measure distance with a rubber band. You won't ever get the same answer twice. It does not have to be that way.
posted by Malor at 12:00 PM on September 25, 2006 [1 favorite]

And GuyZero.... we make a promise to pay with our dollars.... but what, exactly? What promise do we make when we hand someone a dollar bill?

U.S. Dollar, n: A politician's promise to pay nothing on demand.

That's one of the few promises you can be QUITE sure they'll keep.
posted by Malor at 12:02 PM on September 25, 2006

What a great comment, Malor. If 'small government Republicans' learned just a little more economics, they'd puke.
posted by sonofsamiam at 12:18 PM on September 25, 2006

Guy Zero, I'm unevolved, I guess. I like my money to mean something. Doesn't have to be gold. Labour is fine.

Invisible spaghetti is not. And, what these guys are trading is invisible spaghetti, if I understand even a little.

Is there enough cash in the world to pay the US national debt?
posted by QIbHom at 1:59 PM on September 25, 2006

Malor...there is so much wrong in your post that I don't know where to start, so I'll focus on one part. Commodity X farmers go broke because the government subsidizes the price of commodity X which encourages excess production of commodity X depressing the price of commodity X...not because some wall street hotshot is scamming their products pricing. Commodity markets allow the producers (farmer) and the consumers (cereal company) to find a mutually agreeable future price for their transaction. Knowledgable speculators (professional traders) are trying to get paid for doing the deep research on things like weather, soil conditions, demand, etc. that provides the price framework in the market that farmers and cereal companies can't afford or don't want to do. In every market, there are speculators that are just gamblers...those are the guys being fleeced by the hotshots. Your currency discussion is just flat wrong...I don't have the time or patience to explain why...if you bother to reply, perhaps I'll take a whack at it tomorrow...
posted by cyclopz at 2:41 PM on September 25, 2006

i guess my thing is, how can anyone accurately model default probabilities on some of this stuff? particularly for non-traditional 'exotic' subprime mortgages (IO, option ARM, neg-am) that have no history through a credit cycle, much less low- or no-document mortgages (and FICO is a blackbox anyway?)... did they do due diligence on a mortgage pool of, say, two million? gigo... and then you have the ratings agencies' imprimatur...

as for currencies... revolution! also, fwiw, mcculley proposed a "modern day equivalent of the gold standard," altho the inflation basket and methodology could be (and some argue has been) gamed... so back to bancor :D
posted by kliuless at 9:40 PM on September 25, 2006

There are categories of collateral where you can't accurately model default rates and subprime is a good example...in the late 90's, subprime mortgage and auto lenders suffered through a miserable squeeze that wiped out all but the best capitalized participants. The inability to model borrower behavior contributed to the problem but the real issue was insufficient overcollateralization and a rate cushion that was too thin. The derivative security (CMBS, etc.) performance all depends on the underlying loan having the collateral and rate appropriate to the loan's risk category...need to read your other links and may come back to respond...
posted by cyclopz at 5:50 AM on September 26, 2006

too long didn't read
posted by spiderwire at 5:43 PM on September 26, 2006