The Invisible Fist of the Free Market
February 18, 2008 4:32 PM Subscribe
What market has grown from $900 billion in 2000 to more than $45.5 trillion and is completely unregulated? Welcome to the world of Credit Default Swaps. Speculative derivatives have been described as "financial weapons of mass destruction" by some guy named Warren Buffet. Some people wonder how you can have "$1 trillion in swaps bet on the success or failure of GM when the entire market cap of GM is a mere $15 billion." Credit Default Swaps are being triggered from Northern Rock in the UK to ANZ Bank down under as the "subprime" crisis unravels. AIG's CDS loss portfolio has already climbed to $5 billion from a previsouly estimated $1 billion.
Previously on MeFi.
Previously on MeFi.
Don't you wish that your job in life was to make money appear out of thin air?
posted by Rubbstone at 4:54 PM on February 18, 2008
posted by Rubbstone at 4:54 PM on February 18, 2008
Viva Las Vegas.
posted by kuujjuarapik at 5:04 PM on February 18, 2008
posted by kuujjuarapik at 5:04 PM on February 18, 2008
I posted a long excerpt from the Credit Bubble Bulletin here.
Short form: things are really bad, and getting worse extremely quickly. The subprime contagion is spreading.
Been talking about this for years now, to the point of exhaustion. I'm sure my family thought I was a lunatic. There's a small amount of glee at "I told you so!", but... I'd much rather have been wrong.
At least now they're starting to understand why I was so upset about this whole thing.
posted by Malor at 5:12 PM on February 18, 2008
Short form: things are really bad, and getting worse extremely quickly. The subprime contagion is spreading.
Been talking about this for years now, to the point of exhaustion. I'm sure my family thought I was a lunatic. There's a small amount of glee at "I told you so!", but... I'd much rather have been wrong.
At least now they're starting to understand why I was so upset about this whole thing.
posted by Malor at 5:12 PM on February 18, 2008
America's entire economy is smoke and mirrors. What bullshit that when Wall Street winces the fed steps in to adjust the interest rate. Can't have fat rich bastards seeing the down side of their own greed, after all. It has to all be a gravy train all the time for that top 2% and the rest of us can go to hell.
posted by 45moore45 at 5:19 PM on February 18, 2008 [1 favorite]
posted by 45moore45 at 5:19 PM on February 18, 2008 [1 favorite]
What's there to be upset about? Doesn't this mean we're all richer?
posted by UbuRoivas at 5:19 PM on February 18, 2008
posted by UbuRoivas at 5:19 PM on February 18, 2008
This s exactly why I have guns, liquor, gold Krugerrands, and cigarettes hidden under my bed. Well, that, and, you know, I like to party.
posted by Astro Zombie at 5:21 PM on February 18, 2008 [13 favorites]
posted by Astro Zombie at 5:21 PM on February 18, 2008 [13 favorites]
TRICKLE-DOWN turmoil from the US subprime crisis is gathering momentum, with ANZ Bank saying its dealings with companies strained by the global debacle will wipe away first-half profit growth. ANZ shares lost 6% on the announcement that the bank would have to hold back about $367 million from profit for the six months to March 31, most of it the result of dealings with companies struggling in the global credit market.
The shares closed $1.45 lower at $22.46. ANZ chief executive Mike Smith stressed that, were it not for the one-off provisions, profit would have grown by more than last year's 11.5%.
I can sympathise with that. After all, I'd be a millionaire now if only my ostrich farm investment hadn't gone sour.
posted by UbuRoivas at 5:24 PM on February 18, 2008 [1 favorite]
The shares closed $1.45 lower at $22.46. ANZ chief executive Mike Smith stressed that, were it not for the one-off provisions, profit would have grown by more than last year's 11.5%.
I can sympathise with that. After all, I'd be a millionaire now if only my ostrich farm investment hadn't gone sour.
posted by UbuRoivas at 5:24 PM on February 18, 2008 [1 favorite]
Motherfuckers. New law: all people in the finance industry regularly tested for coke, because this has gotten out of hand. If only there was a test for "greedy and reckless."
They Already do, at least according to AskMe. But according to that thread, most i-bankers also do coke. So apparently they're not doing it enough. (Not that i actually know if Cocaine use would actually cause people to screw up this way, I think the companies are just worried about people stealing money to pay for drugs, or something like that)
posted by delmoi at 5:26 PM on February 18, 2008 [1 favorite]
They Already do, at least according to AskMe. But according to that thread, most i-bankers also do coke. So apparently they're not doing it enough. (Not that i actually know if Cocaine use would actually cause people to screw up this way, I think the companies are just worried about people stealing money to pay for drugs, or something like that)
posted by delmoi at 5:26 PM on February 18, 2008 [1 favorite]
when Wall Street winces the fed steps in
also see, cf.
posted by kliuless at 5:28 PM on February 18, 2008
also see, cf.
posted by kliuless at 5:28 PM on February 18, 2008
Man, I'm glad this is happening during the bush administration, and the result of his policies. Can you imagine if it had happened a year later and the economy crashed then? Everyone would blame the new democratic president.
posted by delmoi at 5:32 PM on February 18, 2008 [3 favorites]
posted by delmoi at 5:32 PM on February 18, 2008 [3 favorites]
Yeah, but I think it's gonna be getting worse for a decade or more, delmoi, just like Japan, so the next President is likely to be a one-termer. Like Carter, he'll be sandbagged by the economic mess he inherited.
posted by Malor at 5:34 PM on February 18, 2008 [2 favorites]
posted by Malor at 5:34 PM on February 18, 2008 [2 favorites]
(or 'she', if Hillary gets the nomination, but I expect Obama to win at this point.)
posted by Malor at 5:35 PM on February 18, 2008
posted by Malor at 5:35 PM on February 18, 2008
It should be noted that Mr. Buffett dabbles in this market, despite his rhetoric.
By the way, a bunch of financial firms losing money on hedges is hardly the end of the world. Not sure why all the handwringing. Such a gloomy group here!
posted by blue mustard at 5:38 PM on February 18, 2008 [2 favorites]
By the way, a bunch of financial firms losing money on hedges is hardly the end of the world. Not sure why all the handwringing. Such a gloomy group here!
posted by blue mustard at 5:38 PM on February 18, 2008 [2 favorites]
oh and brad setser helpfully puts it all in global context :P
cheers!
posted by kliuless at 5:40 PM on February 18, 2008
cheers!
posted by kliuless at 5:40 PM on February 18, 2008
All these derivatives have made our economy more vulnerable than the last Tsar's hemophiliac son, Prince Alexei, who threatened to bleed to death from any scratch. Obama had better have a lot more going for him than Rasputin, or we are all in big trouble.
posted by jamjam at 5:42 PM on February 18, 2008 [2 favorites]
posted by jamjam at 5:42 PM on February 18, 2008 [2 favorites]
delmoi: everyone knows that this is really Slick Willie's fault!
posted by papakwanz at 5:48 PM on February 18, 2008
posted by papakwanz at 5:48 PM on February 18, 2008
Oh, and by the way... could someone explain what the fuck this all means? I'm a stupid liberal arts type.
posted by papakwanz at 5:49 PM on February 18, 2008
posted by papakwanz at 5:49 PM on February 18, 2008
Speculation on derivatives caused the bankruptcy of Orange County, California, back in the mid-90s.
posted by Cool Papa Bell at 5:52 PM on February 18, 2008
posted by Cool Papa Bell at 5:52 PM on February 18, 2008
delmoi: everyone knows that this is really Slick Willie's fault!
A lot of it was. The original stock market mania was all Greenspan and Clinton. The fallout from that should have been terrible, but Greenspan went hog-wild with the cash supply to prop things up... and, of course, made them ten times worse.
Now, make no mistake, the Bushies have been asleep at the switch while the new bubbles blew up to 10 times the size of the originals, and are absolutely culpable at this point.... but the Clintonistas share the blame.
posted by Malor at 6:12 PM on February 18, 2008
A lot of it was. The original stock market mania was all Greenspan and Clinton. The fallout from that should have been terrible, but Greenspan went hog-wild with the cash supply to prop things up... and, of course, made them ten times worse.
Now, make no mistake, the Bushies have been asleep at the switch while the new bubbles blew up to 10 times the size of the originals, and are absolutely culpable at this point.... but the Clintonistas share the blame.
posted by Malor at 6:12 PM on February 18, 2008
According to the CIA world factbook, the GDP of the entire world it $50.36 trillion. For whatever that's worth.
posted by absalom at 6:19 PM on February 18, 2008
posted by absalom at 6:19 PM on February 18, 2008
Malor--thanks for pointing out that no one chief executive is to blame, but couldn't you have worked a little harder and shown that everyone back to King George III is also somewhat culpable?
posted by hexatron at 6:22 PM on February 18, 2008
posted by hexatron at 6:22 PM on February 18, 2008
According to the CIA world factbook, the GDP of the entire world it $50.36 trillion.
The $45.5 trillion number above almost certainly comes from ISDA's 2007 mid year survey, but ISDA reports that as the notional amount outstanding, so it can't be directly compared to the value of other markets
posted by Mr. President Dr. Steve Elvis America at 6:42 PM on February 18, 2008
The $45.5 trillion number above almost certainly comes from ISDA's 2007 mid year survey, but ISDA reports that as the notional amount outstanding, so it can't be directly compared to the value of other markets
posted by Mr. President Dr. Steve Elvis America at 6:42 PM on February 18, 2008
It should be noted that Mr. Buffett dabbles in this market, despite his rhetoric.
While it's true that Berkshire Hathaway (the giant corporation which Buffett runs) sells credit default insurance (to a limited extent), this doesn't really make Buffett a hypocrite. Berkshire sells insurance. It's a giant insurance company that participates in all sorts of insurance specialty lines and has adequate reserves to backup its losses. It's only natural that it would write credit/securities insurance to some degree. Those policies can be defined as derivatives, but this doesn't indicate that Berkshire is a player in the CDS market.
The problem with the CDS market is that there is little transparency into who holds the liabilities and whether or not they have adequate reserves to pay out losses. I doubt Buffett is speculating in the broader CDS market, as either a buyer or seller.
posted by mullacc at 6:44 PM on February 18, 2008
While it's true that Berkshire Hathaway (the giant corporation which Buffett runs) sells credit default insurance (to a limited extent), this doesn't really make Buffett a hypocrite. Berkshire sells insurance. It's a giant insurance company that participates in all sorts of insurance specialty lines and has adequate reserves to backup its losses. It's only natural that it would write credit/securities insurance to some degree. Those policies can be defined as derivatives, but this doesn't indicate that Berkshire is a player in the CDS market.
The problem with the CDS market is that there is little transparency into who holds the liabilities and whether or not they have adequate reserves to pay out losses. I doubt Buffett is speculating in the broader CDS market, as either a buyer or seller.
posted by mullacc at 6:44 PM on February 18, 2008
In unrelated news, my new band is called The Speculative Derivatives. We're a little pretentious and nobody comes to our shows, but Warren Buffet gave us a big ironic thumbs-up in his zine.
posted by damehex at 6:45 PM on February 18, 2008 [4 favorites]
posted by damehex at 6:45 PM on February 18, 2008 [4 favorites]
Those policies can be defined as derivatives, but this doesn't indicate that Berkshire is a player in the CDS market.
And just to be clear, Berkshire does indeed participate in the CDS market. Quoting from the WSJ article I linked above (emphasis mine):
Sellers of stock- and credit-insurance contracts typically bet that the risk priced into the underlying reference securities is overstated. The notional value of the underlying contracts, which include equity-index options and credit-default swaps, has increased by $12 billion, or 52%, to $35 billion since the end of 2006.
I'm not really calling Buffett a hypocrite, because I really have no idea of the nature of his company's position other than what I read in the WSJ. That is, I'll give him the benefit of the doubt and assume he's trading in flavors of derivatives that aren't what he considers "financial weapons of mass destruction." Presumably Berkshire's positions are less speculative than some.
posted by blue mustard at 7:07 PM on February 18, 2008
And just to be clear, Berkshire does indeed participate in the CDS market. Quoting from the WSJ article I linked above (emphasis mine):
Sellers of stock- and credit-insurance contracts typically bet that the risk priced into the underlying reference securities is overstated. The notional value of the underlying contracts, which include equity-index options and credit-default swaps, has increased by $12 billion, or 52%, to $35 billion since the end of 2006.
I'm not really calling Buffett a hypocrite, because I really have no idea of the nature of his company's position other than what I read in the WSJ. That is, I'll give him the benefit of the doubt and assume he's trading in flavors of derivatives that aren't what he considers "financial weapons of mass destruction." Presumably Berkshire's positions are less speculative than some.
posted by blue mustard at 7:07 PM on February 18, 2008
Too bad that whole "privatization of social security" didn't happen, or the 2% could offload their losses to the unwashed masses.
posted by yesster at 7:12 PM on February 18, 2008 [4 favorites]
posted by yesster at 7:12 PM on February 18, 2008 [4 favorites]
but Greenspan went hog-wild with the cash supply
I swear when I first read this I thought you'd called him 'Greedspawn.'
posted by jamjam at 7:22 PM on February 18, 2008 [2 favorites]
I swear when I first read this I thought you'd called him 'Greedspawn.'
posted by jamjam at 7:22 PM on February 18, 2008 [2 favorites]
Man, I'm glad this is happening during the bush administration, and the result of his policies. Can you imagine if it had happened a year later and the economy crashed then? Everyone would blame the new democratic president
Apparently, you are not reading from the proper script. Whatever bad happens during Bush's administration, right up until the last minute, is all the result of something Clinton did. Or heck, maybe even Carter. The exact moment he's out of office, anything bad that happens from that point forward, or is already happening for that matter, will be the fault of his successor. Do keep up.
posted by Devils Rancher at 7:26 PM on February 18, 2008 [5 favorites]
Apparently, you are not reading from the proper script. Whatever bad happens during Bush's administration, right up until the last minute, is all the result of something Clinton did. Or heck, maybe even Carter. The exact moment he's out of office, anything bad that happens from that point forward, or is already happening for that matter, will be the fault of his successor. Do keep up.
posted by Devils Rancher at 7:26 PM on February 18, 2008 [5 favorites]
but couldn't you have worked a little harder and shown that everyone back to King George III is also somewhat culpable?
Heh, well, actually, it goes back to LBJ. I suppose you could argue that it goes back to 1917, when the Fed was created, but I think of the modern dysfunction starting with the Great Society, and very slowly snowballing from there. Nixon taking us off the gold standard, Reagan and voodoo economics, Clinton with his rejiggering of the inflation numbers and lies about a balanced budget, and Bush with his absolute ineptitude all contributed... and then, of course, there's Greenspan and Helicopter Ben.
Since LBJ, it would appear our primary governmental focus has been avoiding paying the bills from the prior administrations, and then, in later years, central management of the economy and making sure Nothing Bad Ever Happens Here.
Try as I might, though, I'm not coming up with any way to work King George in. Sorry about that.:)
posted by Malor at 7:43 PM on February 18, 2008
Heh, well, actually, it goes back to LBJ. I suppose you could argue that it goes back to 1917, when the Fed was created, but I think of the modern dysfunction starting with the Great Society, and very slowly snowballing from there. Nixon taking us off the gold standard, Reagan and voodoo economics, Clinton with his rejiggering of the inflation numbers and lies about a balanced budget, and Bush with his absolute ineptitude all contributed... and then, of course, there's Greenspan and Helicopter Ben.
Since LBJ, it would appear our primary governmental focus has been avoiding paying the bills from the prior administrations, and then, in later years, central management of the economy and making sure Nothing Bad Ever Happens Here.
Try as I might, though, I'm not coming up with any way to work King George in. Sorry about that.:)
posted by Malor at 7:43 PM on February 18, 2008
Oh, I think the Clinton administration gamed the GDP numbers, too. I think a lot of the really egregious lies about economic performance started under his watch.
posted by Malor at 7:46 PM on February 18, 2008
posted by Malor at 7:46 PM on February 18, 2008
Oh, and by the way... could someone explain what the fuck this all means? I'm a stupid liberal arts type.
It's a bet between two parties that a credit event will/will not take place in a third party.
My basic understanding: Speculative Funds, LLC decides it wants to place a bet on Widgets Inc. There aren't enough corporate bonds from Widget Inc. so Speculative Funds, LLC (the seller) finds another party -- Greedy Bastards, LLC (the buyer) -- that will cover their bet on the other side. As long as a credit event (the bet) doesn't occur, Greedy Bastards pay Speculative Funds a fee. If the credit event does occur, Speculative Funds takes delivery of the "bonds" and settles with Greedy Bastards.
So, where's the problem? Say Widget Inc. has $1 billion in outstanding debt and CDS are being traded for $10 billion. Widget Inc. defaults with a 75% recovery rate. The loss to investors in Widget Inc. would be $250 million. The loss to the CDS sellers would be $2.5 billion, 2.5 times the outstanding debt Widget Inc. had in the first place, i.e. they are just making shit up and potentially fucking the markets in the meantime.
"But ryoshu," you may ask, "surely no one would be stupid enough to do that?" Well, going back to the original post, GM has a market cap of $15 billion, but there are $1 trillion in credit default swaps placed on it.
This relates to the subprime industry since surely some of the companies effected by the "subprime"[0] fiasco are covered by the unregulated credit default swaps. No one knows if the sellers have enough to cover the losses that are going to occur, since these things are unregulated and stuff.
[0] - subprime is a misnomer. The problems are now spreading to prime market as well.
posted by ryoshu at 8:14 PM on February 18, 2008 [5 favorites]
It's a bet between two parties that a credit event will/will not take place in a third party.
My basic understanding: Speculative Funds, LLC decides it wants to place a bet on Widgets Inc. There aren't enough corporate bonds from Widget Inc. so Speculative Funds, LLC (the seller) finds another party -- Greedy Bastards, LLC (the buyer) -- that will cover their bet on the other side. As long as a credit event (the bet) doesn't occur, Greedy Bastards pay Speculative Funds a fee. If the credit event does occur, Speculative Funds takes delivery of the "bonds" and settles with Greedy Bastards.
So, where's the problem? Say Widget Inc. has $1 billion in outstanding debt and CDS are being traded for $10 billion. Widget Inc. defaults with a 75% recovery rate. The loss to investors in Widget Inc. would be $250 million. The loss to the CDS sellers would be $2.5 billion, 2.5 times the outstanding debt Widget Inc. had in the first place, i.e. they are just making shit up and potentially fucking the markets in the meantime.
"But ryoshu," you may ask, "surely no one would be stupid enough to do that?" Well, going back to the original post, GM has a market cap of $15 billion, but there are $1 trillion in credit default swaps placed on it.
This relates to the subprime industry since surely some of the companies effected by the "subprime"[0] fiasco are covered by the unregulated credit default swaps. No one knows if the sellers have enough to cover the losses that are going to occur, since these things are unregulated and stuff.
[0] - subprime is a misnomer. The problems are now spreading to prime market as well.
posted by ryoshu at 8:14 PM on February 18, 2008 [5 favorites]
blue mustard writes: And just to be clear, Berkshire does indeed participate in the CDS market. Quoting from the WSJ article I linked above (emphasis mine):
Sellers of stock- and credit-insurance contracts typically bet that the risk priced into the underlying reference securities is overstated. The notional value of the underlying contracts, which include equity-index options and credit-default swaps, has increased by $12 billion, or 52%, to $35 billion since the end of 2006.
You're confusing the description of the entire market with what Berkshire is specifically doing. Berkshire writes some insurance policies based on the value of underlying equity indexes or bonds. Such an insurance policy is technically a derivative contract and therefore part of the universe of "stock- and credit-insurance contracts". Credit default swaps (CDS) are also part of that universe. CDS are unique, in part, because they are an attempt to create a standardized insurance contract that can be freely traded among buyers and sellers--that is, they're a way for players other than insurance companies to speculate on credit insurance. Berkshire takes credit risk through insurance policies, but they do it as a traditional insurance carrier, not as a trader of CDS. The difference can be difficult to understand for financial outsiders, but it's not trivial.
posted by mullacc at 8:20 PM on February 18, 2008
Sellers of stock- and credit-insurance contracts typically bet that the risk priced into the underlying reference securities is overstated. The notional value of the underlying contracts, which include equity-index options and credit-default swaps, has increased by $12 billion, or 52%, to $35 billion since the end of 2006.
You're confusing the description of the entire market with what Berkshire is specifically doing. Berkshire writes some insurance policies based on the value of underlying equity indexes or bonds. Such an insurance policy is technically a derivative contract and therefore part of the universe of "stock- and credit-insurance contracts". Credit default swaps (CDS) are also part of that universe. CDS are unique, in part, because they are an attempt to create a standardized insurance contract that can be freely traded among buyers and sellers--that is, they're a way for players other than insurance companies to speculate on credit insurance. Berkshire takes credit risk through insurance policies, but they do it as a traditional insurance carrier, not as a trader of CDS. The difference can be difficult to understand for financial outsiders, but it's not trivial.
posted by mullacc at 8:20 PM on February 18, 2008
Obama had better have a lot more going for him than Rasputin, or we are all in big trouble.
In that case, we're surely doomed.
Rasputin had Boney M on his side, whereas Obama only has that I've got a crush on Obama girl.
posted by UbuRoivas at 8:37 PM on February 18, 2008 [3 favorites]
In that case, we're surely doomed.
Rasputin had Boney M on his side, whereas Obama only has that I've got a crush on Obama girl.
posted by UbuRoivas at 8:37 PM on February 18, 2008 [3 favorites]
CDS are unique, in part, because they are an attempt to create a standardized insurance contract that can be freely traded among buyers and sellers--that is, they're a way for players other than insurance companies to speculate on credit insurance.
I'm not sure how helpful dividing the CDS universe into "insurance" and "speculation" really is. CDS aren't regulated as insurance, and the precise same CDS can be used as either "insurance" or "speculation."
I don't know the extent to which Berkshire hedges its position when entering into CDSs, but the business model is premised on profiting from identifying debt that is less risky than the market believes. Fundamentally, Berkshire is taking a position on the underlying debt.
Maybe it's not "speculation" because the guys at Berkshire are really smart and they're careful to try to limit their losses, but it's not a fundamentally different activity.
posted by Mr. President Dr. Steve Elvis America at 8:49 PM on February 18, 2008
I'm not sure how helpful dividing the CDS universe into "insurance" and "speculation" really is. CDS aren't regulated as insurance, and the precise same CDS can be used as either "insurance" or "speculation."
I don't know the extent to which Berkshire hedges its position when entering into CDSs, but the business model is premised on profiting from identifying debt that is less risky than the market believes. Fundamentally, Berkshire is taking a position on the underlying debt.
Maybe it's not "speculation" because the guys at Berkshire are really smart and they're careful to try to limit their losses, but it's not a fundamentally different activity.
posted by Mr. President Dr. Steve Elvis America at 8:49 PM on February 18, 2008
I don't know about this, but has anyone actually tried to value vanilla cds? Oh so fun! Oh so fun! I haven't had this much fun since interest rate swaps, seriously.
In any case, it shouldn't really be viewed as insurance and the risks are obvious to 90% who deal with this. I'm more worried about another SocGen or "rogue" trader doing something stupid, somewhere and destabilizing the market when they try to sloppily unwind their positions. Far, far more dangerous than vanilla and exotic options will ever be on their own.
posted by geoff. at 8:58 PM on February 18, 2008
In any case, it shouldn't really be viewed as insurance and the risks are obvious to 90% who deal with this. I'm more worried about another SocGen or "rogue" trader doing something stupid, somewhere and destabilizing the market when they try to sloppily unwind their positions. Far, far more dangerous than vanilla and exotic options will ever be on their own.
posted by geoff. at 8:58 PM on February 18, 2008
Bill Fleckenstein, over at Fleckenstein Capital, had this to say at the end of January, more than two weeks ago. Note that this is a pay service, so I try not to quote him very often, but this is just such a good explanation of the root causes of the mess that I couldn't resist.
No Need to Dread a Prudent Fedposted by Malor at 9:02 PM on February 18, 2008 [1 favorite]
I am somewhat surprised that after having been head-faked by the fraud in France, people aren't a bit more anxious about whether or not the Fed will again cut rates 50 points on Wednesday. Before the problems at SoGen were revealed, folks were looking for 50 basis points, and now, after the Fed got head-faked out of 75, people think we should get another 50, making a total of 125. I grant you, the economy is weak, but I didn't see anyone making the case two weeks ago that it was so weak that the Fed should cut 125 basis points (in sum: 75 + 50) -- which it's now expected to do.
To me, it just shows how completely in over his head Ben Bernanke is. Of course, the root cause of the problems we face is the interest-rate targeting championed by Greenspan and Bernanke. Only someone completely delusional would think that he knew how to pick the right interest rate to run a $14 trillion economy.
Paul Volcker achieved his greatest anti-inflationary success when he targeted the money supply. Money, admittedly, is not an easy target to define, let alone to hit. Some have suggested that the Fed just control the one thing it can indisputably control, namely, its own balance sheet. Let the Fed's footings expand by, say 3%, or 4% a year, and let interest rates go where they will. Greenspan and Bernanke fixed the funds rate and let credit growth go where it would. It went up.
The side benefit of a Fed targeting a somewhat quantifiable measure (like money supply) is that it lets the world know that interest rates are going to go where they're going to go, thereby reducing speculation. Thus, in addition to creating the misallocation of capital, the policy of targeting interest rates caused people to take far too much risk.
That's a quick and dirty explanation of the problems that are unwinding. Of course, they're far more severe than that, but regular Rap readers are well versed in the main problems in this country -- which stem from the fact that the average person can't afford his house and is now saddled with a debt that he's having trouble servicing.
It all starts with the Great Society? Never mind that other expensive government initiative that expanded under LBJ--the Vietnam War. Its expense from '65 to '68 dwarfs that of the Great Society programs, easily. I don't think you'll find exact figures online, but you'd be hard pressed to find any decent presidential historian or public administration or public finance/budgeting specialist who'd disagree.
posted by raysmj at 9:10 PM on February 18, 2008
posted by raysmj at 9:10 PM on February 18, 2008
Well, I really meant Great Society PLUS Vietnam.... overspending, and our subsequent bankruptcy under Nixon (which is what taking us off the gold standard was; a bankruptcy by any reasonable standard). Then, our complete reinvention of the world monetary system, and our gradual abandonment of anything resembling fiscal sense or actual free-market capitalism.
It's taken us a tremendously long time to fail, because we were so immensely wealthy when the process started. The government was bankrupt in 1971, but the country certainly wasn't. Now, a generation later, both are in debt beyond their ability to pay.
posted by Malor at 9:35 PM on February 18, 2008
It's taken us a tremendously long time to fail, because we were so immensely wealthy when the process started. The government was bankrupt in 1971, but the country certainly wasn't. Now, a generation later, both are in debt beyond their ability to pay.
posted by Malor at 9:35 PM on February 18, 2008
I'm not sure how helpful dividing the CDS universe into "insurance" and "speculation" really is. CDS aren't regulated as insurance, and the precise same CDS can be used as either "insurance" or "speculation."
I wasn't trying to divide up the CDS market. The equity-linked and credit insurance that Berkshire is writing isn't in the form of CDS (at least, as far as I can tell--that WSJ article is unclear and so is BRK's annual report). I was trying to draw a distinction between insurance policies written by regulated insurance carriers and trade-able CDS contracts. Because the former is not traded, it's much easier to determine who the risk-taker is and what the status of their reserves are. Buffett's criticism of the derivatives market has to do, in part, with this dubious status of counter-parties.
Maybe it's not "speculation" because the guys at Berkshire are really smart and they're careful to try to limit their losses, but it's not a fundamentally different activity.
I agree that it's not a fundamentally different activity. But Berkshire is in a better position to pay out losses than many protection-sellers in the CDS market (and as a protection-buyer in the CDS market, it's hard or impossible to manage this counter-party risk). So buying credit insurance from Berkshire IS a fundamentally different proposition than buying a CDS.
As an aside, Berkshire liquidated its financial derivatives subsidiary, Gen Re Securities, back in 2002 (though it's a long-tailed operation, so it's still in run-off).
posted by mullacc at 9:50 PM on February 18, 2008
I wasn't trying to divide up the CDS market. The equity-linked and credit insurance that Berkshire is writing isn't in the form of CDS (at least, as far as I can tell--that WSJ article is unclear and so is BRK's annual report). I was trying to draw a distinction between insurance policies written by regulated insurance carriers and trade-able CDS contracts. Because the former is not traded, it's much easier to determine who the risk-taker is and what the status of their reserves are. Buffett's criticism of the derivatives market has to do, in part, with this dubious status of counter-parties.
Maybe it's not "speculation" because the guys at Berkshire are really smart and they're careful to try to limit their losses, but it's not a fundamentally different activity.
I agree that it's not a fundamentally different activity. But Berkshire is in a better position to pay out losses than many protection-sellers in the CDS market (and as a protection-buyer in the CDS market, it's hard or impossible to manage this counter-party risk). So buying credit insurance from Berkshire IS a fundamentally different proposition than buying a CDS.
As an aside, Berkshire liquidated its financial derivatives subsidiary, Gen Re Securities, back in 2002 (though it's a long-tailed operation, so it's still in run-off).
posted by mullacc at 9:50 PM on February 18, 2008
I agree that it's not a fundamentally different activity. But Berkshire is in a better position to pay out losses than many protection-sellers in the CDS market (and as a protection-buyer in the CDS market, it's hard or impossible to manage this counter-party risk). So buying credit insurance from Berkshire IS a fundamentally different proposition than buying a CDS.
We basically agree. It sounds like neither of us knows how Berkshire is structuring their credit protection. I don't think "CDS" necessarily carries the same connotations of free transferability and anonymous counterparties that you do, but whatever.
The big point is that risk is like entropy. It can only be shifted from place to place, not reduced overall, and everything you do creates more.
In the case of derivatives, every transaction creates counterparty risk on top of the risk that is being shifted by the contract. While derivatives allow the underlying risk to be distributed better, and I think they're fundamentally a sound idea, they introduce additional risks that need to be carefully managed.
Perhaps unsurprisingly, some institutions' ideas of "careful management" was "ignoring it," but so it goes.
posted by Mr. President Dr. Steve Elvis America at 10:02 PM on February 18, 2008 [1 favorite]
We basically agree. It sounds like neither of us knows how Berkshire is structuring their credit protection. I don't think "CDS" necessarily carries the same connotations of free transferability and anonymous counterparties that you do, but whatever.
The big point is that risk is like entropy. It can only be shifted from place to place, not reduced overall, and everything you do creates more.
In the case of derivatives, every transaction creates counterparty risk on top of the risk that is being shifted by the contract. While derivatives allow the underlying risk to be distributed better, and I think they're fundamentally a sound idea, they introduce additional risks that need to be carefully managed.
Perhaps unsurprisingly, some institutions' ideas of "careful management" was "ignoring it," but so it goes.
posted by Mr. President Dr. Steve Elvis America at 10:02 PM on February 18, 2008 [1 favorite]
Whoops, I'm an idiot. I was reading that WSJ article completely wrong. It does specifically say that Berkshire is buying CDS. But the BRK financials use the vague term "credit default derivative contracts", which can have a broader meaning than just CDS. Mea culpa. Sorry, blue mustard and Dr. Steve.
posted by mullacc at 10:06 PM on February 18, 2008
posted by mullacc at 10:06 PM on February 18, 2008
In other news: Banks "quietly" borrow $50 billion from Fed
Banks in the United States have been quietly borrowing "massive amounts" from the U.S. Federal Reserve in recent weeks, using a new measure the Fed introduced two months ago to help ease the credit crunch, according to a report on the web site of The Financial Times.posted by PenDevil at 11:25 PM on February 18, 2008
Why is US government debt so bad?
Looking at the wikipedia ranking of countries by government debt the US is only ranked 65th in the world.
Surely, with the reversal of Bush II's tax cuts and an end to the Iraq war, both of which are quite likely, the situation is not that dire at all.
(The subprime thing is bad though, that is clearing causing, and will cause more pain).
posted by sien at 11:34 PM on February 18, 2008
Looking at the wikipedia ranking of countries by government debt the US is only ranked 65th in the world.
Surely, with the reversal of Bush II's tax cuts and an end to the Iraq war, both of which are quite likely, the situation is not that dire at all.
(The subprime thing is bad though, that is clearing causing, and will cause more pain).
posted by sien at 11:34 PM on February 18, 2008
Because both the GDP and the debt numbers are bogus.
GDP point A: the numbers are largely untrustworthy, being badly distorted by hedonic adjustments. Almost all of the famed 'productivity improvements' of the 90s were from statistical hoodoo on the computer-sector numbers. Dell shipped a 486-33 in 1994 for $3000, and a 486-66 in 1995 for the same $3000, so... hey, productivity doubled! With all the components in the computer doubling every 18 months, this single sector resulted in about half of the "productivity growth" of the entire country... when no more actual dollars were changing hands. They even had the balls to call this entirely fictional value 'real dollars'.
GDP point B: the American consumer is presently spending about 125% of what he or she makes. That means that consumer spending has to drop by 25% just to get back to a zero savings rate. I don't know how that will directly transfer to GDP, but it wouldn't shock me if it had a total effect GREATER than 25%, since we're counting the same dollars changing hands multiple times, and those same bullshit 'real dollar' multipliers are going to be equally large going in reverse. Each dollar that's not spent in computer products probably counts for 30+ dollars of GDP by now.
Debt: per the GAO, the US has a fifty trillion dollar debt, not the paltry nine trillion it claims. That means, to pay all the debts we've taken on, we need to have fifty trillion dollars in cash earning interest right now to be sure we can pay all our bills.
So, the debt is five times larger than what shows on that table, the GDP is fictional to begin with and HAS TO shrink dramatically, meaning tax revenues are going to decline sharply.... and we haven't even touched the consumer debt, the trade deficit, or the gigantic dollar holdings by overseas entities.
We're in deep shit.
posted by Malor at 12:17 AM on February 19, 2008
GDP point A: the numbers are largely untrustworthy, being badly distorted by hedonic adjustments. Almost all of the famed 'productivity improvements' of the 90s were from statistical hoodoo on the computer-sector numbers. Dell shipped a 486-33 in 1994 for $3000, and a 486-66 in 1995 for the same $3000, so... hey, productivity doubled! With all the components in the computer doubling every 18 months, this single sector resulted in about half of the "productivity growth" of the entire country... when no more actual dollars were changing hands. They even had the balls to call this entirely fictional value 'real dollars'.
GDP point B: the American consumer is presently spending about 125% of what he or she makes. That means that consumer spending has to drop by 25% just to get back to a zero savings rate. I don't know how that will directly transfer to GDP, but it wouldn't shock me if it had a total effect GREATER than 25%, since we're counting the same dollars changing hands multiple times, and those same bullshit 'real dollar' multipliers are going to be equally large going in reverse. Each dollar that's not spent in computer products probably counts for 30+ dollars of GDP by now.
Debt: per the GAO, the US has a fifty trillion dollar debt, not the paltry nine trillion it claims. That means, to pay all the debts we've taken on, we need to have fifty trillion dollars in cash earning interest right now to be sure we can pay all our bills.
So, the debt is five times larger than what shows on that table, the GDP is fictional to begin with and HAS TO shrink dramatically, meaning tax revenues are going to decline sharply.... and we haven't even touched the consumer debt, the trade deficit, or the gigantic dollar holdings by overseas entities.
We're in deep shit.
posted by Malor at 12:17 AM on February 19, 2008
(oh and I'm probably wrong about what model of 486 was shipping in what year -- that's a figurative example, not a literal one.)
posted by Malor at 12:17 AM on February 19, 2008
posted by Malor at 12:17 AM on February 19, 2008
Boy, I really oughta proofread better. I said, "when no more actual dollars were changing hands", but that's obviously untrue, since the computer sector really was growing very very quickly. But the hedonic adjustments overstated that growth's impact on productivity numbers and GDP by a gigantic degree.
posted by Malor at 12:23 AM on February 19, 2008
posted by Malor at 12:23 AM on February 19, 2008
Ok, FPP starts out with "Credit Default Swaps are being triggered ..."
Great. That's precisely what the instruments were designed to do. And in spite of some of the skepticism (we've seen such expressions during earlier times of systemic stress) the market seems to be coping rather well, and more than likely creating additional opportunities for well placed participants.
For example, when Delphi went under in 2005, the protection in force at that time exceeded the underling debt by a factor of ten.
Credit Default Swaps allowed some market participants to assume economic exposure to Delphi (a view, in other words on the viability of this company as an ongoing concern) but without having to locate and purchase the underlying paper. So that's a plus.
Meanwhile, precisely none of the protection sellers themselves defaulted. And that market opp? Well the price of Dephi bonds spiked, so if you were long the paper or fleet of foot (maybe had prop trading in that segment of the market thus quickly gaining a sense that something was going on and went long the paper on a hunch) you made money.
At the end of the Deplhi event, the money shook out this way: protection sellers had to make protection buyers whole on their losses. So they paid out but what's the problem? They were selling protection, Delphi's bankruptcy didn't come as a surprise so this probability was priced in.
Protection buyers got precisely what they paid for - insurance against their losses. So they were only out premiums, not the value of the underlying assets (or more precisely net of recovery value).
Folks that were long Delphi bonds probably made money as they shook out at about seventy cents on the dollar and they were previously traded (off the top of my head mind you) at perhaps twenty cents on the dollar - longs did well.
"The problem with the CDS market is that there is little transparency into who holds the liabilities and whether or not they have adequate reserves to pay out losses."
I haven't worked in this market for about six years, but when I did it all transactions were strictly counterparty to counterparty i.e., not exchange traded (which is itself controversial, but a centralised exchange would guarantee contract performance and although Euronext has plans to offer exchange traded CDS' this won't be realised until mid 2009 IIRC)
Yeh, this is indeed a concern, but a couple of rules apply - first of all, who are you purchasing your protection from? The basic questions are what is the reference asset? In other words, what are you trying to purchase protection on? Then, who is guaranteeing the protection? It would be ill advised to purchase, for example, default protection from Delphi on their own bonds. Or even another auto manufacturer on Delphi bonds (systemic issues).
So desks have to perform their own due diligence - that's what they're paid for.
One things for sure - the current credit event would be a lot worse if not for CDS'.
posted by Mutant at 1:03 AM on February 19, 2008 [1 favorite]
Great. That's precisely what the instruments were designed to do. And in spite of some of the skepticism (we've seen such expressions during earlier times of systemic stress) the market seems to be coping rather well, and more than likely creating additional opportunities for well placed participants.
For example, when Delphi went under in 2005, the protection in force at that time exceeded the underling debt by a factor of ten.
Credit Default Swaps allowed some market participants to assume economic exposure to Delphi (a view, in other words on the viability of this company as an ongoing concern) but without having to locate and purchase the underlying paper. So that's a plus.
Meanwhile, precisely none of the protection sellers themselves defaulted. And that market opp? Well the price of Dephi bonds spiked, so if you were long the paper or fleet of foot (maybe had prop trading in that segment of the market thus quickly gaining a sense that something was going on and went long the paper on a hunch) you made money.
At the end of the Deplhi event, the money shook out this way: protection sellers had to make protection buyers whole on their losses. So they paid out but what's the problem? They were selling protection, Delphi's bankruptcy didn't come as a surprise so this probability was priced in.
Protection buyers got precisely what they paid for - insurance against their losses. So they were only out premiums, not the value of the underlying assets (or more precisely net of recovery value).
Folks that were long Delphi bonds probably made money as they shook out at about seventy cents on the dollar and they were previously traded (off the top of my head mind you) at perhaps twenty cents on the dollar - longs did well.
"The problem with the CDS market is that there is little transparency into who holds the liabilities and whether or not they have adequate reserves to pay out losses."
I haven't worked in this market for about six years, but when I did it all transactions were strictly counterparty to counterparty i.e., not exchange traded (which is itself controversial, but a centralised exchange would guarantee contract performance and although Euronext has plans to offer exchange traded CDS' this won't be realised until mid 2009 IIRC)
Yeh, this is indeed a concern, but a couple of rules apply - first of all, who are you purchasing your protection from? The basic questions are what is the reference asset? In other words, what are you trying to purchase protection on? Then, who is guaranteeing the protection? It would be ill advised to purchase, for example, default protection from Delphi on their own bonds. Or even another auto manufacturer on Delphi bonds (systemic issues).
So desks have to perform their own due diligence - that's what they're paid for.
One things for sure - the current credit event would be a lot worse if not for CDS'.
posted by Mutant at 1:03 AM on February 19, 2008 [1 favorite]
Guns don't kill people, people do. All financial instruments are just tools. The risk comes with how they are used, and unfortunatley many of them allow risk to migrate to those least able to price it. There is nothing wrong with betting on sports if you know what you are doing. Putting your life savings on a "sure thing" your friend told you about might appear to be a less good idea.
This seems to escape the boards of many organisations.
The real issue is the the banks have become the high rollers, and are no longer the casino. Being a casino is a good thing.
What is worse is that many of the high rollers are relatively unsophisticated pension fund managers, insurance fund managers and government agencys, who are 'investing' in things they don't understand with your money.
Having your money with a Buffet is better because at least he thinks about these things before they happen, while most of the industry seems to get surprised a lot.
HSBC warned on the subprime issue in Q3 2006. What was everybody else doing at the time?
posted by fistynuts at 2:32 AM on February 19, 2008
This seems to escape the boards of many organisations.
The real issue is the the banks have become the high rollers, and are no longer the casino. Being a casino is a good thing.
What is worse is that many of the high rollers are relatively unsophisticated pension fund managers, insurance fund managers and government agencys, who are 'investing' in things they don't understand with your money.
Having your money with a Buffet is better because at least he thinks about these things before they happen, while most of the industry seems to get surprised a lot.
HSBC warned on the subprime issue in Q3 2006. What was everybody else doing at the time?
posted by fistynuts at 2:32 AM on February 19, 2008
Mutant is completely correct if the CDS were being triggered. Except they're not. There's been one recent default that triggered CDS protection (Quebecor). The link in the FPP explicitly says that the CDS has not been triggered, though the premium payable by a new buyer has risen. (As an aside, that looks like a prime selling opportunity for a couple of years - the government is unlikely to let NR go bust). I'm not surprised the Bershire Hathaway has a portfolio of CDS - it's the job of insurance companies to take on that kind risk.
The point about the outstanding notional being higher than the value of outstanding debt of a reference entity has been dealt with before in the comments a different, equally alarmist, FPP. Essentially, the headline figure is made up of double/triple/etc counting so the real figure at risk is substantially lower.
Given that the CDS market is OTC all the contracts should be collateralised under standard ISDA CSAs - the net counterparty exposure between the banks should be very low at any time.
AIG is a somewhat special case as its portfolio of CDS are written on the extremely safe portions of the capital structure (where safe means that the CDS protection is unlikely to be triggered, not that it is immune from declines in value) and it relied on certain accounting tricks to make cash.
I am biased, given that it's my day job, but credit default swaps conceptually make the world a better place by allowing credit risk to be allocated to those best placed to take it. The growth in the market does throw up questions though, in particular whether banks who have bought CDS protection that would previously have had an interest in keeping companies alive will now prefer to let them go bust so the bank can collect under the CDS. If the downturn continues there may be a larger wave of bankruptcies than there would be otherwise.
posted by patricio at 3:17 AM on February 19, 2008 [2 favorites]
The point about the outstanding notional being higher than the value of outstanding debt of a reference entity has been dealt with before in the comments a different, equally alarmist, FPP. Essentially, the headline figure is made up of double/triple/etc counting so the real figure at risk is substantially lower.
Given that the CDS market is OTC all the contracts should be collateralised under standard ISDA CSAs - the net counterparty exposure between the banks should be very low at any time.
AIG is a somewhat special case as its portfolio of CDS are written on the extremely safe portions of the capital structure (where safe means that the CDS protection is unlikely to be triggered, not that it is immune from declines in value) and it relied on certain accounting tricks to make cash.
I am biased, given that it's my day job, but credit default swaps conceptually make the world a better place by allowing credit risk to be allocated to those best placed to take it. The growth in the market does throw up questions though, in particular whether banks who have bought CDS protection that would previously have had an interest in keeping companies alive will now prefer to let them go bust so the bank can collect under the CDS. If the downturn continues there may be a larger wave of bankruptcies than there would be otherwise.
posted by patricio at 3:17 AM on February 19, 2008 [2 favorites]
fistynuts - you've made two very good points that really can't be separated - that many of these instruments are being sold to folks that shouldn't be alowed to purchase them.
Secondly, what are the boards up to while this is happening? It does indeed seem like governance or, more properly, lack of is the real issue here, not the instruments themselves.
Someone else posted a link about the Orange County bankruptcy. That's an interesting case - Robert L. Citron, by most accounts an experienced fund manager, someone who should have known better purchased instruments known as "inverse floaters" and, compounding the mistake, leverage up the position by borrowing (disclaimer - I haven't watched the video as I'm at work, but I'm familiar with the case).
Leverage is of interest here as a the market participant can effectively multiply returns by borrowing, but sometimes the fact is overlooked that unless hedged, the positions losses can be multiplied as well. Whoops!
Citron's strategy was cash flow positive as long as short term interest rates remained below long term, but in February 1994 The Fed started raising rates and his position rapidly lost value.
The whole mess became public once he'd lost $2 billion of about $7.5 billion nominal.
Since then Orange County has put in a lot more oversight. At the bank I work for I've been opining this current market stress will see a lot more regulatory oversight into certain segments of business, which is both good and bad.
Good as we probably won't see the same types of market stress we're now seeing.
Bad because considering the sums involved, the sheer money that can be made, banks and funds almost always find a way to game the system. The denser the rulebook, the more regulation the better as its more likely holes will be found.
That being said, I do rather like the UK's principles based approach to market regulation rather than The US' rules based.
On preview - patricio - excellent point about NR; we were talking along these same lines this AM, trying to see if we could line up an opp. Rather curious situtation BOE has gotten themselves into. I'm betting they aint' got an exit strategy so this could get messy ...
posted by Mutant at 3:26 AM on February 19, 2008
Secondly, what are the boards up to while this is happening? It does indeed seem like governance or, more properly, lack of is the real issue here, not the instruments themselves.
Someone else posted a link about the Orange County bankruptcy. That's an interesting case - Robert L. Citron, by most accounts an experienced fund manager, someone who should have known better purchased instruments known as "inverse floaters" and, compounding the mistake, leverage up the position by borrowing (disclaimer - I haven't watched the video as I'm at work, but I'm familiar with the case).
Leverage is of interest here as a the market participant can effectively multiply returns by borrowing, but sometimes the fact is overlooked that unless hedged, the positions losses can be multiplied as well. Whoops!
Citron's strategy was cash flow positive as long as short term interest rates remained below long term, but in February 1994 The Fed started raising rates and his position rapidly lost value.
The whole mess became public once he'd lost $2 billion of about $7.5 billion nominal.
Since then Orange County has put in a lot more oversight. At the bank I work for I've been opining this current market stress will see a lot more regulatory oversight into certain segments of business, which is both good and bad.
Good as we probably won't see the same types of market stress we're now seeing.
Bad because considering the sums involved, the sheer money that can be made, banks and funds almost always find a way to game the system. The denser the rulebook, the more regulation the better as its more likely holes will be found.
That being said, I do rather like the UK's principles based approach to market regulation rather than The US' rules based.
On preview - patricio - excellent point about NR; we were talking along these same lines this AM, trying to see if we could line up an opp. Rather curious situtation BOE has gotten themselves into. I'm betting they aint' got an exit strategy so this could get messy ...
posted by Mutant at 3:26 AM on February 19, 2008
I'm glad some guys who understand this business better then I came in at the end to help explain why its not necessarily a bad thing that the notional value of CDS' based on a particular security may be a multiple of the actual outstanding value of that reference issue.
One thing I can't let go - comparing a company's equity market value and the notional value of derivatives on its debt is just silly. Literally apples and oranges.
posted by JPD at 4:55 AM on February 19, 2008
One thing I can't let go - comparing a company's equity market value and the notional value of derivatives on its debt is just silly. Literally apples and oranges.
posted by JPD at 4:55 AM on February 19, 2008
"...but has anyone actually tried to value vanilla cds? Oh so fun! Oh so fun! I haven't had this much fun since interest rate swaps, seriously."
Gosh I'm missing something here. The valuation exercise does seem relatively straightforward, if we make some assumptions - namely, no risk of counterparty default and independent distribution of default probabilities, interest rates, and recovery rates. In actual practice two of the last three do exhibit some degree of dependence - probabilty of default being positively correlated with interest rates - but we have other modeling techniques that can help us deal with series such as this.
In any case, these assumptions provide us with a model that can calculate a baseline value, much like a textbook Black Scholes will give a rather crude metric of far value for an option. Hull did much of this work in early 2000.
Relaxing the assumption 'no risk of counterparty default' is the first step toward a more realistic model; again, Hull & White worked through this problem towards the end of 2000.
Tavakoli was into her second edition on this topic back in 2001 ("Credit Derivatives and Synthetic Structures", I've only read the first and its well worth the twenty quid Amazon is flogging it for), so the basic models were rapidly mainstreaming five, six years ago.
Academic literature is but one driver in finance and I'm sure many desks have much more advanced models. At least they must have different models, otherwise there would hardly be a market, what with single views on price and all...and a robust market for CDS exists, in fact was the opening sentence of this FPP.
I know the guys behind Quantlib (open sourced under a BSD license) were talking about incorporating CDS back in 2005. I haven't kept up with their work but it does seem that models valuing plain vanilla CDS are widely available.
Of course I always tell folks having a model is one thing - data is the real problem. So you've got a model? Great! Simple model, fancy model, doesn't matter - the question is how do you plan to calibrate it? Calibration is a very difficult exercise, especially so in the rather opaque market for Credit Default Swaps. If that was your point, I'd agree with you.
Valuation's easy. Calibration's a bitch.
posted by Mutant at 5:19 AM on February 19, 2008
Gosh I'm missing something here. The valuation exercise does seem relatively straightforward, if we make some assumptions - namely, no risk of counterparty default and independent distribution of default probabilities, interest rates, and recovery rates. In actual practice two of the last three do exhibit some degree of dependence - probabilty of default being positively correlated with interest rates - but we have other modeling techniques that can help us deal with series such as this.
In any case, these assumptions provide us with a model that can calculate a baseline value, much like a textbook Black Scholes will give a rather crude metric of far value for an option. Hull did much of this work in early 2000.
Relaxing the assumption 'no risk of counterparty default' is the first step toward a more realistic model; again, Hull & White worked through this problem towards the end of 2000.
Tavakoli was into her second edition on this topic back in 2001 ("Credit Derivatives and Synthetic Structures", I've only read the first and its well worth the twenty quid Amazon is flogging it for), so the basic models were rapidly mainstreaming five, six years ago.
Academic literature is but one driver in finance and I'm sure many desks have much more advanced models. At least they must have different models, otherwise there would hardly be a market, what with single views on price and all...and a robust market for CDS exists, in fact was the opening sentence of this FPP.
I know the guys behind Quantlib (open sourced under a BSD license) were talking about incorporating CDS back in 2005. I haven't kept up with their work but it does seem that models valuing plain vanilla CDS are widely available.
Of course I always tell folks having a model is one thing - data is the real problem. So you've got a model? Great! Simple model, fancy model, doesn't matter - the question is how do you plan to calibrate it? Calibration is a very difficult exercise, especially so in the rather opaque market for Credit Default Swaps. If that was your point, I'd agree with you.
Valuation's easy. Calibration's a bitch.
posted by Mutant at 5:19 AM on February 19, 2008
I see that the $45T mark is fake, but I'm still quite worried by Mr. Buffet's underlying point. Because a) they aren't openly traded and b) pricing is allegedly difficult, he thinks that they are not sending risk to those best able to tolerate it. Rather, they are creating the false appearance of safety for a number of institutions while nominal risk is concentrated in a very few hands. Because those few are under-reserved, the actual protection is minimal. The possibility that financial institutions (like those I pointed out at the beginning) are systemically miscalculating their risk exposure is pretty frightening after some of our recent episodes of poor risk-allocation.
posted by a robot made out of meat at 6:39 AM on February 19, 2008
posted by a robot made out of meat at 6:39 AM on February 19, 2008
Mutant: I'm a little confused by your commentary on Delphi...the article implies that many protection-buyers expected to be made whole to the tune of par for every $1,000 in protection bought but the auction process resulted in only $366.25 for their $1,000. Was the gap equal to the expected recovery value on the bonds, or was this a case of compromise on the part of protection-buyers? The article seems to say that $366.25 was all the protection-sellers could afford.
posted by mullacc at 7:20 AM on February 19, 2008
posted by mullacc at 7:20 AM on February 19, 2008
mullacc - the auction outcome was 63.375% (i.e. that was the recovery) so the number in the article is the loss amount that was paid to protection buyers to make them whole.
posted by patricio at 7:32 AM on February 19, 2008
posted by patricio at 7:32 AM on February 19, 2008
patricio: Thanks. The Delphi example in the NYT article was horribly misleading. From the article:
Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond.
Was this actually a problem for anyone, I wonder? If it was, that's hardly a problem with the CDS market and entirely a problem with someone's shifty accounting practices.
posted by mullacc at 7:39 AM on February 19, 2008
Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond.
Was this actually a problem for anyone, I wonder? If it was, that's hardly a problem with the CDS market and entirely a problem with someone's shifty accounting practices.
posted by mullacc at 7:39 AM on February 19, 2008
A question for whoever... If an investor has a large amount of money invested in whether or not a company defaults, doesn't it eventually make it likely that the investor will try to bring about that outcome.
Say I "bet" a trillion dollars that Ford was going to default, considering how much I had invested, wouldn't it be a good idea to actively get involved in Ford's defaulting, say by getting a slate of people who will make the moves I want to Ford's board.
posted by drezdn at 9:01 AM on February 19, 2008
Say I "bet" a trillion dollars that Ford was going to default, considering how much I had invested, wouldn't it be a good idea to actively get involved in Ford's defaulting, say by getting a slate of people who will make the moves I want to Ford's board.
posted by drezdn at 9:01 AM on February 19, 2008
"The possibility that financial institutions (like those I pointed out at the beginning) are systemically miscalculating their risk exposure is pretty frightening..."
Frightening I agree, but I'd argue the probability is relatively small. In terms of calculating risk, models for CDS are admittedly complex as we're dealing with both credit and market risk drivers.
Just to illustrate - if we were discussing an equity only portfolio then we're concerned solely with changes in the market value of our holdings. Value at Risk, VAR, is pretty simple and anyone with a high school education and knowledge of basic statistics is able to comprehend how this stuff works, representations of some of my stuffier colleagues in finance (none posting on MeFi 'tho!) aside.
If we were looking at, for example, Commercial Products, as loans to corporate counterparty's are called at our institution, then you're concerned with Credit Risk. There are a two main approaches to looking at Credit Risk - Structural and Reduced Form.
Again, I always tell people if you can't explain it simply then YOU don't understand it. So that being said, hopefully I'll do ok here. Structural models are just what the name implies - we look at the structure of the obligors balance sheet. Assets, liabilities, cash flow in vs. cash flow out, ability to pay bills in other words. Structural Models are really that simple. Sure, a few bells and whistles might be bolted on but at their core not much more to them than this.
Reduced form models get a little funkier (aka difficult to visualise) as we're dealing with mathematical models predicting obligor default based on an underlying process representing the asset / liability ratio in general and specifically how it evolves over time. Depending upon the model used (the literature is rich, lots of variants) calibration might make use of financial ratios, macroeconomic factors or share prices all of which, under some circumstances, will result in the value of the firms liabilities exceeding those of its assets - bankrupt, in other words.
A curious aside, and you might have caught on to this - Structural Models are by definition, largely backward looking as we make use of financial data captured on the balance sheet. Reduced form can model forward looking probabilities, as they make use of an assumed data generating process to evolve the asset liability ratio over time. In practice Structural Models have been tweaked to calculate forward looking probabilities, typically by enriching their results with other data sets (e.g., given a AAA rated obligor we can use previously calculated ratings transition probabilities as well as default probabilities to gain insight into where this obligor most likely will end up across some horizon)
Now a CDS is an interesting creation from the point of view of calculating risk exposure, as the instrument has both market and credit drivers. Two sets of credit sensitivities, actually.
In its simplest definition, we got a reference asset, something that we want to insure the value of. Let's say this is an IBM bond.
Next thing we need is a protection seller, some market entity that is willing to make us whole, in other words pay any loss of value associated with a credit event (need not be bankruptcy by the way, there are six or so different ISDA recognised events) impacting the value of our wonderful IBM bond.
So the value of our bond is impacted by both market and credit risk, reflecting changes in the bonds value due to overall market conditions (e.g., interest rates) as well as effects of IBM's ability to pay their bills, in finance-speak "service their debt", in this case the coupons due on the bond they issued.
But the value of the CDS (or more properly, volatility or changes in its value)isn't determined solely by the riskyness of the IBM bond; you've also got to take into account the protection seller across a couple of dimensions. First creditworthiness - after all, insurance purchased from a AAA rated seller MUST be worth more than the same product sold by a BBB (one step above junk). Secondly, you've got to look at the degree of default correlation between the protection seller and the reference asset. You really shouldn't purchase default protection for your IBM bond from IBMs financial services subsidiary. Or another computer manufacturer such as Dell. Both are impacted by the same systemic factors or risks. No, you want your protection seller to have relatively low default correlation with the asset you're trying to protect. After all, you can't be made whole on your losses if your protection seller is also bankrupt!
So I realise this is terribly verbose but not because I'm trying to illustrate how complicated all of this is, rather that there are so many choices available to each market participant that I don't believe the chances of systemic miscalculation - in other words, making the same choises, identical assumptions, using the same data for calibration, to name but a few alternatives here - are very high.
Non zero, yes. Approaching unity? Nope.
posted by Mutant at 9:32 AM on February 19, 2008 [1 favorite]
Frightening I agree, but I'd argue the probability is relatively small. In terms of calculating risk, models for CDS are admittedly complex as we're dealing with both credit and market risk drivers.
Just to illustrate - if we were discussing an equity only portfolio then we're concerned solely with changes in the market value of our holdings. Value at Risk, VAR, is pretty simple and anyone with a high school education and knowledge of basic statistics is able to comprehend how this stuff works, representations of some of my stuffier colleagues in finance (none posting on MeFi 'tho!) aside.
If we were looking at, for example, Commercial Products, as loans to corporate counterparty's are called at our institution, then you're concerned with Credit Risk. There are a two main approaches to looking at Credit Risk - Structural and Reduced Form.
Again, I always tell people if you can't explain it simply then YOU don't understand it. So that being said, hopefully I'll do ok here. Structural models are just what the name implies - we look at the structure of the obligors balance sheet. Assets, liabilities, cash flow in vs. cash flow out, ability to pay bills in other words. Structural Models are really that simple. Sure, a few bells and whistles might be bolted on but at their core not much more to them than this.
Reduced form models get a little funkier (aka difficult to visualise) as we're dealing with mathematical models predicting obligor default based on an underlying process representing the asset / liability ratio in general and specifically how it evolves over time. Depending upon the model used (the literature is rich, lots of variants) calibration might make use of financial ratios, macroeconomic factors or share prices all of which, under some circumstances, will result in the value of the firms liabilities exceeding those of its assets - bankrupt, in other words.
A curious aside, and you might have caught on to this - Structural Models are by definition, largely backward looking as we make use of financial data captured on the balance sheet. Reduced form can model forward looking probabilities, as they make use of an assumed data generating process to evolve the asset liability ratio over time. In practice Structural Models have been tweaked to calculate forward looking probabilities, typically by enriching their results with other data sets (e.g., given a AAA rated obligor we can use previously calculated ratings transition probabilities as well as default probabilities to gain insight into where this obligor most likely will end up across some horizon)
Now a CDS is an interesting creation from the point of view of calculating risk exposure, as the instrument has both market and credit drivers. Two sets of credit sensitivities, actually.
In its simplest definition, we got a reference asset, something that we want to insure the value of. Let's say this is an IBM bond.
Next thing we need is a protection seller, some market entity that is willing to make us whole, in other words pay any loss of value associated with a credit event (need not be bankruptcy by the way, there are six or so different ISDA recognised events) impacting the value of our wonderful IBM bond.
So the value of our bond is impacted by both market and credit risk, reflecting changes in the bonds value due to overall market conditions (e.g., interest rates) as well as effects of IBM's ability to pay their bills, in finance-speak "service their debt", in this case the coupons due on the bond they issued.
But the value of the CDS (or more properly, volatility or changes in its value)isn't determined solely by the riskyness of the IBM bond; you've also got to take into account the protection seller across a couple of dimensions. First creditworthiness - after all, insurance purchased from a AAA rated seller MUST be worth more than the same product sold by a BBB (one step above junk). Secondly, you've got to look at the degree of default correlation between the protection seller and the reference asset. You really shouldn't purchase default protection for your IBM bond from IBMs financial services subsidiary. Or another computer manufacturer such as Dell. Both are impacted by the same systemic factors or risks. No, you want your protection seller to have relatively low default correlation with the asset you're trying to protect. After all, you can't be made whole on your losses if your protection seller is also bankrupt!
So I realise this is terribly verbose but not because I'm trying to illustrate how complicated all of this is, rather that there are so many choices available to each market participant that I don't believe the chances of systemic miscalculation - in other words, making the same choises, identical assumptions, using the same data for calibration, to name but a few alternatives here - are very high.
Non zero, yes. Approaching unity? Nope.
posted by Mutant at 9:32 AM on February 19, 2008 [1 favorite]
drezdn - yes, if an investor takes a purely speculative position then you're right, there is an incentive to cause a quick default. However, getting protection under a CDS doesn't give you any voting or other rights over the company so your influence is limited. The things that do give you those rights (e.g. stock) lose value if the company tanks, so it's not exactly a straightforward strategy (and is probably illegal in various ways).
posted by patricio at 9:43 AM on February 19, 2008
posted by patricio at 9:43 AM on February 19, 2008
Frightening I agree, but I'd argue the probability is relatively small.
We are talking about the same industry that packaged mortgages into CDOs, backed them with insurance through companies that don't have enough to cover in the face of a major housing downturn, used those companies to get the CDOs a AAA rating, then lived on the assumption that real estate always goes up?
First creditworthiness - after all, insurance purchased from a AAA rated seller MUST be worth more than the same product sold by a BBB (one step above junk).
Like Ambac and MBIA?
...I don't believe the chances of systemic miscalculation - in other words, making the same choises, identical assumptions, using the same data for calibration, to name but a few alternatives here - are very high.
It doesn't have to be about making the same choices and calculations system wide, it could be something like a major downturn in a single market that a lot of people have hedged against. What happens if the sellers can't pay up? Someone is going to take a bath. A lot of someones is my guess.
Sorry if I sound like a pessimist. I tend to get worried when the financial whiz kids start getting too cute by half with markets that tend be un- or under-regulated.
Here you have AIG, a company one would hope knows something about insurance, and their CDS desk was wrong by at least a factor of 5. AIG can meet their obligations since they do this insurance type stuff for a living (I'd put BRK in the same boat). But it's going to hurt, potentially to the tune of 10% of AIG's equity and 3/4 of its earnings.
What about the other folks? It's not like the mortgage mess is close to fully unwinding yet.
posted by ryoshu at 10:19 AM on February 19, 2008
We are talking about the same industry that packaged mortgages into CDOs, backed them with insurance through companies that don't have enough to cover in the face of a major housing downturn, used those companies to get the CDOs a AAA rating, then lived on the assumption that real estate always goes up?
First creditworthiness - after all, insurance purchased from a AAA rated seller MUST be worth more than the same product sold by a BBB (one step above junk).
Like Ambac and MBIA?
...I don't believe the chances of systemic miscalculation - in other words, making the same choises, identical assumptions, using the same data for calibration, to name but a few alternatives here - are very high.
It doesn't have to be about making the same choices and calculations system wide, it could be something like a major downturn in a single market that a lot of people have hedged against. What happens if the sellers can't pay up? Someone is going to take a bath. A lot of someones is my guess.
Sorry if I sound like a pessimist. I tend to get worried when the financial whiz kids start getting too cute by half with markets that tend be un- or under-regulated.
Here you have AIG, a company one would hope knows something about insurance, and their CDS desk was wrong by at least a factor of 5. AIG can meet their obligations since they do this insurance type stuff for a living (I'd put BRK in the same boat). But it's going to hurt, potentially to the tune of 10% of AIG's equity and 3/4 of its earnings.
What about the other folks? It's not like the mortgage mess is close to fully unwinding yet.
posted by ryoshu at 10:19 AM on February 19, 2008
One things for sure - the current credit event would be a lot worse if not for CDS'.
I believe this is untrue. The current credit event wouldn't be HAPPENING if not for CDSes.
Why do I say that? Because if banks can't get protection against a default, they wouldn't make the loans in the first place. Because they could buy protection, they were willing to make the loans. The people who sold protection, in many cases, can't actually provide it, because they're depending on their unproven models to provide protection instead of their assets. Because everyone feels protected, rveryone takes on more risk. The system, as it stands, is rotten with the stuff.
The whole point of hedging is to protect a small player by using the deep pockets of much larger ones. When the hedger IS the market, as soon as things go south, there's nobody left who can pay the bills.
I also think the notional values of these swaps are important. All speculation exerts force on the economy underneath. With the sheer size and leverage of these notional values, this allows relatively small entities to exert wildly disproportionate forces. This is damaging. Extracting value from the economy, as though you have 10 or 100 times the capital you actually do, means that other people, somewhere, are losing that value.
posted by Malor at 11:23 AM on February 19, 2008
I believe this is untrue. The current credit event wouldn't be HAPPENING if not for CDSes.
Why do I say that? Because if banks can't get protection against a default, they wouldn't make the loans in the first place. Because they could buy protection, they were willing to make the loans. The people who sold protection, in many cases, can't actually provide it, because they're depending on their unproven models to provide protection instead of their assets. Because everyone feels protected, rveryone takes on more risk. The system, as it stands, is rotten with the stuff.
The whole point of hedging is to protect a small player by using the deep pockets of much larger ones. When the hedger IS the market, as soon as things go south, there's nobody left who can pay the bills.
I also think the notional values of these swaps are important. All speculation exerts force on the economy underneath. With the sheer size and leverage of these notional values, this allows relatively small entities to exert wildly disproportionate forces. This is damaging. Extracting value from the economy, as though you have 10 or 100 times the capital you actually do, means that other people, somewhere, are losing that value.
posted by Malor at 11:23 AM on February 19, 2008
The absolutely ineluctable problem with all derivatives of this kind is that if they are successful and do what they say they will do, they result in the destruction of the currency.
The aim and the claim of all these sorts of instruments is to prevent monetary losses no matter what economic conditions eventuate-- or even to make money.
However, if money can be made no matter what happens, or at least can never be lost, then money loses any connection to underlying economic reality. That is the very definition of worthlessness for a currency.
In practice, therefore, derivatives which work as advertised (and do not destroy the currency) must impose the monetary losses they prevent on other players, and the situation is even worse if they actually make money, because if everyone is protected from monetary loss by such a derivative in bad economic times, no one loses money, but money itself is the loser, because more or an equal amount of money is pursuing fewer goods.
Inflation, in other words, and the various positive feedback loops in the economy will tend to make that hyperinflation in short order.
Game over.
posted by jamjam at 11:33 AM on February 19, 2008 [3 favorites]
The aim and the claim of all these sorts of instruments is to prevent monetary losses no matter what economic conditions eventuate-- or even to make money.
However, if money can be made no matter what happens, or at least can never be lost, then money loses any connection to underlying economic reality. That is the very definition of worthlessness for a currency.
In practice, therefore, derivatives which work as advertised (and do not destroy the currency) must impose the monetary losses they prevent on other players, and the situation is even worse if they actually make money, because if everyone is protected from monetary loss by such a derivative in bad economic times, no one loses money, but money itself is the loser, because more or an equal amount of money is pursuing fewer goods.
Inflation, in other words, and the various positive feedback loops in the economy will tend to make that hyperinflation in short order.
Game over.
posted by jamjam at 11:33 AM on February 19, 2008 [3 favorites]
jamjam - that makes no sense at all. The claim for credit derivatives is that the protection buyer will be compensated for the decline in value of the obligations of a specified company if that company defaults. The protection seller explicitly has to make a payment and will suffer a loss. The equivalent is insurance -- insurance companies have been around for a while...
posted by patricio at 1:33 PM on February 19, 2008
posted by patricio at 1:33 PM on February 19, 2008
ryoshu -- "We are talking about the same industry that packaged mortgages into CDOs, backed them with insurance through companies that don't have enough to cover in the face of a major housing downturn, used those companies to get the CDOs a AAA rating, then lived on the assumption that real estate always goes up?"
Well, you do know the industry is NOT single minded or monolithic, with hundreds of people involved in structuring a CDO. Not sure how many work at the monolines and I have no idea how many folks were / are involved with selling real estate. My point is, there are hundreds of thousands - perhaps a few million - of independent entities working in the industry. They don't all have the same goals or objectives.
"Like Ambac and MBIA?"
That comparison is out of context. My point is a rational market participant will value protection sold by a AAA higher than a BBB, and the premium will be priced accordingly - less in the case of a AAA, because in the limit you've got far more confidence this participant will be around to pay off
"It doesn't have to be about making the same choices and calculations system wide, it could be something like a major downturn in a single market that a lot of people have hedged against."
Such as? I'd like to see an example of an entire market moving one way that caught all market participants out. Again, markets are NOT monolithic and everyone does not take the same side of a trade. I find this point abstract, I'm not aware of an event such as your describing. Which would, of course, be rather nasty - for some. Not everyone will line up on the same side, markets just don't work like that. After all, in the fundamental instance for a market to exist there must be two views on price. Otherwise there is no trade, and hence no market.
"I tend to get worried when the financial whiz kids start getting too cute by half with markets that tend be un- or under-regulated."
But these "whiz kids" as you're describing them - quants, I'm assuming - are part of a team. That's just how modern trading desks, whether an iBank or fund, operate. Some "whiz kid" just doesn't decide to move the market, or singlehandedly assume positions on behalf of the firm that might destablise a market. Sure, Soc Gen recently showed us a single rogue trade can seriously impact the viability of a bank, but he hardly threatened the viability of the markets, the excitement of that day aside.
Sure, AIG got it wrong. It happens, even for those who presumably know their market. Its just the nature of this business.
Malor -- "Because everyone feels protected, rveryone takes on more risk. "
Interesting position, but I'm not sure I agree. Banks are highly regulated, and for every position they assume, insured or not, they must set aside regulatory capital. The Central Banks, operating accordiing to the Basel II accord, have determined what capital is needed to support a position. I agree that CDS' have both widened and deepened the lending pool to some extent, but I'm not sure they're (solely) responsible for this problem.
"The whole point of hedging is to protect a small player by using the deep pockets of much larger ones. "
Actually hedging is a form of risk transference, where the relative wealth of your counterparty doesn't figure. I think this cuts both ways, with sometimes smaller players getting bailed out by a much larger counterparty who was willing to assume some risk for a fee.
jamjam -- "The aim and the claim of all these sorts of instruments is to prevent monetary losses no matter what economic conditions eventuate..."
I don't see this. Let's look at the simplest example again - someone purchases default protection on IBM bonds.
The holder of IBM bonds pays a relatively small premium to the protection seller who will, in the event of a credit event make them whole; in other words, make good on their loss.
So scenario A is no credit event. Protection seller makes out as this entity has collected a premium but delivered nothing. The protection buyer, meanwhile, enjoys full economic benefit of their asset, the IBM bond. If anyone lost here it would be the prudent IBM bond holder, who purchased insurance they didn't (with benefit of hindsight) need.
Scenario B is the credit event. Protection seller is informed by the protection buyer of their need to be made whole. The reference asset is valued at the ISDA agreed time, and the sums necessary to cover the protection buyers losses are paid. So protection seller effectively lost money, protection buyer was made whole. Winner - protection buyer, loser protection seller.
I just don't see who we're preventing monetary losess no matter what and I'm afraid I don't get the connection between derivatives and inflation.
posted by Mutant at 1:58 PM on February 19, 2008
Well, you do know the industry is NOT single minded or monolithic, with hundreds of people involved in structuring a CDO. Not sure how many work at the monolines and I have no idea how many folks were / are involved with selling real estate. My point is, there are hundreds of thousands - perhaps a few million - of independent entities working in the industry. They don't all have the same goals or objectives.
"Like Ambac and MBIA?"
That comparison is out of context. My point is a rational market participant will value protection sold by a AAA higher than a BBB, and the premium will be priced accordingly - less in the case of a AAA, because in the limit you've got far more confidence this participant will be around to pay off
"It doesn't have to be about making the same choices and calculations system wide, it could be something like a major downturn in a single market that a lot of people have hedged against."
Such as? I'd like to see an example of an entire market moving one way that caught all market participants out. Again, markets are NOT monolithic and everyone does not take the same side of a trade. I find this point abstract, I'm not aware of an event such as your describing. Which would, of course, be rather nasty - for some. Not everyone will line up on the same side, markets just don't work like that. After all, in the fundamental instance for a market to exist there must be two views on price. Otherwise there is no trade, and hence no market.
"I tend to get worried when the financial whiz kids start getting too cute by half with markets that tend be un- or under-regulated."
But these "whiz kids" as you're describing them - quants, I'm assuming - are part of a team. That's just how modern trading desks, whether an iBank or fund, operate. Some "whiz kid" just doesn't decide to move the market, or singlehandedly assume positions on behalf of the firm that might destablise a market. Sure, Soc Gen recently showed us a single rogue trade can seriously impact the viability of a bank, but he hardly threatened the viability of the markets, the excitement of that day aside.
Sure, AIG got it wrong. It happens, even for those who presumably know their market. Its just the nature of this business.
Malor -- "Because everyone feels protected, rveryone takes on more risk. "
Interesting position, but I'm not sure I agree. Banks are highly regulated, and for every position they assume, insured or not, they must set aside regulatory capital. The Central Banks, operating accordiing to the Basel II accord, have determined what capital is needed to support a position. I agree that CDS' have both widened and deepened the lending pool to some extent, but I'm not sure they're (solely) responsible for this problem.
"The whole point of hedging is to protect a small player by using the deep pockets of much larger ones. "
Actually hedging is a form of risk transference, where the relative wealth of your counterparty doesn't figure. I think this cuts both ways, with sometimes smaller players getting bailed out by a much larger counterparty who was willing to assume some risk for a fee.
jamjam -- "The aim and the claim of all these sorts of instruments is to prevent monetary losses no matter what economic conditions eventuate..."
I don't see this. Let's look at the simplest example again - someone purchases default protection on IBM bonds.
The holder of IBM bonds pays a relatively small premium to the protection seller who will, in the event of a credit event make them whole; in other words, make good on their loss.
So scenario A is no credit event. Protection seller makes out as this entity has collected a premium but delivered nothing. The protection buyer, meanwhile, enjoys full economic benefit of their asset, the IBM bond. If anyone lost here it would be the prudent IBM bond holder, who purchased insurance they didn't (with benefit of hindsight) need.
Scenario B is the credit event. Protection seller is informed by the protection buyer of their need to be made whole. The reference asset is valued at the ISDA agreed time, and the sums necessary to cover the protection buyers losses are paid. So protection seller effectively lost money, protection buyer was made whole. Winner - protection buyer, loser protection seller.
I just don't see who we're preventing monetary losess no matter what and I'm afraid I don't get the connection between derivatives and inflation.
posted by Mutant at 1:58 PM on February 19, 2008
Malor: "I believe this is untrue. The current credit event wouldn't be HAPPENING if not for CDSes. Why do I say that? Because if banks can't get protection against a default, they wouldn't make the loans in the first place. Because they could buy protection, they were willing to make the loans."
I think there is some truth in that, but not really at the mortgage level. The reason mortgage lending became lax is that banks were able securitise the mortgages through SPVs and sell on into the asset-backed paper market. A similar thing has happened to lending standards in the leveraged loan market (i.e. those backing buyouts) where lending criteria slipped because of the massive demand for loans from CLO vehicles. Where CDS are particularly used as hedging tools is on a more reactive than proactive basis -- they are used to e.g. reduce exposure to huge portfolios of loans to small and mid size corporate clients of banks with lending arms.
posted by patricio at 3:51 PM on February 19, 2008
I think there is some truth in that, but not really at the mortgage level. The reason mortgage lending became lax is that banks were able securitise the mortgages through SPVs and sell on into the asset-backed paper market. A similar thing has happened to lending standards in the leveraged loan market (i.e. those backing buyouts) where lending criteria slipped because of the massive demand for loans from CLO vehicles. Where CDS are particularly used as hedging tools is on a more reactive than proactive basis -- they are used to e.g. reduce exposure to huge portfolios of loans to small and mid size corporate clients of banks with lending arms.
posted by patricio at 3:51 PM on February 19, 2008
Here's part of a talk that Doug Noland gave, almost five years ago... it's not like this stuff has been invisible. This disaster has been entirely obvious if you just looked at all the pieces and assembled them into a very slightly different whole than the established orthodoxy. You can read his full speech here.
(again, Mr. Noland has this really horrible habit of Inappropriately Capping Everything. It drives me nuts, but his fundamental insights are so good that I tolerate the pain. All underlines are his, not mine.)
"The GSEs have basically become the market, and the day they turn more cautious is the day the Bubble is in serious jeopardy. "
And, when that happened, the wheels indeed started to come off the cart. It was Fannie Mae's sudden decision to tighten lending standards that started this gigantic landslide of failure.
Once again, let me remind you: that speech was FIVE YEARS ago.
posted by Malor at 4:11 PM on February 19, 2008 [3 favorites]
(again, Mr. Noland has this really horrible habit of Inappropriately Capping Everything. It drives me nuts, but his fundamental insights are so good that I tolerate the pain. All underlines are his, not mine.)
Regarding the Proliferation of Derivatives, I have in the past used a flood insurance analogy: If inexpensive and easily accessible flood insurance becomes available, this development will arouse a self-reinforcing building boom along the river. The newly offered insurance will increase individual risk-taking behavior and set in motion dynamics that pyramid systemic risk. Yet the insurance business will thrive, the riverside economy will boom, and it will appear to happy onlookers as a “miracle economy.” That is, until the inevitable flood arrives.Pulling this one quote out, which I think was quite prescient:
For the system, derivatives provide the means for altering, disguising and transferring risk, but not the mitigation of risk. And, unfortunately for systemic stability, this risk is too often transferred to speculators and highly leveraged players without the wherewithal to manage this risk in the event of a systemic crisis. Moreover, derivatives and structured finance nurture risk-taking. Specifically, they cultivate aggressive lending and leveraged speculation.
And a few comments are in order regarding the Government-sponsored Enterprises (GSEs). These are very problematic, unmanageable institutions at the very heart of today’s Bubbles. The GSEs enjoy unlimited access to Credit, thus operating with an extraordinary capacity to expand liabilities and create system liquidity. They are the major force fueling a historic Mortgage Finance Bubble, fostering destabilizing asset-inflation, over-consumption, endless trade deficits, and severe economic maladjustment. Moreover, they are the leading creators of system liquidity. This role becomes paramount during periods of systemic stress. I argue that they now operate as the key “Buyers of First and Last Resort” throughout the Credit market, essentially functioning as a Dual Central Bank. They have evolved into the Liquidity Backstop, emboldening the leveraged speculating community. This is an especially powerful and dangerous role for the GSEs. But, at the same time, they are the “Guardians of the American Dream.” Especially in today’s environment, the GSEs are politically invulnerable, and the debt market knows this.
And this transitions smoothly to the U.S. Bubble Economy. Recall the old adage “You are what you eat”? Well, I say “An Economy is How it Lends.” Financial Arbitrage Capitalism and its Dysfunctional Monetary Processes guarantee endemic unsound lending and the wholesale misallocation of resources. The character of liquidity now significantly impacts the nature of demand. The underlying structure of the economy is dictated by, and developed for, Credit-induced over-consumption, while the general economy has evolved to be asset inflation and services-centric. This ensures extreme investment and structural distortions.
The outcome is a lot of non-tangible “output” and “productivity,” along with an enormous inflation of financial claims. The problem is there is little in the way of true economic wealth to support this inflation. Therefore, today’s “monetary” economy is acutely vulnerable to any reduction in the growth of Credit.
Today’s Critical Issues:
The paramount issue is the intractable Credit Bubble – the antithesis of the stability offered by The Way We Were. The old banking system was relatively simple to govern, while today’s complex, expansive Credit system is virtually unmanageable. There are today three interrelated Bubbles. First, the Mortgage Finance Bubble. Second, the Leveraged Speculation Bubble throughout the Credit system. And third, the Risk Intermediation/“Structured Finance” Bubble
There is also the critical dilemma that we Can’t Even Turn These Bubbles Down, Let Alone Turn Them Off. Mortgage Finance is today the horse, while the economy is the cart. The Bubble throughout mortgage finance has become the overriding source for system liquidity and income growth.
Regarding GSE risk intermediation: The thinly-capitalized GSEs balloon exposure and use resulting boom-time experience to claim they will never suffer severe Credit losses. The GSEs have basically become the market, and the day they turn more cautious is the day the Bubble is in serious jeopardy. Unprecedented mortgage Credit growth has national prices levitated and many major localities in dangerous Bubbles. Any reduction in liquidity risks setting in motion a telecom-style bust.
Closely related is the issue of the Credit insurers. These thinly capitalized financial guarantors have written well over $1 trillion of insurance. But what would be the consequence - what impact on Credit Availability - if the insurers were to back away from writing new policies? I argue this is yet another Bubble; it only functions well during expansion.
"The GSEs have basically become the market, and the day they turn more cautious is the day the Bubble is in serious jeopardy. "
And, when that happened, the wheels indeed started to come off the cart. It was Fannie Mae's sudden decision to tighten lending standards that started this gigantic landslide of failure.
Once again, let me remind you: that speech was FIVE YEARS ago.
posted by Malor at 4:11 PM on February 19, 2008 [3 favorites]
Academic literature is but one driver in finance and I'm sure many desks have much more advanced models. At least they must have different models, otherwise there would hardly be a market, what with single views on price and all...and a robust market for CDS exists, in fact was the opening sentence of this FPP.
Right, I have more fun with the disparity between model predictions and actual price. In fact I have never in my life done a black box trade, but I still find modeling data useful. At the very least it provides me a foundation to falsify a hypothesis. And as someone smarter than me once said about the markets, I forget who: if you have a hypothesis test it.
Of course I've spend weeks deep in thought on models and mathematics only conclude that it is just Platonic horse-shit, that it doesn't mean anything and you can't in the end begin to model this like the motions of planets ... but I didn't say anything about the validity of models, did I? It is sort of like a Pynchon novel. A fun intellectual feat, but don't go beyond that.
posted by geoff. at 4:36 PM on February 19, 2008
Right, I have more fun with the disparity between model predictions and actual price. In fact I have never in my life done a black box trade, but I still find modeling data useful. At the very least it provides me a foundation to falsify a hypothesis. And as someone smarter than me once said about the markets, I forget who: if you have a hypothesis test it.
Of course I've spend weeks deep in thought on models and mathematics only conclude that it is just Platonic horse-shit, that it doesn't mean anything and you can't in the end begin to model this like the motions of planets ... but I didn't say anything about the validity of models, did I? It is sort of like a Pynchon novel. A fun intellectual feat, but don't go beyond that.
posted by geoff. at 4:36 PM on February 19, 2008
My point is, there are hundreds of thousands - perhaps a few million - of independent entities working in the industry. They don't all have the same goals or objectives.
True. We also know that a major crisis can cause ripples through other industries when things like credit dry up. The Fed doesn't call an emergency session to drop the rate by 75 points for giggles (not trying to divert the conversation, this stuff is already complex enough as is).
That comparison is out of context. My point is a rational market participant will value protection sold by a AAA higher than a BBB, and the premium will be priced accordingly
I got your point, I was just pointing out that a AAA rating can mean nothing depending on the fundamentals being, um, fundamentally broken. I'm not a financial genius by any measure, but some of this stuff has been obvious for years. The unraveling of the "new market paradigm" was painfully clear the first time "Flip That House" aired.
I'd like to see an example of an entire market moving one way that caught all market participants out.
It's not a matter of catching "all market participants" out. You are absolutely correct that having two sides of a trade make a market. The problem occurs, in my limited view, when part of a substantial market (say, real estate) can't meet their obligations. The risk taken on, thanks to CDOs and the CDS that accompany the risk, is that banks were more likely to make risky loans. After all, they can spread the risk around, and if they are buying the CDOs, well, they're insured! AAA!
But these "whiz kids" as you're describing them - quants, I'm assuming - are part of a team.
Quants are one issue, but some of these exotic derivatives go beyond the quants. I get nervous when MBAs get together with math guys to "figure out the market." But that's a bit different than my overall concern of boys playing with their very large financial toys.
Call it irrational exuberance 9.0.
btw, Mutant (and everyone else), thanks for engaging in this discussion. I'm a bit of a novice at this finance stuff. I tend to follow my gut[0] on things and my gut tells me bad things are on the horizon. Your insight into this has been very helpful.
[0] - a ton of reading and a more than passing familiarity with stats
posted by ryoshu at 6:15 PM on February 19, 2008
True. We also know that a major crisis can cause ripples through other industries when things like credit dry up. The Fed doesn't call an emergency session to drop the rate by 75 points for giggles (not trying to divert the conversation, this stuff is already complex enough as is).
That comparison is out of context. My point is a rational market participant will value protection sold by a AAA higher than a BBB, and the premium will be priced accordingly
I got your point, I was just pointing out that a AAA rating can mean nothing depending on the fundamentals being, um, fundamentally broken. I'm not a financial genius by any measure, but some of this stuff has been obvious for years. The unraveling of the "new market paradigm" was painfully clear the first time "Flip That House" aired.
I'd like to see an example of an entire market moving one way that caught all market participants out.
It's not a matter of catching "all market participants" out. You are absolutely correct that having two sides of a trade make a market. The problem occurs, in my limited view, when part of a substantial market (say, real estate) can't meet their obligations. The risk taken on, thanks to CDOs and the CDS that accompany the risk, is that banks were more likely to make risky loans. After all, they can spread the risk around, and if they are buying the CDOs, well, they're insured! AAA!
But these "whiz kids" as you're describing them - quants, I'm assuming - are part of a team.
Quants are one issue, but some of these exotic derivatives go beyond the quants. I get nervous when MBAs get together with math guys to "figure out the market." But that's a bit different than my overall concern of boys playing with their very large financial toys.
Call it irrational exuberance 9.0.
btw, Mutant (and everyone else), thanks for engaging in this discussion. I'm a bit of a novice at this finance stuff. I tend to follow my gut[0] on things and my gut tells me bad things are on the horizon. Your insight into this has been very helpful.
[0] - a ton of reading and a more than passing familiarity with stats
posted by ryoshu at 6:15 PM on February 19, 2008
from my perspective -- what might charitably be described as 'shotgun impressionism' -- the larger issue is the US has been consuming more than it can produce and trade for and more than its income, so it has borrowed from foreign central banks -- namely from china and saudi arabia, but from other 'emerging markets' as well -- against the full faith and credit of the US gov't, i.e. you the US taxpayer, to stunning result. even greenspan has noted "the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit." in short, when you go into debt to finance spending (rather than productive investment, and i don't think residential investment qualifies, unless you count mortgage-backed securities as 'tradeables'), you are living beyond your means, which in the long run isn't sustainable (ben "bueller?" stein's dad btw).
so if the job of the US is to (over)consume and for the rest of the world to (over)produce -- aka 'peaceful development' -- and then to go on and finance the US' (ultra)consumption, what happens if americans are no longer consuming (against the value of their homes), when 'vendor financing' runs out? well yourcrack dealer predatory lenders creditors might reasonably start to question your ability to repay your loans [cf. the opium wars]. but unlike a credit agency capping yo repoing recoverable assets or a bank foreclosing on a house, the claims made against the US can only be settled in dollars, and guess who has an unlimited supply (and/or the proverbial 'helicopter')? moreover, it's the US -- the borrower/deficit nation -- that sets the interest rate. imagine if you maxed out your credit card, lost your job and were unable to roll/refinance your debt. what rate of interest would you charge yourself? why not just walk away, esp in high LTV/negative equity/impaired collateral situations... wait, what was i talking about again? oh right, diminished prestige. like keynes' maxim -- "if you owe your bank a hundred pounds, you have a problem. but if you owe a million, it has" -- this is the 'exorbitant privilege' of a profligate reserve currency nation and why, when nixon took us off the gold standard, the US treasury sec'y quipped the dollar is "our currency, but your problem" to miffed europeans everywhere (who, btw, subsequently went about creating their own currency bloc). they wanted gold and all they got was paper.
now if you're a foreign creditor to the US chafing under global 'dollar hegemony' (or 'bretton woods II') that sounds like a raw deal. four decades ago there was nothing you could really do about it --'modern' central banking was still nascent and unproven -- but now with trillions in forex reserves available (backed by supposedly-sound central banks, independent stewards, zealously guardingtheir credibility the money supply), a burgeoning industrial/infrastructure base, higher growth rates and a comparative advantage in increasingly scarce (and demand-inelastic) commodities, they have more options at their disposal.
first tho, an aside: while the fed controls short-term interest rates, they have less influence over long-term rates, which are determined more by inflation and inflation expectations -- intuitively, higher inflation should raise the cost of borrowing. measuring inflation is a tricky business, but overall with emerging markets (re)joining the global economy, adding to the labor force and adopting technology, the world has been 'disinflationary' the last few decades. however, that's beginning to change as the process is running into resource constraints and political bottlenecks. in the US, this can be seen in increasing food & energy prices, conveniently ignored for the most part by the fed, who're more concerned about 'core' measures of inflation. but if 'ex-core' measures of inflation aren't about to come back down and they are, as they say, necessities, then 1) they will eat up more of our income, and 2) start to exert upward pressure on overall levels of inflation. the rest of the world is experiencing higher inflation too, only moreso, because food & energy make up bigger portions of their consumption baskets and, at any rate, most central banks around the world don't exclude food & energy from their measures of inflation.
so what's a foreign central bank, which has been quietly and patiently, if somewhat surreptitiously, financing US consumption (accumulating vast sums of US debt in the process), to do? in other words, with the mountain of IOUs you have, how do you prevent getting stiffed with yet more (depreciating) IOUs? two things come to mind:
as the emperor once said: "As you can see, my young apprentice, your friends have failed. Now witness the firepower of this fully ARMED and OPERATIONAL battle station!"
only it's the rebels who havethe death star SWFs trained against the empire; the shields are down and the barbarians are at the gate ;P
---
*furthermore, by letting their currencies appreciate they would have to book losses on their existing dollar hoards. i think people (who care) already implicitly acknowledge at least paper losses will be realised, whether or not everyone else, in the fullness of time, admits them as such is left to be determined. money, after all, is a function of collective memory. like market participants are sometimes rewarded by not adding to losses anymore; the mere recognition of ceasing to dig the hole deeper implies an attempt to climb out.
**tacit approval could be won, for example, thru trained intermediaries, passive indexing or greater transparency and regulatory oversight.
posted by kliuless at 6:39 PM on February 19, 2008
so if the job of the US is to (over)consume and for the rest of the world to (over)produce -- aka 'peaceful development' -- and then to go on and finance the US' (ultra)consumption, what happens if americans are no longer consuming (against the value of their homes), when 'vendor financing' runs out? well your
now if you're a foreign creditor to the US chafing under global 'dollar hegemony' (or 'bretton woods II') that sounds like a raw deal. four decades ago there was nothing you could really do about it --'modern' central banking was still nascent and unproven -- but now with trillions in forex reserves available (backed by supposedly-sound central banks, independent stewards, zealously guarding
first tho, an aside: while the fed controls short-term interest rates, they have less influence over long-term rates, which are determined more by inflation and inflation expectations -- intuitively, higher inflation should raise the cost of borrowing. measuring inflation is a tricky business, but overall with emerging markets (re)joining the global economy, adding to the labor force and adopting technology, the world has been 'disinflationary' the last few decades. however, that's beginning to change as the process is running into resource constraints and political bottlenecks. in the US, this can be seen in increasing food & energy prices, conveniently ignored for the most part by the fed, who're more concerned about 'core' measures of inflation. but if 'ex-core' measures of inflation aren't about to come back down and they are, as they say, necessities, then 1) they will eat up more of our income, and 2) start to exert upward pressure on overall levels of inflation. the rest of the world is experiencing higher inflation too, only moreso, because food & energy make up bigger portions of their consumption baskets and, at any rate, most central banks around the world don't exclude food & energy from their measures of inflation.
so what's a foreign central bank, which has been quietly and patiently, if somewhat surreptitiously, financing US consumption (accumulating vast sums of US debt in the process), to do? in other words, with the mountain of IOUs you have, how do you prevent getting stiffed with yet more (depreciating) IOUs? two things come to mind:
- revalue. food & energy are globally traded (and remember increasingly scarce) commodities. they are also priced in dollars. if foreign central banks allowed their currencies to appreciate versus the dollar (recall they have been intervening to prevent this) their countries would be better able to afford higher living standards and mitigate, if not limit, inflation. of course, doing so would prevent them from financing US consumption (their export market), but if that was faltering anyway, then no big loss; they can just focus on their own markets, fostering domestic demand and consumption -- ostensibly their original development goal anyway.*
- a 'debt/equity swap'. whereas foreign creditors can adeptly ride inflation/exchange rate waves to greater prosperity, by shifting into real assets and out of nominal ones, an asset class preference swap from debt to equity (ownership, if not control, and not disallowed by congress**) they may fairly insulate themselves from both inflation and exchange rate dynamics. the joke/irony is that this entails 'cross-border nationalisation' or 'state capitalism'. if gov't-owned/run businesses are unacceptable in the US, why should foreign gov't be able to? regardless, they can and are, just another example of 'innovation' outpacing any attempt to prudentially consider the matter beforehand and thus leaving legal gray areas it its wake. as usual, we're making it up as we go along.
as the emperor once said: "As you can see, my young apprentice, your friends have failed. Now witness the firepower of this fully ARMED and OPERATIONAL battle station!"
only it's the rebels who have
---
*furthermore, by letting their currencies appreciate they would have to book losses on their existing dollar hoards. i think people (who care) already implicitly acknowledge at least paper losses will be realised, whether or not everyone else, in the fullness of time, admits them as such is left to be determined. money, after all, is a function of collective memory. like market participants are sometimes rewarded by not adding to losses anymore; the mere recognition of ceasing to dig the hole deeper implies an attempt to climb out.
**tacit approval could be won, for example, thru trained intermediaries, passive indexing or greater transparency and regulatory oversight.
posted by kliuless at 6:39 PM on February 19, 2008
re: noland - that's like saying seat belts, 4wd and airbags contribute to higher incidence of crashes, which i think is debatable, cuz they've also saved lives... actually, i think studies have shown that while they increase survivability and decrease casualties overall (lowering the bell curve/normal distribution) 'losses' that are incurred tend to be more catastrophic (fattening the tails for dame fortune).
it bears repeating: they're just tools, which can be used for hedging as well as speculation; understanding what they are with a healthy regard for their limitations -- what they can and cannot accomplish -- is paramount. underappreciation of the risks, as always, gets one into trouble, but then there's that whole decision making under uncertainty thing... um, which is why god invented conditional probabilities/bayesian statistics, cf. causal inference :P
cheers!
posted by kliuless at 7:28 PM on February 19, 2008
it bears repeating: they're just tools, which can be used for hedging as well as speculation; understanding what they are with a healthy regard for their limitations -- what they can and cannot accomplish -- is paramount. underappreciation of the risks, as always, gets one into trouble, but then there's that whole decision making under uncertainty thing... um, which is why god invented conditional probabilities/bayesian statistics, cf. causal inference :P
cheers!
posted by kliuless at 7:28 PM on February 19, 2008
that's like saying seat belts, 4wd and airbags contribute to higher incidence of crashes,
No, it really isn't, because seat belts actually mitigate risk. Derivatives don't. They just move it to other people. If you're not running the risk, you're going to be willing to take more risks.
It's like saying, "ok, this car is magic: if you hit a wall, a lot of other people get hurt, but only a little bit each." So, everyone starts driving too goddamn fast.
posted by Malor at 9:12 PM on February 19, 2008 [1 favorite]
No, it really isn't, because seat belts actually mitigate risk. Derivatives don't. They just move it to other people. If you're not running the risk, you're going to be willing to take more risks.
It's like saying, "ok, this car is magic: if you hit a wall, a lot of other people get hurt, but only a little bit each." So, everyone starts driving too goddamn fast.
posted by Malor at 9:12 PM on February 19, 2008 [1 favorite]
I agree with you Malor, but your analogy is flawed
You make the 'lot of other people' seem like innocents, they have, in contract ,agreed to get hurt if the car crashes.
Now you may argue that these risk takers have been 'sold' the risk when they didn't know what it was, but the regulators don't allow 'selling' in that sense and the banks are very aware of the potential for mis-selling. You will struggle to find a 'salesman' at an investment back who will advise their client to buy anything. Its much more like Wall-Mart ... this is what we have, you want it?
In any arms length transaction between market profesionals, "we didn't know what we were buying" is not an excuse that the courts will uphold.
posted by fistynuts at 6:20 AM on February 20, 2008
You make the 'lot of other people' seem like innocents, they have, in contract ,agreed to get hurt if the car crashes.
Now you may argue that these risk takers have been 'sold' the risk when they didn't know what it was, but the regulators don't allow 'selling' in that sense and the banks are very aware of the potential for mis-selling. You will struggle to find a 'salesman' at an investment back who will advise their client to buy anything. Its much more like Wall-Mart ... this is what we have, you want it?
In any arms length transaction between market profesionals, "we didn't know what we were buying" is not an excuse that the courts will uphold.
posted by fistynuts at 6:20 AM on February 20, 2008
Malor -- ...part of a talk that Doug Noland gave, almost five years ago..."
Yeh, Noland is an interesting guy, folks here bounce his stuff around and I've read some from time to time. At least he's got a consistent view, 'cause what he was saying five years ago he's been saying pretty much every year since your excerpt above. In fact looking at his archive and pulling out a relevant piece every November or so seems to parse down to the same message. I have found his stuff thought inspiring on many levels, not least of which is the markets have changed but the message hasn't. Which makes me curious.
So while I respect and enjoy his work I can't accept it as a central driver of my thought process on this topic. Noland clearly has a view and more importantly a voice capable of making his message heard, but I've wondered in the past if there wasn't an agenda tying his published work to that fund those folks are running? The fund's objectives are clearly aligned with his (excellent) work.
Since I've put this on the table I guess I'll be up front and say it clearly - if one is advising a fund that is short the market, its no surprise their published work backs that view and warns (for years!) of doom & gloom. Also curious - lots of concerns raised about derivatives but it seems ok to use them sometimes, like in a fund designed to be short the market? After all, if a fund manager is looking for excess alpha (who isn't?) one sure fire way to generate it is to leverage up, and like it or not the safest & cheapest way to do this is via some form of derivative product. Easier to cap your (inevitable) losses, for starters.
"unfortunately for systemic stability, this risk is too often transferred to speculators and highly leveraged players without the wherewithal to manage this risk..."
Well, I realise it's not your statement but as this fallacy is central to our discussion I'd like to comment. In general, this is not true. It really depends upon the derivative under discussion. Puts and Futures for example - the type of derivative traded by the fund Noland's associated with - are guaranteed by an exchange or clearing house. There is no counterparty risk (the exchange is your counterparty), except in the case of OTC trades, perhaps CDS' like we're discussing. But then the banks own know your customer obligation comes into play, and you damn well better know who you're trading with, your firms exposure to them and have some idea of their overall creditworthiness.
'Cause if you don't you're going to have a problem, and not just from internal groups at your bank who are paid to police this activity (and incentivised accordingly) but from a key party that everyone in this thread seems to have missed even though I've raised it before - banks are highly regulated. You just can't create money by assuming positions ad infinitum, as some folks upthread seem to believe. Every position has to be backed by capital (well, except in the case of SIV's but let's not muddy the water at this point). This capital, regulatory capital supports the positions, and is intended to protect the bank (and the entire financial system) from not only what we call known losses but also (and most importantly!) unknown losses.
So this need to set aside capital covering positions in the market mitigates and regulates banking activity. After all, banks have limited equity.
While we're on the topic of limits, another phrase that I've seen before so I won't attribute soely to Noland, but it does bug the hell out of me "The GSEs enjoy unlimited access to Credit..."
How so? That isnt' true at all. There is an implicit guarantee to their paper, but this tenuous, implied government guarantee hardly approximates unlimited access. This guarantee is markedy less formalised (and reliable) than the German Landesbanken, for example. So I've always had a problem with this argument whenever I've seen it, and I wish someone would explain how this works. 'Cause even a Northern Rock here in the UK aint' got no such access (well, these are different times so maybe I'll retract the Northern Rock comment as BOE is already exhibited some degree of recklessness by getting into the consumer mortgage biz, and as I said yesterday I got money on the table saying they ain't got no exit strategy either ...)
geoff -- "I have more fun with the disparity between model predictions and actual price." Yeh, I suspected this was your point and it always is challenging (that's spelled impossible) to get model and market in agreement. In the past I've attributed this somewhat to expectations of participants, in addition to the other issues previously raised (e.g., and working backwards, calibration, assumptions regarding the relative importance of various factors, even implementation specific details). It's definitely art leveraged onto science in many cases.
ryoshu -- "I was just pointing out that a AAA rating can mean nothing depending on the fundamentals being, um, fundamentally broken. I'm not a financial genius by any measure, but some of this stuff has been obvious for years. The unraveling of the "new market paradigm" was painfully clear the first time "Flip That House" aired."
Well, we do know - based on historical, backwards looking data - that a Aaa rated entity has a (roughly, looking at 2002 tables) 93% chance of still being rated Aaa in one years time, a 5% chance the entity will be rated Aa (one step lower) and so on. Again, this is just how the system works, and you'll have to present a case of the fundamentals being so flawed that system wide, a large number of Aaa' are all of sudden downgraded. One step, or more. As we haven't seen this happen before we're back to my original point - a non zero probability of this event happening? Yes, anything can happen.. But a probability approaching unity - nope
Ok, now I just did something horribly confusing - switched to Moody's ratings (for example, Aaa is the Moody's equivalent of an S&P AAA rating) as that's what I'm most familiar with - I should have started out with that system so apologies if I've mislead anyone ...
"...when part of a substantial market (say, real estate) can't meet their obligations."
But can you quantify part of? 'Cause I know the folks structuring CDOs not only can, but have. Default risk is priced in, at various assumed rates of default. As is recovery value of the underlying asset (after all, the property still exists, so unless we're talking nuclear strike systemic event there will be some residual value, and I suspect a log higher than some people wish to admit to), once again, at various, assumed rates. We'd have to ask someone working on a desk structuring these products - no disrespect to anyone but I wouldn't trust blogger links like some other FPPs have provided as "evidence" to back up assertions - but when I worked on a MBS desk in New York back in the early 90's, we did run all these assumptions through. NOT because we were bored and looking for busy work, but - and this is very important but everyone seem to over look this in an attempt to paint this as dot com 2.0 - the customer requires it.
Why? Well, various reasons. First, the ratings agencies won't go near it unless they get this transparancy. If a agency hasn't rated your paper - provided an alternative (and presumably unbiased metric on it's riskyness - let's not discuss their failings at this point in time) your funding costs will be higher as nobody will purchase your paper. A ratings agency wants to see your models, your data as inputs, as you've already told them what you think it should be rated at and what it's gonna pay. So getting the ratings agencies onboard is critical.
Second, and covering market participants who openly operate - banks, mutual funds, etc - the regulators require it. Once again, if you're holding that paper the your banks (or funds) Risk Management folks are gonna want to know how it works, how it's funded, etc. Same quesitons as the ratings agencies in fact, but from a different perspective.
And I guess the third interested party would be market participants who don't operate openly - hedge funds, perhaps soverign wealth funds, etc. Often times understaffed they certainly ain't gonna hold a structured product - no matter how attractive the yield or cheap the price - if they don't know how it works, and they haven't got the headcount to exhaustively reverse engineer it. So they'll want to know before they buy.
"The risk taken on, thanks to CDOs and the CDS that accompany the risk, is that banks were more likely to make risky loans. After all, they can spread the risk around, and if they are buying the CDOs, well, they're insured! AAA!"
But once again I'll point out there is no such thing as a free lunch, banks have to set aside capital to support these positions. So yes, they may have been more likely to make a riskier loan, but I'd suggest systemically (that's what we're discussing after all) not to the point of recklessness. After all, why use your capital to support a very risky loan when you can take on the books one with less risk? The CDS' isn't free either, so that's effectively cost needed to assume, in addition to capital requirements. So sure, there no doubt were and are reckless counterpartys out there. But is this line of business the norm? Or well publicised outlyers?
"Quants are one issue, but some of these exotic derivatives go beyond the quants. I get nervous when MBAs get together with math guys to "figure out the market." But that's a bit different than my overall concern of boys playing with their very large financial toys."
Yeh, I agree that some of the more exotic derivatives are somewhat suspect; while a CDO is fine and synthetic CDO's not much of a problem, I've got a real issue trying to understand a CDO squared (CDO where each tranche itself is composed of a CDO) let alone a CDO cubed. Still, I wonder how much actual issuance of these products there is. But on the topic of the folks doing the structuring, while I'm not sure who else but an MBA (presumably in finance) is qualified I'd once more make the point that they aren't operating alone, they are part of a team, and no matter how singular the creation of a baseline product is, before that instrument is sold or traded a large body of folks have signed off.
"btw, Mutant (and everyone else), thanks for engaging in this discussion. I'm a bit of a novice at this finance stuff. "
Well I've got to thank you (as well as everyone else) for what I'd call an engaging discussion. And novice or not, your questions are comments are fairly incisive and we're all having a great time.
kliuless -- "a 'debt/equity swap'. whereas foreign creditors can adeptly ride inflation/exchange rate waves to greater prosperity, by shifting into real assets and out of nominal ones…"
Now this is a very interesting point and something that I won't say has been going on below the radar, very few people seem to grasp the significance of. Folks can think what they want about the propriety of Chinese acquistions of foreign enterprises (US included, however The Aussies seem to have reacted particualrly poorly), but you've got admit at least they're spending their money on productive assets e.g., energy, manufacturing, etc) rather than art and "trophy" real estate like another group of cash rich folks (also demonised to some extent) were up to perhaps twenty years ago.
Wow guys once again lots of great points in this thread. I've said it before - MeFi finance threads rock!
posted by Mutant at 9:34 AM on February 20, 2008
"The risk taken on, thanks to CDOs and the CDS that accompany the risk, is that banks were more likely to make risky loans. After all, they can spread the risk around, and if they are buying the CDOs, well, they're insured! AAA!"
But once again I'll point out there is no such thing as a free lunch, banks have to set aside capital to support these positions. So yes, they may have been more likely to make a riskier loan, but I'd suggest systemically (that's what we're discussing after all) not to the point of recklessness. After all, why use your capital to support a very risky loan when you can take on the books one with less risk? The CDS' isn't free either, so that's effectively cost needed to assume, in addition to capital requirements. So sure, there no doubt were and are reckless counterpartys out there. But is this line of business the norm? Or well publicised outlyers?
I think there's perhaps more to this point that you allow. The availability of the CLO market was a (if not the) main driver in the substantial weakening of covenants in leveraged loans for a couple of years. Originating banks were so confident that they weren't going to have to keep any of the loan on their books that they acquiesced to extraordinary cov-lite/no cov documentation. The moment that market went away the safeguards in the docs returned pretty much instantly. At the margin the availability of off-balance sheet securitisation must mean that riskier loans are made - there is no capital cost to the originating bank (perhaps bar the equity tranche if they can't get a hedge fund interested) and there are fees/spreads to be made in the process. I'd say the cost attached to CDS is why it's used more reactively as a portfolio risk management tool and probably has less effect on the riskiness of lending.
Your comments on Noland are interesting too, thanks. I'm interested in the point about systemic stability too -- I don't think you can ignore the failure of the rating agencies in this process. It now appears that there was far too little buy-side due diligence done and investors effectively outsourced it to the rating agencies. That has intuitive appeal but when the raters claim first amendment protection for their ratings you might want something more substantial to fall back on (or perhaps I just want to set up a buy-side DD consultancy...).
posted by patricio at 11:06 AM on February 20, 2008
But once again I'll point out there is no such thing as a free lunch, banks have to set aside capital to support these positions. So yes, they may have been more likely to make a riskier loan, but I'd suggest systemically (that's what we're discussing after all) not to the point of recklessness. After all, why use your capital to support a very risky loan when you can take on the books one with less risk? The CDS' isn't free either, so that's effectively cost needed to assume, in addition to capital requirements. So sure, there no doubt were and are reckless counterpartys out there. But is this line of business the norm? Or well publicised outlyers?
I think there's perhaps more to this point that you allow. The availability of the CLO market was a (if not the) main driver in the substantial weakening of covenants in leveraged loans for a couple of years. Originating banks were so confident that they weren't going to have to keep any of the loan on their books that they acquiesced to extraordinary cov-lite/no cov documentation. The moment that market went away the safeguards in the docs returned pretty much instantly. At the margin the availability of off-balance sheet securitisation must mean that riskier loans are made - there is no capital cost to the originating bank (perhaps bar the equity tranche if they can't get a hedge fund interested) and there are fees/spreads to be made in the process. I'd say the cost attached to CDS is why it's used more reactively as a portfolio risk management tool and probably has less effect on the riskiness of lending.
Your comments on Noland are interesting too, thanks. I'm interested in the point about systemic stability too -- I don't think you can ignore the failure of the rating agencies in this process. It now appears that there was far too little buy-side due diligence done and investors effectively outsourced it to the rating agencies. That has intuitive appeal but when the raters claim first amendment protection for their ratings you might want something more substantial to fall back on (or perhaps I just want to set up a buy-side DD consultancy...).
posted by patricio at 11:06 AM on February 20, 2008
Well, I realise it's not your statement but as this fallacy is central to our discussion I'd like to comment. In general, this is not true. It really depends upon the derivative under discussion.
I don't think of gets and puts as being a problem. What I think of as being a problem is the example of a relatively small-time player who sells default protection on a high-risk tranche in a CDO, and hedges by buying protection on the low-risk tranche, reasoning that if one blows up, the other has to as well, so the big players will make him whole and he can make his customers whole. But if the model breaks down, he's dead. He's covering his bets with a model, not an asset, but other players definitely will buy his paper. This spreads risk into the system, as they themselves will use this paper as the justification to write paper of their own.
Every position has to be backed by capital (well, except in the case of SIV's but let's not muddy the water at this point)
You can ignore the crux of my argument if you wish, but of course a good chunk of my position falls apart if you do. As far as I can see, one of the central problems is that, through the securitization-and-purchase process, crappy loans get 'cleaned up'... almost like money laundering. After being purchased, they become assets again and can be lent against. If this happens with even a small percentage of the total loans made, the money-multiplier effects are tremendous; reserve rates are already very low (2.5%, I think), and dropping that by just another percentage point is going to far more than double the available money supply.
Further, because so much of this stuff doesn't show in M3, the government entities aren't tracking it properly. FNM's books are immense and frightening, and their expansion of available credit has been the linchpin of the housing bubble. But because the inflation was in an area people liked, we cheered and wanted more, more, more... and the system was only too happy to provide it, against a backdrop of unlimited liquidity supplied by the Fed at absolutely predictable interest rates. The Fed's been a big cheerleader, in fact: Greespan, just a couple of years ago, was telling the industry that they should be giving people more ARMs to make housing 'more affordable'.
so unless we're talking nuclear strike systemic event there will be some residual value, and I suspect a log higher than some people wish to admit to
Oh yeah, and that will be the time to make famous profits... when the market is depressed, those who still have capital left will become immensely wealthy. The third-world model of a bunch of economic slaves and a hyper-rich ruling junta is far from inconceivable in America of 2025 or so.
Basically, a lot of your argument seems to be 'no, no, you're all wrong', using the established models and arguments to refute us. Which is okay, and it's obvious that you know them a lot better than I do, at least. But I'd ask you... if all this stuff is really true, and it's all safe as houses.... then why do we have all these bubbles? And why is the system disintegrating before our eyes?
I submit that Noland's arguments appear to be a much better model of what's actually happening than yours are.
posted by Malor at 12:00 PM on February 20, 2008
I don't think of gets and puts as being a problem. What I think of as being a problem is the example of a relatively small-time player who sells default protection on a high-risk tranche in a CDO, and hedges by buying protection on the low-risk tranche, reasoning that if one blows up, the other has to as well, so the big players will make him whole and he can make his customers whole. But if the model breaks down, he's dead. He's covering his bets with a model, not an asset, but other players definitely will buy his paper. This spreads risk into the system, as they themselves will use this paper as the justification to write paper of their own.
Every position has to be backed by capital (well, except in the case of SIV's but let's not muddy the water at this point)
You can ignore the crux of my argument if you wish, but of course a good chunk of my position falls apart if you do. As far as I can see, one of the central problems is that, through the securitization-and-purchase process, crappy loans get 'cleaned up'... almost like money laundering. After being purchased, they become assets again and can be lent against. If this happens with even a small percentage of the total loans made, the money-multiplier effects are tremendous; reserve rates are already very low (2.5%, I think), and dropping that by just another percentage point is going to far more than double the available money supply.
Further, because so much of this stuff doesn't show in M3, the government entities aren't tracking it properly. FNM's books are immense and frightening, and their expansion of available credit has been the linchpin of the housing bubble. But because the inflation was in an area people liked, we cheered and wanted more, more, more... and the system was only too happy to provide it, against a backdrop of unlimited liquidity supplied by the Fed at absolutely predictable interest rates. The Fed's been a big cheerleader, in fact: Greespan, just a couple of years ago, was telling the industry that they should be giving people more ARMs to make housing 'more affordable'.
so unless we're talking nuclear strike systemic event there will be some residual value, and I suspect a log higher than some people wish to admit to
Oh yeah, and that will be the time to make famous profits... when the market is depressed, those who still have capital left will become immensely wealthy. The third-world model of a bunch of economic slaves and a hyper-rich ruling junta is far from inconceivable in America of 2025 or so.
Basically, a lot of your argument seems to be 'no, no, you're all wrong', using the established models and arguments to refute us. Which is okay, and it's obvious that you know them a lot better than I do, at least. But I'd ask you... if all this stuff is really true, and it's all safe as houses.... then why do we have all these bubbles? And why is the system disintegrating before our eyes?
I submit that Noland's arguments appear to be a much better model of what's actually happening than yours are.
posted by Malor at 12:00 PM on February 20, 2008
OH, and as an aside: There's a reason the Fed stopped tracking M3 awhile ago. That was not for your benefit.
posted by Malor at 12:02 PM on February 20, 2008
posted by Malor at 12:02 PM on February 20, 2008
Oh, and let's expand the car analogy a little bit more.
Imagine a magic car that can hurt other people instead of the owner if it crashes. The other people have to volunteer, this doesn't come out of nowhere; a blood pact has to be signed or some such nonsense. If you get enough of these cars, all the people who own them could group up into the giant cooperative, BPA... Blood Pact of America.
Now, BPA has only a few thousand members to start. They're all sharing each others' risk. When one has an accident, everyone else suddenly get tiny cuts and bruises, which their bodies can easily handle... maybe they might need the occasional bandaid. But, hey, this is freaking awesome... suddenly, even having a terrible accident isn't risky anymore. Yeah, sure, you wake up every morning with a little cut or something, but you get used to that pretty quickly. And people discover that the more people they get into BPA, the smaller the cuts get, to the point that they don't even notice them. A millionth of the damage from a car crash wouldn't even be razor burn.
Non-BPA members are going to see the BPAers walk away unscathed from crash after crash, and the paramedics are going to be full of horror stories and warning their friends about the dangers of not having a BPA car. Quite rapidly, the idea will spread to cover practically everyone, because the advantages are so profound.
But then, okay, now everyone is pretty much covered, and car crashes don't hurt anymore. Why, everyone would reason, should speed limits be kept so low? There's no reason to drive only at 70; we can all get where we're going at 100 easily enough. And roads and bridges would start to be redesigned in crazy ways that are highly efficient most of the time, but more dangerous... because if something bad DOES happen, well, nobody's gonna die, and time is limited, so what the hell.
If this system stays in place long enough, the entire traffic system will be designed around high risk, high-speed movement. Gradually, the failures will get more and more and more profound. People start waking up every morning discovering that they're quite sore, and worse every day. And then they discover the other problem: there's no way out of BPA. Once you're in, you're in until you die.
So, they try reducing the speed limit, but not everyone gets the message, or not everyone can be bothered to comply, and the accidents get worse and worse. All the traffic devices are designed for high-speed, low-safety maneuvers, and rebuilding those will take a giant amount of investment and effort. Giant traffic jams start happening, making it frequently impossible to get where you want to go. And everyone wakes up bleeding every morning...
This is where the analogy breaks down, because speed limits aren't a feedback loop like real economics. In the case of the real financial system, adding in regulation will slow the creation of new credit, and the system absolutely requires gobs of new credit to even keep operating. So if we try to reduce the 'speed limit', we'll get a snowball of new problems. The system has been rebuilt wrong, and we're going to have to tear down almost twenty years' worth of economic growth and start pretty much over.
Overall, most fundamentally: we've redesigned our financial system into a casino instead of an investment allocation mechanism. Even you used that word up there, Mutant. A healthy economic system isn't about speculation, much less entirely focused on it.
posted by Malor at 12:21 PM on February 20, 2008 [2 favorites]
Imagine a magic car that can hurt other people instead of the owner if it crashes. The other people have to volunteer, this doesn't come out of nowhere; a blood pact has to be signed or some such nonsense. If you get enough of these cars, all the people who own them could group up into the giant cooperative, BPA... Blood Pact of America.
Now, BPA has only a few thousand members to start. They're all sharing each others' risk. When one has an accident, everyone else suddenly get tiny cuts and bruises, which their bodies can easily handle... maybe they might need the occasional bandaid. But, hey, this is freaking awesome... suddenly, even having a terrible accident isn't risky anymore. Yeah, sure, you wake up every morning with a little cut or something, but you get used to that pretty quickly. And people discover that the more people they get into BPA, the smaller the cuts get, to the point that they don't even notice them. A millionth of the damage from a car crash wouldn't even be razor burn.
Non-BPA members are going to see the BPAers walk away unscathed from crash after crash, and the paramedics are going to be full of horror stories and warning their friends about the dangers of not having a BPA car. Quite rapidly, the idea will spread to cover practically everyone, because the advantages are so profound.
But then, okay, now everyone is pretty much covered, and car crashes don't hurt anymore. Why, everyone would reason, should speed limits be kept so low? There's no reason to drive only at 70; we can all get where we're going at 100 easily enough. And roads and bridges would start to be redesigned in crazy ways that are highly efficient most of the time, but more dangerous... because if something bad DOES happen, well, nobody's gonna die, and time is limited, so what the hell.
If this system stays in place long enough, the entire traffic system will be designed around high risk, high-speed movement. Gradually, the failures will get more and more and more profound. People start waking up every morning discovering that they're quite sore, and worse every day. And then they discover the other problem: there's no way out of BPA. Once you're in, you're in until you die.
So, they try reducing the speed limit, but not everyone gets the message, or not everyone can be bothered to comply, and the accidents get worse and worse. All the traffic devices are designed for high-speed, low-safety maneuvers, and rebuilding those will take a giant amount of investment and effort. Giant traffic jams start happening, making it frequently impossible to get where you want to go. And everyone wakes up bleeding every morning...
This is where the analogy breaks down, because speed limits aren't a feedback loop like real economics. In the case of the real financial system, adding in regulation will slow the creation of new credit, and the system absolutely requires gobs of new credit to even keep operating. So if we try to reduce the 'speed limit', we'll get a snowball of new problems. The system has been rebuilt wrong, and we're going to have to tear down almost twenty years' worth of economic growth and start pretty much over.
Overall, most fundamentally: we've redesigned our financial system into a casino instead of an investment allocation mechanism. Even you used that word up there, Mutant. A healthy economic system isn't about speculation, much less entirely focused on it.
posted by Malor at 12:21 PM on February 20, 2008 [2 favorites]
An exceptional post, Mutant, but (with respect) I think you’re missing the forest for the trees. Your view, whilst sound and well-informed under normal market conditions, is very reminiscent of the Meriwether rationalisation for the LTCM debacle in times of stress. To paraphrase, if only everyone stopped selling then we’d be ok. Participants at the market coalface have a tendency to assume as self-evident certain ‘truths’ –
(1) that my counterparty is solvent and will meet his obligations,
(2) that there will always be liquidity (and a willing market) when I wish to buy and sell, and
(3) that the market will always behave rationally, with every market particpant an independent agent behaving without reference to other partipants.
All these assumptions, I believe, can be thrown out the window in the present environment.
(1) Solvent counterparties? The monolines have, in scale and effect, done the financial equivalent of me personally walking through New Orleans and promising to cover the entire state for flood damage the day before Hurricane Katrina. Insurance works from an actuarial standpoint only whilst the models assumptions hold. Sadly, as we continually rediscover, the models and assumptions are often imperfect. Taleb has written some belligerent but worthwhile books on the subject.
The problem is not the insurance itself but that the entire system is hinged upon a single point which is incapable of bearing the weight. So you end up with a situation where a company with a $5bn balance sheet is guaranteeing the equivalent of the entire mortgage and municipal bond book of the state of California. The sold insurance is worthless because you cannot collect when the insured event happens.
CDS is a joke. In the current environment you have more counterparty risk than you do risk of default – that is, the likelihood of the protection seller being overwhelmed by multiple claims is greater than the likelihood of any single corporate entity going under. In other words, statistically your insurer is more likely to go broke than the individual companies you are trying to protect yourself against, making the entire exercise a futile quant circle-jerk.
Why? The risk of any one of thousands of individual entities going under is remote, but when this risk is pooled and aggregated at a single point, the likelihood of multiple defaults overwhelming the protection seller is several orders of magnitude larger. Insurance does not eliminate risk, it passes it from the insured to the insurer. Now, rather than thousands of people worrying about hurricanes, we have thousands of people worrying whether the insurer will pay up should a hurricane happen. It’s three-card monty writ large. A fragile shell game. There is a reason that insurers exclude cover for terror and other tail events. The bond market is rediscovering why.
(2) What you really need, then, is insurance against the insurers. You may point to the protection sellers’ much-vaunted ‘hedging’ strategies and reinsurance as answers. In theory, yes. In reality? Heh. They’re good for mark-to-market and modelling purposes only. Witness the Adelphi example above. What do you think will happen to the hedges (eg short credit / long CDS index positions) when everyone rushes to cash them in? Their value reverses sharply. And yet the value of the toxic debt offset remains zero. Oops, hedge fails. I’d imagine that when it comes to cash-in time, most of the outstanding hedges are going to be good for about half of what they’re marked at. People seem to forget you need a buyer for every seller.
The only real insurance in this scenario comes in the form of government bailouts (witness Northern Rock in the UK). The impact on the currency and bond markets of this behaviour should be self-evident. Helicopter Ben is going to make an awful lot of joyflights before this is over …
(3) The credit market, as the Fed has noted, is in danger of entering a reflexive feedback loop where negative news begets further negative news, where forced selling begets forced selling begts forced selling. It reminds me of a (probably) apocryphal story about Cold War MAD. The US had built a skynet-like computer system to anticipate and respond to a possible Soviet nuclear strike. The computer took in all available information, and then projected forward to an endpoint. Given that outcome, it then calculated backward to find the optimal strategy for the present – ie the behaviour that would result in the most favourable endpoint for the US. It was all very complex. Game theory and binomial tree probabilities and matrices and everything.
Of course the computer calculated that nuclear war was more likely than not. Therefore the optimal strategy was to strike first, as striking second meant armageddon. But of course the Soviets would also have made the same calculation, and therefore the optimal strategy was to strike immediately. At this point the would-be skynet was hastily switched off.
We are in much the same situation. Sellers are eyeing one another nervously. No-one wants to sell because the valuations are so ‘unreasonable’. Books are being marked (somewhat) to market, under protest. But what if Bank A decides to close out its books, cover its hedges, and exit the market? Well the book value plummets, and the hedge moves against them, and liquidity evaporates. This will result in further writedowns, further forced selling, for everyone else. What is my optimal behaviour in this scenario? To sell first. All it takes is one counterparty to blink …
This is why the interbank market is struggling, why banks are hoarding capital, why the TAF auctions are a necessity, why CDS premiums and credit indices are soaring, why financial stocks are tanking, why the Fed is cutting rates as fast as it can. The entire system is in jeopardy.
posted by bookie at 11:30 PM on February 20, 2008
(1) that my counterparty is solvent and will meet his obligations,
(2) that there will always be liquidity (and a willing market) when I wish to buy and sell, and
(3) that the market will always behave rationally, with every market particpant an independent agent behaving without reference to other partipants.
All these assumptions, I believe, can be thrown out the window in the present environment.
(1) Solvent counterparties? The monolines have, in scale and effect, done the financial equivalent of me personally walking through New Orleans and promising to cover the entire state for flood damage the day before Hurricane Katrina. Insurance works from an actuarial standpoint only whilst the models assumptions hold. Sadly, as we continually rediscover, the models and assumptions are often imperfect. Taleb has written some belligerent but worthwhile books on the subject.
The problem is not the insurance itself but that the entire system is hinged upon a single point which is incapable of bearing the weight. So you end up with a situation where a company with a $5bn balance sheet is guaranteeing the equivalent of the entire mortgage and municipal bond book of the state of California. The sold insurance is worthless because you cannot collect when the insured event happens.
CDS is a joke. In the current environment you have more counterparty risk than you do risk of default – that is, the likelihood of the protection seller being overwhelmed by multiple claims is greater than the likelihood of any single corporate entity going under. In other words, statistically your insurer is more likely to go broke than the individual companies you are trying to protect yourself against, making the entire exercise a futile quant circle-jerk.
Why? The risk of any one of thousands of individual entities going under is remote, but when this risk is pooled and aggregated at a single point, the likelihood of multiple defaults overwhelming the protection seller is several orders of magnitude larger. Insurance does not eliminate risk, it passes it from the insured to the insurer. Now, rather than thousands of people worrying about hurricanes, we have thousands of people worrying whether the insurer will pay up should a hurricane happen. It’s three-card monty writ large. A fragile shell game. There is a reason that insurers exclude cover for terror and other tail events. The bond market is rediscovering why.
(2) What you really need, then, is insurance against the insurers. You may point to the protection sellers’ much-vaunted ‘hedging’ strategies and reinsurance as answers. In theory, yes. In reality? Heh. They’re good for mark-to-market and modelling purposes only. Witness the Adelphi example above. What do you think will happen to the hedges (eg short credit / long CDS index positions) when everyone rushes to cash them in? Their value reverses sharply. And yet the value of the toxic debt offset remains zero. Oops, hedge fails. I’d imagine that when it comes to cash-in time, most of the outstanding hedges are going to be good for about half of what they’re marked at. People seem to forget you need a buyer for every seller.
The only real insurance in this scenario comes in the form of government bailouts (witness Northern Rock in the UK). The impact on the currency and bond markets of this behaviour should be self-evident. Helicopter Ben is going to make an awful lot of joyflights before this is over …
(3) The credit market, as the Fed has noted, is in danger of entering a reflexive feedback loop where negative news begets further negative news, where forced selling begets forced selling begts forced selling. It reminds me of a (probably) apocryphal story about Cold War MAD. The US had built a skynet-like computer system to anticipate and respond to a possible Soviet nuclear strike. The computer took in all available information, and then projected forward to an endpoint. Given that outcome, it then calculated backward to find the optimal strategy for the present – ie the behaviour that would result in the most favourable endpoint for the US. It was all very complex. Game theory and binomial tree probabilities and matrices and everything.
Of course the computer calculated that nuclear war was more likely than not. Therefore the optimal strategy was to strike first, as striking second meant armageddon. But of course the Soviets would also have made the same calculation, and therefore the optimal strategy was to strike immediately. At this point the would-be skynet was hastily switched off.
We are in much the same situation. Sellers are eyeing one another nervously. No-one wants to sell because the valuations are so ‘unreasonable’. Books are being marked (somewhat) to market, under protest. But what if Bank A decides to close out its books, cover its hedges, and exit the market? Well the book value plummets, and the hedge moves against them, and liquidity evaporates. This will result in further writedowns, further forced selling, for everyone else. What is my optimal behaviour in this scenario? To sell first. All it takes is one counterparty to blink …
This is why the interbank market is struggling, why banks are hoarding capital, why the TAF auctions are a necessity, why CDS premiums and credit indices are soaring, why financial stocks are tanking, why the Fed is cutting rates as fast as it can. The entire system is in jeopardy.
posted by bookie at 11:30 PM on February 20, 2008
Rather than one obnoxiously large post, I thought I'd make one final point here: you seem to have this unshakeable faith in the ‘regulated’ nature of our banking system to ensure adequate regulatory capital. You dismiss the SIV’s as ‘muddying the waters’. Well I hate to break it to you - but friend, the waters ARE muddy.
As Malor notes, banks have been lending ever-increasing amounts against their capital base. They have been able to do this because their capital base – asset and house prices -were rising. If you have $100 and require a 5% capital ratio, you can lend $95. Let’s assume the banks have been prudent and secured these loans against $95 worth of property. If the asset values rise to 200, they can now lend $190 and still have their $10 (5%) in capital. Now assume asset values fall back to $150, a 25% correction (this is not an unreasonable assumption. Typical deflationary housing unwinds result in 60-80% revals – witness Japan, HK). All of a sudden you have $150 in assets, $190 in loans, and -$40 in capital. Regulatory breach. Oh noes.
In effect, the banks’ loan book has been exposed as a pyramid scheme – they keep doubling down as the market doubles, resulting in an exponentially greater loss (in magnitude) on the way down. Their capital base is gone, non-existent. To get it back in order they have to get $47.50 in debt off their books, presumably by foreclosure or factoring (onselling) the debt – but the forced selling drives the valuations down further, resulting in greater losses, resulting in your regulatory scheme requiring further forced selling – thus making things worse.
Repeat ad infinitum across the entire banking sector and you have a credit unwind / debt deflation on a massive scale. And this doesn’t take into account the SIV’s, which now must be brought back on balance-sheet a la Enron. Let’s say there’s another $10 outstanding against $7.50 in assets. Now you’re $157.50 assets against $200 in loans and -$43.50 in the hole, requiring $51.375 in asset sales to get your house back in order. Only an incremental negative, but it doesn’t help.
What all this means is that –
(1) banks must rein in their loan books, and fast, meaning less capital is available to the market (and, despite the Fed cutting rates, it remains relatively expensive to the end-user). So borrowers either cannot access capital to run their business or buy with asset values collapsing around them, or the cost of doing so remains high, or loan requirements become more stringent (eg LTV’s max out at 80%). This removes a key support for inflated asset prices – buyers, even if willing, cannot buy at current prices with forced sellers everywhere.
(2) All this is further complicated by the banks’ practice of writing puts against their MBS exposure, guaranteeing to ‘take back’ the paper from the holder should the unthinkable happen and asset prices fall by 20-25%. Well the unthinkable is happening, and Citi (amongst others) are going to find themselves once again saddled with a pile of marked-down inventory they thought they’d offloaded years ago. Who do they think they’re going to sell it on to now?
(3) Any major default event – such as a monoline downgrade (despite Moody’s best efforts to sidestep this overnight) will result in forced selling of MBS, ABCP, muni bonds etc etc etc by pension funds that are required to hold only AAA debt. The current ratings are obviously not worth the paper they’re printed on, and markets can only sustain illusion for so long. Again: who are they going to sell to?
(4) The real danger of the capital writedowns is that Joe Sixpack gets nervous and decides to stick his cash under the mattress rather than leaving it with Bank A. The banks, in our example, only have a $10 buffer with asset prices at highs – which clearly they are not. If the public withdraws part of their deposit base – let’s say just $2 of $200 is taken back – due to multiplier effects the bank then has to sell another $10 in assets to maintain their capital ratios. Thus: more pressure on asset prices. The multiplers mean this step must be avoided at all costs. Once started, the game will unwind too fast to stop (as Northern Rock recently discovered).
The endpoint to my mind is a government (read: taxpayer-funded) bailout to short-circuit the negative feedback loop. The assets must pass from weak hands to strong, the single point of failure be removed from the market, the banks cut back to bare bones, slowly rebuilding their balance sheets off the steeper yield curve, and the growth cycle can begin anew ... in a decade or so.
Frankly, the government is the only entity with a balance sheet large enough to absorb the losses. Not that this is a ‘good’ outcome, but anything else results in disaster. Nothing comes without cost. The USD tanks, the long-end of the bond market sells off (meaning higher real rates for mortgages etc in the US however low the short rates, with the Fed thus somewhat hamstrung in their ability to pass through cheaper rates to the end consumer), and the US consumer themselves take it in the neck (with consequent implications for domestic and global growth). So bad news, but a hole we can dig our way out of. What is left of the financial markets after all this comes to pass I watch with some interest.
posted by bookie at 11:35 PM on February 20, 2008 [1 favorite]
As Malor notes, banks have been lending ever-increasing amounts against their capital base. They have been able to do this because their capital base – asset and house prices -were rising. If you have $100 and require a 5% capital ratio, you can lend $95. Let’s assume the banks have been prudent and secured these loans against $95 worth of property. If the asset values rise to 200, they can now lend $190 and still have their $10 (5%) in capital. Now assume asset values fall back to $150, a 25% correction (this is not an unreasonable assumption. Typical deflationary housing unwinds result in 60-80% revals – witness Japan, HK). All of a sudden you have $150 in assets, $190 in loans, and -$40 in capital. Regulatory breach. Oh noes.
In effect, the banks’ loan book has been exposed as a pyramid scheme – they keep doubling down as the market doubles, resulting in an exponentially greater loss (in magnitude) on the way down. Their capital base is gone, non-existent. To get it back in order they have to get $47.50 in debt off their books, presumably by foreclosure or factoring (onselling) the debt – but the forced selling drives the valuations down further, resulting in greater losses, resulting in your regulatory scheme requiring further forced selling – thus making things worse.
Repeat ad infinitum across the entire banking sector and you have a credit unwind / debt deflation on a massive scale. And this doesn’t take into account the SIV’s, which now must be brought back on balance-sheet a la Enron. Let’s say there’s another $10 outstanding against $7.50 in assets. Now you’re $157.50 assets against $200 in loans and -$43.50 in the hole, requiring $51.375 in asset sales to get your house back in order. Only an incremental negative, but it doesn’t help.
What all this means is that –
(1) banks must rein in their loan books, and fast, meaning less capital is available to the market (and, despite the Fed cutting rates, it remains relatively expensive to the end-user). So borrowers either cannot access capital to run their business or buy with asset values collapsing around them, or the cost of doing so remains high, or loan requirements become more stringent (eg LTV’s max out at 80%). This removes a key support for inflated asset prices – buyers, even if willing, cannot buy at current prices with forced sellers everywhere.
(2) All this is further complicated by the banks’ practice of writing puts against their MBS exposure, guaranteeing to ‘take back’ the paper from the holder should the unthinkable happen and asset prices fall by 20-25%. Well the unthinkable is happening, and Citi (amongst others) are going to find themselves once again saddled with a pile of marked-down inventory they thought they’d offloaded years ago. Who do they think they’re going to sell it on to now?
(3) Any major default event – such as a monoline downgrade (despite Moody’s best efforts to sidestep this overnight) will result in forced selling of MBS, ABCP, muni bonds etc etc etc by pension funds that are required to hold only AAA debt. The current ratings are obviously not worth the paper they’re printed on, and markets can only sustain illusion for so long. Again: who are they going to sell to?
(4) The real danger of the capital writedowns is that Joe Sixpack gets nervous and decides to stick his cash under the mattress rather than leaving it with Bank A. The banks, in our example, only have a $10 buffer with asset prices at highs – which clearly they are not. If the public withdraws part of their deposit base – let’s say just $2 of $200 is taken back – due to multiplier effects the bank then has to sell another $10 in assets to maintain their capital ratios. Thus: more pressure on asset prices. The multiplers mean this step must be avoided at all costs. Once started, the game will unwind too fast to stop (as Northern Rock recently discovered).
The endpoint to my mind is a government (read: taxpayer-funded) bailout to short-circuit the negative feedback loop. The assets must pass from weak hands to strong, the single point of failure be removed from the market, the banks cut back to bare bones, slowly rebuilding their balance sheets off the steeper yield curve, and the growth cycle can begin anew ... in a decade or so.
Frankly, the government is the only entity with a balance sheet large enough to absorb the losses. Not that this is a ‘good’ outcome, but anything else results in disaster. Nothing comes without cost. The USD tanks, the long-end of the bond market sells off (meaning higher real rates for mortgages etc in the US however low the short rates, with the Fed thus somewhat hamstrung in their ability to pass through cheaper rates to the end consumer), and the US consumer themselves take it in the neck (with consequent implications for domestic and global growth). So bad news, but a hole we can dig our way out of. What is left of the financial markets after all this comes to pass I watch with some interest.
posted by bookie at 11:35 PM on February 20, 2008 [1 favorite]
Frankly, the government is the only entity with a balance sheet large enough to absorb the losses. Not that this is a ‘good’ outcome, but anything else results in disaster.
This will result in a disaster even more profound. It will be slower, but the destruction will be absolute.
The market must be allowed to clear without interference.
This won't happen, and things will just keep getting worse until it can't be kept up any longer, even by the government. If we just let things fail now, we'll be poor, but we'll survive. If we try to prop up these bad business models, we will slowly bleed entirely to death.
posted by Malor at 2:27 AM on February 21, 2008
This will result in a disaster even more profound. It will be slower, but the destruction will be absolute.
The market must be allowed to clear without interference.
This won't happen, and things will just keep getting worse until it can't be kept up any longer, even by the government. If we just let things fail now, we'll be poor, but we'll survive. If we try to prop up these bad business models, we will slowly bleed entirely to death.
posted by Malor at 2:27 AM on February 21, 2008
I like this analysis piece in today's FT. Slightly gloomy, but not quite as gloomy as Malor...
posted by patricio at 4:24 AM on February 21, 2008
posted by patricio at 4:24 AM on February 21, 2008
patricio"I think there's perhaps more to this point that you allow. The availability of the CLO market was a (if not the) main driver in the substantial weakening of covenants in leveraged loans for a couple of years. Originating banks were so confident that they weren't going to have to keep any of the loan on their books that they acquiesced to extraordinary cov-lite/no cov documentation."
We I do have a problem with the "originate to syndicate" model that some (but not all) of the market seems to have migrated to . In fact I'd posted this view previously, as a follow up on some comments I made to Business Week back in early 2006. So this problem has indeed been on my radar screen for a while, and as much as I share concerns with folks posting here I think we clearly differ to some extent on the degree of the problem (some operational, market / instrument specific issues aside).
For example, I don't believe that all banks now syndicate all of their loans. And yet one might get that impression reading this and some of the other FPPs on similar topics. So it's important that we start to categorise what we all (myself included) previously have been referring to as "the market".
The credit markets aren't monolithic by any stretch of the imagination, and when someone talks about "lending freezing up", they're really addressing a specific segment of this market. There are different participants in the market, few operate across all segments (at least fully, some have a minor presence in all as part of the price discovery mechanism banks and other FIs routinely engage in) and in fact all will have business plans focusing and detailing their activites into the specific sub-market they're working in. Some credit market participants will only operate at the retail mortgage level, some will only loan to small business, while others only lend to multinational, Someone in another one of these FPPs raised the spectre of The Great Depression, where banks and other market participants refused to lend. Well, as horrible as that would be (and a great irony, considering Bernanke is a a student of the big one and has openly spoke of his wish to be handed a depression class problem to fix) I'm not sure if that is likely to happen today.
For example and looking only at corporate lending, last summer while we did see freeze ups in some segments of the credit markets (e.g., small caps, say $50M and lower), the middle market (loans of about $200M to maybe $400M) did ok, ample liquidity, no real signs of stress. The large cap segment did indeed totally freeze up in terms of new origination; while there were still large deals announced and in motion that completed during Q4 (Texas Utility is one that comes to mind). But this was because the participants could no longer move the paper so now it seems there is a renewed emphasis on the "originate to service" model, which I'm sure we'll agree is a positive, but anyone reading this thread would also agree this development - this change in business practices by market participants, has largely been ignored by folks posting.
I guess my point is the markets are dynamic, participants want to do biz, and will change how they go about their activites accordingly. Folks are finding it hard to offload paper now. But their customers still want to do deals. So they change their business somewhat, and hold the debt. Great. Change to suit a changing market. That's what it's all about.
"Your comments on Noland are interesting too, thanks."
Yeh, I actually like some (well, a lot) of his work but I needed to make the point that he's hardly without bias, and perhaps could be accused of the same bias other folks would want to attribute to people who are actually doing CDO structuring for a living.
Malor -- "What I think of as being a problem is the example of a relatively small-time player who sells default protection on a high-risk tranche in a CDO, and hedges by buying protection on the low-risk tranche, reasoning that if one blows up, the other has to as well, so the big players will make him whole and he can make his customers whole."
Now that's an interesting trade and it does indeed seem like a money machine. But you've hit the nail on the head with the phrase small time player. How many trades like you're describing can such an entity do? I certainly don't know but I do know that the Tier 1 banks very, very carefully scrutinise all counterparties, and especially so in these tough times for the possible outcome you're detailed. Some desks are sharply cutting back counterparty limits or markedly increasing collateral as insurance against precisely this (and a wide range of other) eventualities.
"You can ignore the crux of my argument if you wish, but of course a good chunk of my position falls apart if you do."
Gosh Malor I'm not ignoring it I'm just trying to rationalise it somewhat as gravity does indeed apply in the Captial Markets; banks are obliged to hold regulatory capital to support positions. The amount of captial is a function of multiple variables, a very complex area but (and I like to keep things simple as I'm easily confused) it boils down to probability of default - the riskier the asset, the more captial is required on balance sheet to support the position. Banks don't have a choice. They have to set aside this capital. Its not optional (however the amounts involved are frequently the subject of prolonged discussion with the regulators).
That point seems to be ignored in this (and other FPPs on similar topics), and someone uninformed on the topic would probably walk away thinking banks had a free reign, and can litterally take on positions without regard to risk as they'd like - a crap shoot, by any other name. And that's not how these markets work. I still refer back to the point that I made previously - banks are highly regulated. And that's nothing the banks like, mind you, its just that submitting to said regulation is the price of a banking license, especially so in OECD class nations. Of course I'm blissfully ignoring the developing world, where a Class B license can be bought for perhaps $50K, and a similarly low level of equity capital needed, but Basel II has forced many banks in many of these countries to sharpen business practices and bring regulatory capital up to OECD levels, otherwise biz opps would evaporate. I only mention this as in the past there were concerns that shaky banks in the developing world could bring down a OECD institution or two, but the regulatory community has moved to address this.
"...crappy loans get 'cleaned up'... "
I'm sorry, that's not correct - loans are not "cleaned up" - low grade loans can be packed into tranches. The tranches will still contain sub grade loans, but because of the way the overall product has been structured, some of the higher level tranches carry higher level credit ratings.
"After being purchased, they become assets again and can be lent against. "
I just don't know myself how much repo activity is going on using CDO tranches as collateral. But once again, unfortunately overlooked, is the fact that the CDO tranches does indeed have value. It's not worthless, by any stretch of the imagination. So what's the problem? I did a quick google and I certainly can't find any authoritative source that mentions the repo market making significant use ot CDO tranches as collateral (well, a few blogs definitely mention this but I think we'll all benefit if an authoritative source could be found … )
"...reserve rates are already very low (2.5%, I think)..."
Well, now I suspect we're talking about two different things - reserve rates are liquid banks are required to keep to support cash and cash like deposits . What applies with the instruments under discussion, and what I've been referring to is Economic Capital, money that banks and other market participants are required to set aside to support positions in the capital markets . Basel II takes a pretty hard line on this, we've recently integrated Operational Risk into the mix (joining Market and Credit Risk). And once again, banks can't assume positions in the market without setting this capital aside to guard against loss. This is a point that now I fear has been broadly missed.
"...so much of this stuff doesn't show in M3..."
Well, we've touched up my opinion regarding this in a previous thread - in my personal accounts I went long gold in 2005 and silver in 2006, both physical metal as these trades predated the ETFs. I added another 6K ounces of Silver (SLV, and ETF this time) about six weeks ago, this time in my retirement account, as I share your view on the obfuscation of M3. I say "obfuscation" as I've seen some academic papers where folks have backed into M3 using other data still available; we're looking at YOY growth since they stopped announcing this statistic of (off the top of my head mind you) 15% to 20% or so. Applying the Rule of 72 we see that the real value of the dollar would be halved in about three years.
"Basically, a lot of your argument seems to be 'no, no, you're all wrong', using the established models and arguments to refute us. Which is okay, and it's obvious that you know them a lot better than I do, at least. "
Oh now come on! I've tried to engage in dialog and debate, knowing what I know, and I've never once said - even implied - "no, no you're all wrong". 'Cause it ain't like that. You've got a view and so do I. And I'm sure you're not suggesting that I shouldn't add to the discussion by leveraging off of and adding my personal knowledge. I said in an earlier thread I'm suspicious of self proclaimed experts in finance, the field is just too broad. But when someone makes a statement like "The GSE's have unlimited credit" I'm entitled to disagree and illustrate why I don't believe this (or any other argument to hold).
"But I'd ask you... if all this stuff is really true, and it's all safe as houses.... then why do we have all these bubbles? And why is the system disintegrating before our eyes?"
Well, I never said any capital market activity was "as safe as houses". But I would suggest a wee bit more safer than some folks here post. Ah but the bubbles you ask? Well, pal if I knew the answer to that question I wouldn't be posting on MeTa as you folks would be watching me collecting my Noble Prize (and thanking my colleagues on MeTa for engaging debate); there has been so much damn money poured into behavioral finance over the years but no answers. Must be terribly frustrating for some, as every five years or so you'll hear about some fund with some star who has some insight raising capital as they've finally solved the puzzle. And inevitably the liquidate a few short years later. In terms of the system "disintegrating",
"Overall, most fundamentally: we've redesigned our financial system into a casino instead of an investment allocation mechanism. Even you used that word up there, Mutant. "
Now this is the type of hyperbole that's unacceptable. The entire financial system as a casino? I don't think so; I put my money in HSBC, I get X%. Nothing probabilistic about that return, as in a casino. I take out a loan, and pay Y%. As I generall borrow fixed, no worries. I purchase shares or bonds - yep, relative certainty. Nothing casino like going on. I take my wife down to Monaco for the weekend - now that's casino country. I understand what you're trying to say, but the way you said it is an exaggeration, full stop. And I realise this was a typo, but I never said "casino"
bookie -- "under normal market conditions, is very reminiscent of the Meriwether rationalisation for the LTCM debacle in times of stress."
Maybe so, but as I was querying above, how - and bear with me before answering this - abnormal are the market conditions now ? And look at the bigger picture, not just focusing on retail mortgage defaults as they get all the headlines.
Sure, we're seeing - as you've pointed out - default swap premiums hitting record levels (a good thing in my view as risk is being priced accordingly) but that's only one side of the equation - what about defaults? Someone upthread mentioned that credit events were NOT being triggered. Corporate bankruptcies are predicted to roughly double, but as liquidity has been so available for so long many feel corporate insolvency has been artificially depressed by the cheap money. So a little taste of Malor's medicine here - let 'em go bankrupt! But I still don't think we're seeing - as has been claimed in this or other FPPs on the topic - systemic wipeouts of capital. Banks are operating. Retail money is seeing a lot bankruptcys, but as I opined to Business Week and this will no doubt sound harsh - they didn't deserve the loans. They shouldn't have gotten the loans. Folks should ONLY be sold 30 year fixed rate, 80% LTV mortgages for their primary residence. Full stop.
So I agree, folks are nervous. But I think The Fed and other Central Banks are doing a great job of calming the markets down. In fact ECB refused to cut which from my viewpoint shows the focus is more on inflation and less on liquidity, at least in Europe. So another vote against the G7 sliding into a systemic crisis.
"you seem to have this unshakeable faith in the ‘regulated’ nature of our banking system to ensure adequate regulatory capital. You dismiss the SIV’s as ‘muddying the waters’. Well I hate to break it to you - but friend, the waters ARE muddy."
Well, two points here. Yes, I have faith, it's by no means unshakable, but I do believe in the systems resilience and also know that banks worry - and have worried - about this stuff long before bloggers picked up on it. Just because bloggers don't know what banks and the various regulatory agencies are up to regarding these problems by no means implies that NOTHING is being done. Quite the contrary, I'd argue. The problem keeps people awake at night, but it is being solved - much of the work behind closed doors - but its being taken care.
And in terms of regulation - well, nobody seems to have acknowledged nor been aware before I raised the point that CDS', as well as other derivatives, MUST be supported by regulatory capital. Some confusion I clarified in this response alone proves that to me. No, banks aren't free to do whatever they'd like, take whatever risks they'd like, make money make money make money until they lose money. And then get a taxpayer bailout. Just doesn't work that way. Take a position only if you've got the money to assume that position AND support that position.
Finally, I only suggested we not talk about SIV's as they're a complication we don't need when folks aren't cognizant of nor acknoweldge the existance of regulatory capital requirements. Which were NOT as strong back in 1929, I'll point out.
"...In effect, the banks’ loan book has been exposed as a pyramid scheme – they keep doubling down as the market doubles, ..."
Now this is a point that I agree with somewhat, but, like other views, its a question of degree. No doubt this is true to some extent, but I'd disagree about repeatedly doubling down. I'd like to see some data supporting the position that this has happened to such a large extent. Even now we're seeing banks report earnings and yes, some are being whacked - big time. But others are flat on earnings or even up. It gets back to my point from yesterday - the market's not monolithic, all parties moving with a single view. There are a wide range of participants, each with their own risk / reward preference, each with their own view of past, current and future events. And planning / acting accordingly. Your example would only systemically be valid if ALL participants engaged in such behaviour. And we know this isn't true as while some banks are reporting losses others are not. How it shakes out over time remains to be seen, but now? Nope, we're seeing winners and we're seeing losers.
I'd also agree with Malor's point about a government bail out. Lots of speculators sitting on the sidelines with cash, just waiting for the right price. Don't want to rob them of their feast, you know.
patricio -- Yeh, I read that piece as well. Malor and I are going team up to write one and submit it to FT. Between my over the top optimism and hisgloominess realism, we'll have a market neutral article published.
posted by Mutant at 10:18 AM on February 21, 2008
We I do have a problem with the "originate to syndicate" model that some (but not all) of the market seems to have migrated to . In fact I'd posted this view previously, as a follow up on some comments I made to Business Week back in early 2006. So this problem has indeed been on my radar screen for a while, and as much as I share concerns with folks posting here I think we clearly differ to some extent on the degree of the problem (some operational, market / instrument specific issues aside).
For example, I don't believe that all banks now syndicate all of their loans. And yet one might get that impression reading this and some of the other FPPs on similar topics. So it's important that we start to categorise what we all (myself included) previously have been referring to as "the market".
The credit markets aren't monolithic by any stretch of the imagination, and when someone talks about "lending freezing up", they're really addressing a specific segment of this market. There are different participants in the market, few operate across all segments (at least fully, some have a minor presence in all as part of the price discovery mechanism banks and other FIs routinely engage in) and in fact all will have business plans focusing and detailing their activites into the specific sub-market they're working in. Some credit market participants will only operate at the retail mortgage level, some will only loan to small business, while others only lend to multinational, Someone in another one of these FPPs raised the spectre of The Great Depression, where banks and other market participants refused to lend. Well, as horrible as that would be (and a great irony, considering Bernanke is a a student of the big one and has openly spoke of his wish to be handed a depression class problem to fix) I'm not sure if that is likely to happen today.
For example and looking only at corporate lending, last summer while we did see freeze ups in some segments of the credit markets (e.g., small caps, say $50M and lower), the middle market (loans of about $200M to maybe $400M) did ok, ample liquidity, no real signs of stress. The large cap segment did indeed totally freeze up in terms of new origination; while there were still large deals announced and in motion that completed during Q4 (Texas Utility is one that comes to mind). But this was because the participants could no longer move the paper so now it seems there is a renewed emphasis on the "originate to service" model, which I'm sure we'll agree is a positive, but anyone reading this thread would also agree this development - this change in business practices by market participants, has largely been ignored by folks posting.
I guess my point is the markets are dynamic, participants want to do biz, and will change how they go about their activites accordingly. Folks are finding it hard to offload paper now. But their customers still want to do deals. So they change their business somewhat, and hold the debt. Great. Change to suit a changing market. That's what it's all about.
"Your comments on Noland are interesting too, thanks."
Yeh, I actually like some (well, a lot) of his work but I needed to make the point that he's hardly without bias, and perhaps could be accused of the same bias other folks would want to attribute to people who are actually doing CDO structuring for a living.
Malor -- "What I think of as being a problem is the example of a relatively small-time player who sells default protection on a high-risk tranche in a CDO, and hedges by buying protection on the low-risk tranche, reasoning that if one blows up, the other has to as well, so the big players will make him whole and he can make his customers whole."
Now that's an interesting trade and it does indeed seem like a money machine. But you've hit the nail on the head with the phrase small time player. How many trades like you're describing can such an entity do? I certainly don't know but I do know that the Tier 1 banks very, very carefully scrutinise all counterparties, and especially so in these tough times for the possible outcome you're detailed. Some desks are sharply cutting back counterparty limits or markedly increasing collateral as insurance against precisely this (and a wide range of other) eventualities.
"You can ignore the crux of my argument if you wish, but of course a good chunk of my position falls apart if you do."
Gosh Malor I'm not ignoring it I'm just trying to rationalise it somewhat as gravity does indeed apply in the Captial Markets; banks are obliged to hold regulatory capital to support positions. The amount of captial is a function of multiple variables, a very complex area but (and I like to keep things simple as I'm easily confused) it boils down to probability of default - the riskier the asset, the more captial is required on balance sheet to support the position. Banks don't have a choice. They have to set aside this capital. Its not optional (however the amounts involved are frequently the subject of prolonged discussion with the regulators).
That point seems to be ignored in this (and other FPPs on similar topics), and someone uninformed on the topic would probably walk away thinking banks had a free reign, and can litterally take on positions without regard to risk as they'd like - a crap shoot, by any other name. And that's not how these markets work. I still refer back to the point that I made previously - banks are highly regulated. And that's nothing the banks like, mind you, its just that submitting to said regulation is the price of a banking license, especially so in OECD class nations. Of course I'm blissfully ignoring the developing world, where a Class B license can be bought for perhaps $50K, and a similarly low level of equity capital needed, but Basel II has forced many banks in many of these countries to sharpen business practices and bring regulatory capital up to OECD levels, otherwise biz opps would evaporate. I only mention this as in the past there were concerns that shaky banks in the developing world could bring down a OECD institution or two, but the regulatory community has moved to address this.
"...crappy loans get 'cleaned up'... "
I'm sorry, that's not correct - loans are not "cleaned up" - low grade loans can be packed into tranches. The tranches will still contain sub grade loans, but because of the way the overall product has been structured, some of the higher level tranches carry higher level credit ratings.
"After being purchased, they become assets again and can be lent against. "
I just don't know myself how much repo activity is going on using CDO tranches as collateral. But once again, unfortunately overlooked, is the fact that the CDO tranches does indeed have value. It's not worthless, by any stretch of the imagination. So what's the problem? I did a quick google and I certainly can't find any authoritative source that mentions the repo market making significant use ot CDO tranches as collateral (well, a few blogs definitely mention this but I think we'll all benefit if an authoritative source could be found … )
"...reserve rates are already very low (2.5%, I think)..."
Well, now I suspect we're talking about two different things - reserve rates are liquid banks are required to keep to support cash and cash like deposits . What applies with the instruments under discussion, and what I've been referring to is Economic Capital, money that banks and other market participants are required to set aside to support positions in the capital markets . Basel II takes a pretty hard line on this, we've recently integrated Operational Risk into the mix (joining Market and Credit Risk). And once again, banks can't assume positions in the market without setting this capital aside to guard against loss. This is a point that now I fear has been broadly missed.
"...so much of this stuff doesn't show in M3..."
Well, we've touched up my opinion regarding this in a previous thread - in my personal accounts I went long gold in 2005 and silver in 2006, both physical metal as these trades predated the ETFs. I added another 6K ounces of Silver (SLV, and ETF this time) about six weeks ago, this time in my retirement account, as I share your view on the obfuscation of M3. I say "obfuscation" as I've seen some academic papers where folks have backed into M3 using other data still available; we're looking at YOY growth since they stopped announcing this statistic of (off the top of my head mind you) 15% to 20% or so. Applying the Rule of 72 we see that the real value of the dollar would be halved in about three years.
"Basically, a lot of your argument seems to be 'no, no, you're all wrong', using the established models and arguments to refute us. Which is okay, and it's obvious that you know them a lot better than I do, at least. "
Oh now come on! I've tried to engage in dialog and debate, knowing what I know, and I've never once said - even implied - "no, no you're all wrong". 'Cause it ain't like that. You've got a view and so do I. And I'm sure you're not suggesting that I shouldn't add to the discussion by leveraging off of and adding my personal knowledge. I said in an earlier thread I'm suspicious of self proclaimed experts in finance, the field is just too broad. But when someone makes a statement like "The GSE's have unlimited credit" I'm entitled to disagree and illustrate why I don't believe this (or any other argument to hold).
"But I'd ask you... if all this stuff is really true, and it's all safe as houses.... then why do we have all these bubbles? And why is the system disintegrating before our eyes?"
Well, I never said any capital market activity was "as safe as houses". But I would suggest a wee bit more safer than some folks here post. Ah but the bubbles you ask? Well, pal if I knew the answer to that question I wouldn't be posting on MeTa as you folks would be watching me collecting my Noble Prize (and thanking my colleagues on MeTa for engaging debate); there has been so much damn money poured into behavioral finance over the years but no answers. Must be terribly frustrating for some, as every five years or so you'll hear about some fund with some star who has some insight raising capital as they've finally solved the puzzle. And inevitably the liquidate a few short years later. In terms of the system "disintegrating",
"Overall, most fundamentally: we've redesigned our financial system into a casino instead of an investment allocation mechanism. Even you used that word up there, Mutant. "
Now this is the type of hyperbole that's unacceptable. The entire financial system as a casino? I don't think so; I put my money in HSBC, I get X%. Nothing probabilistic about that return, as in a casino. I take out a loan, and pay Y%. As I generall borrow fixed, no worries. I purchase shares or bonds - yep, relative certainty. Nothing casino like going on. I take my wife down to Monaco for the weekend - now that's casino country. I understand what you're trying to say, but the way you said it is an exaggeration, full stop. And I realise this was a typo, but I never said "casino"
bookie -- "under normal market conditions, is very reminiscent of the Meriwether rationalisation for the LTCM debacle in times of stress."
Maybe so, but as I was querying above, how - and bear with me before answering this - abnormal are the market conditions now ? And look at the bigger picture, not just focusing on retail mortgage defaults as they get all the headlines.
Sure, we're seeing - as you've pointed out - default swap premiums hitting record levels (a good thing in my view as risk is being priced accordingly) but that's only one side of the equation - what about defaults? Someone upthread mentioned that credit events were NOT being triggered. Corporate bankruptcies are predicted to roughly double, but as liquidity has been so available for so long many feel corporate insolvency has been artificially depressed by the cheap money. So a little taste of Malor's medicine here - let 'em go bankrupt! But I still don't think we're seeing - as has been claimed in this or other FPPs on the topic - systemic wipeouts of capital. Banks are operating. Retail money is seeing a lot bankruptcys, but as I opined to Business Week and this will no doubt sound harsh - they didn't deserve the loans. They shouldn't have gotten the loans. Folks should ONLY be sold 30 year fixed rate, 80% LTV mortgages for their primary residence. Full stop.
So I agree, folks are nervous. But I think The Fed and other Central Banks are doing a great job of calming the markets down. In fact ECB refused to cut which from my viewpoint shows the focus is more on inflation and less on liquidity, at least in Europe. So another vote against the G7 sliding into a systemic crisis.
"you seem to have this unshakeable faith in the ‘regulated’ nature of our banking system to ensure adequate regulatory capital. You dismiss the SIV’s as ‘muddying the waters’. Well I hate to break it to you - but friend, the waters ARE muddy."
Well, two points here. Yes, I have faith, it's by no means unshakable, but I do believe in the systems resilience and also know that banks worry - and have worried - about this stuff long before bloggers picked up on it. Just because bloggers don't know what banks and the various regulatory agencies are up to regarding these problems by no means implies that NOTHING is being done. Quite the contrary, I'd argue. The problem keeps people awake at night, but it is being solved - much of the work behind closed doors - but its being taken care.
And in terms of regulation - well, nobody seems to have acknowledged nor been aware before I raised the point that CDS', as well as other derivatives, MUST be supported by regulatory capital. Some confusion I clarified in this response alone proves that to me. No, banks aren't free to do whatever they'd like, take whatever risks they'd like, make money make money make money until they lose money. And then get a taxpayer bailout. Just doesn't work that way. Take a position only if you've got the money to assume that position AND support that position.
Finally, I only suggested we not talk about SIV's as they're a complication we don't need when folks aren't cognizant of nor acknoweldge the existance of regulatory capital requirements. Which were NOT as strong back in 1929, I'll point out.
"...In effect, the banks’ loan book has been exposed as a pyramid scheme – they keep doubling down as the market doubles, ..."
Now this is a point that I agree with somewhat, but, like other views, its a question of degree. No doubt this is true to some extent, but I'd disagree about repeatedly doubling down. I'd like to see some data supporting the position that this has happened to such a large extent. Even now we're seeing banks report earnings and yes, some are being whacked - big time. But others are flat on earnings or even up. It gets back to my point from yesterday - the market's not monolithic, all parties moving with a single view. There are a wide range of participants, each with their own risk / reward preference, each with their own view of past, current and future events. And planning / acting accordingly. Your example would only systemically be valid if ALL participants engaged in such behaviour. And we know this isn't true as while some banks are reporting losses others are not. How it shakes out over time remains to be seen, but now? Nope, we're seeing winners and we're seeing losers.
I'd also agree with Malor's point about a government bail out. Lots of speculators sitting on the sidelines with cash, just waiting for the right price. Don't want to rob them of their feast, you know.
patricio -- Yeh, I read that piece as well. Malor and I are going team up to write one and submit it to FT. Between my over the top optimism and his
posted by Mutant at 10:18 AM on February 21, 2008
it boils down to probability of default
i'd add severity of loss upon default...
any authoritative source that mentions the repo market making significant use ot CDO tranches as collateral
dunno if this counts, but in the FT's lex today on central bank lending:
something that I won't say has been going on below the radar, very few people seem to grasp the significance of
wait, so short of managing a SWF itself, a global macro fund could just go "what would a SWF do?" and then do it (before they do)? that's your theory? :P
No, it really isn't, because seat belts actually mitigate risk. Derivatives don't.
well what if everyone drives faster because of the perceived safety that seat belts/air bags provide? it's not like people's reaction times are better... look, i'm not saying they do, i don't know; i'm just saying it's debatable :P
that is all!
oh hey, or like, i also heard that the introduction of helmets and pads to american football allowed the hits to come harder; obviously it doesn't make you invulnerable, but if you believe it provides partial protection/immunity you might be willing to take more chances, which may just mean you've 'hidden' the risks. all the concussions you avoided let you stay in the game and extend your playing career, but the repeated hits turned out to have cumulative health repercussions down the road.
now arguably you could make the causal connection and blame helmets and pads for an increase in certain types of injuries (and perhaps the decreased risk of others), certainly they changed the game, but objectively speaking it also took a change in behaviour, perhaps not understanding all the risks and without a full appreciation of 'unintended' consequences.
it's not sufficient enough to say CDS or derivatives in general increase risk, when it depends on how they're used, when outcomes are simultaneously determined. would you say the same thing about options? again i think the main difference is probably that they're better understood (behaving predictably under a range of circumstances) and can be used with a higher degree of confidence.
by the same token, if recent events have gotten everyone to double and triple check their counterparty risks and engage in due diligence (after the fact) wouldn't you think that would help lower overall systemic risk? i'm with mutant (again) -- markets are complex adaptive systems.
maybe i'm trying to be overly nuanced and putting too fine a point on this, but i think it's important; the fault isn't in our stars, etc. like when quants can self-assuredly proclaim: "We were seeing things that were 25-standard deviation moves, several days in a row."
are you sure? absolutely 100% (or at least 'to the nines') positive? could it be your black box model of the world doesn't consider all the other black boxes mushrooming out in the woods, and so the leverage employed so boldly upon a correlation matrix during "normal" times (e.g. a world where home prices never decline) implodes as correlations go to one? but then, if not, why are you absolutely certain that we're all going to hell and utterly undeserving of salvation?
btw, the flood insurance analogy also works for 'fake alpha' and bankers' pay :P
cheers!
posted by kliuless at 7:21 PM on February 21, 2008
i'd add severity of loss upon default...
any authoritative source that mentions the repo market making significant use ot CDO tranches as collateral
dunno if this counts, but in the FT's lex today on central bank lending:
All central banks are facing difficult choices in how to deal with the credit crunch. The European Central Bank is widely regarded as having responded effectively. But worries are growing that its success at easing liquidity constraints has come at the price of accepting low-quality assets, particularly mortgage-backed securities, as collateral.moot? also note what the fed accepts versus the ECB and BoE; everything!
Europe’s banks have pledged increasing amounts of asset-backed securities (ABS) as collateral against borrowing from the ECB. By the end of September, ABS represented 17 per cent, or €215bn, of €1,300bn total eurosystem collateral, up from 12 per cent in 2006 and zero in 2003. The Bank of Spain, one of the few national central banks to provide updated information in advance of the ECB itself next month, says net lending by the ECB to Spanish banks, much of it presumably ABS-collateralised, has increased from €18bn in August to €40bn in January.
The ECB itself points out that, compared to other central banks, it accepts a high volume of “private label” ABS, which are not government-guaranteed. The Fed has even looser eligibility criteria, but the BoE is stricter – although it did temporarily ease the rules in September and December. All three central banks apply a “haircut” to securities which subtracts a percentage of their market value according to maturity and type. And if collateral, which is revalued daily, no longer meets the eligibility criteria, borrowing banks must stump up an acceptable substitute. What happens, though, if other collateral is unavailable, is moot.
The ECB, to a certain extent, is a victim of its history and the need to amalgamate eligibility criteria from 17 national central banks. It is clearly aware of the dangers of its approach – in 2006 it tightened up the criteria for structured finance products, for example allowing only the most senior ABS tranches to be eligible. But the ECB is caught between a rock and a hard place – if it does not tighten the rules, it could face losses on low-quality collateral. But if it does, liquidity could well seize up again.
something that I won't say has been going on below the radar, very few people seem to grasp the significance of
wait, so short of managing a SWF itself, a global macro fund could just go "what would a SWF do?" and then do it (before they do)? that's your theory? :P
No, it really isn't, because seat belts actually mitigate risk. Derivatives don't.
well what if everyone drives faster because of the perceived safety that seat belts/air bags provide? it's not like people's reaction times are better... look, i'm not saying they do, i don't know; i'm just saying it's debatable :P
that is all!
oh hey, or like, i also heard that the introduction of helmets and pads to american football allowed the hits to come harder; obviously it doesn't make you invulnerable, but if you believe it provides partial protection/immunity you might be willing to take more chances, which may just mean you've 'hidden' the risks. all the concussions you avoided let you stay in the game and extend your playing career, but the repeated hits turned out to have cumulative health repercussions down the road.
now arguably you could make the causal connection and blame helmets and pads for an increase in certain types of injuries (and perhaps the decreased risk of others), certainly they changed the game, but objectively speaking it also took a change in behaviour, perhaps not understanding all the risks and without a full appreciation of 'unintended' consequences.
it's not sufficient enough to say CDS or derivatives in general increase risk, when it depends on how they're used, when outcomes are simultaneously determined. would you say the same thing about options? again i think the main difference is probably that they're better understood (behaving predictably under a range of circumstances) and can be used with a higher degree of confidence.
by the same token, if recent events have gotten everyone to double and triple check their counterparty risks and engage in due diligence (after the fact) wouldn't you think that would help lower overall systemic risk? i'm with mutant (again) -- markets are complex adaptive systems.
maybe i'm trying to be overly nuanced and putting too fine a point on this, but i think it's important; the fault isn't in our stars, etc. like when quants can self-assuredly proclaim: "We were seeing things that were 25-standard deviation moves, several days in a row."
are you sure? absolutely 100% (or at least 'to the nines') positive? could it be your black box model of the world doesn't consider all the other black boxes mushrooming out in the woods, and so the leverage employed so boldly upon a correlation matrix during "normal" times (e.g. a world where home prices never decline) implodes as correlations go to one? but then, if not, why are you absolutely certain that we're all going to hell and utterly undeserving of salvation?
btw, the flood insurance analogy also works for 'fake alpha' and bankers' pay :P
cheers!
posted by kliuless at 7:21 PM on February 21, 2008
Thanks for the response M. How abnormal? We’re witnessing a developed world banking crisis. The mirror image of 1997, down to the need for the EM / Asian Governments to come to OUR rescue. Ahh the irony. I’ll concede (what I think is) your point – I’d guess it’s a once a decade event on a global scale (ie somewhere you’re going to have an analogous event once every ten years or so), so of itself not that unusual. But that is up to the present – you’d be a brave punter to suggest this is as bad as it’s gonna get. The russian debt crisis in 1998 nearly overturned the applecart. But – and again I’ll concede your point – it didn’t. Solutions are always found, the dude will always abide, it was ever thus, yeehah.
There’s no doubt a US equivalent is, in scale and effect, an entirely different animal, but that doesn’t mean we (and more particularly, everyone but the US) won’t come through the other side more or less intact.
I have some sympathy for the decoupling view – it’s hard not to living in Australia, with the economy through capacity, unemployment at generational lows, interest rates at decade highs and climbing. So Chinese growth slows from 10-12 to 8-10 for awhile. Big deal. The BRICS and EM world may just drag us kicking and screaming through what will be nothing more than a period of adjustment – everyone getting used to the idea that the USA is no longer the centre of the economic universe and that their populace is going to have to accept a reversion to the mean, suffering a marked decline in living standards and economic growth relative to the rest of the globe. Maybe I give this more significance than it deserves purely because of where it is happening, rather than because of what is happening.
Personally though – and particularly given the supply-side issues with commodities going forward – I think the world a decade from now is going to be a much more contentious, fractious, antagonistic place. We need to relearn that scarce resources are not just dry academic theory – they are reality for much of the globe, and at least part of the western world will rediscover this the hard way. The issues we face are much broader than just some exotic derivatives crisis, but if I start on that I might as well GMOFB.
The upshot? I have no idea where this all ends up, but like Malor I fear left unchecked this time around is of more significance - I believe a once in three-generation event. To me that’s abnormal. You and I will be lucky (unlucky?) enough to witness two events of this magnitude in a lifetime. It’ll end up being taught to uninterested fifth-graders fifty years from now. So yeah, significant.
I think the difference between your perspective and mine is that you are (very sensibly) marking events from observation, not from forward projection. I’m getting jumpy because I look at where things might go, not just because of where they are – but there is a danger in doing this. Things might get worse, they might not. All I know is that I – and I suspect Malor – have been waiting on this turn of events for the better part of a decade. It’s not purely a market phenomenon – it is a sociological, political, economic event with many historic analogies. The wheels have been in motion for some time, and watching the entire process unfold is fascinating.
I’ll try and wind up before this gets stupid again. I agree the Fed has responded admirably – and if you read Bernanke’s research on combating deflation, they have plenty of ammunition left should it be required. There are of course other costs and dislocations and ineffiencies created by doing so, but given the stakes I suppose that is by-the-by. And the ECB? Heh. Like the Fed, I suspect that when push comes to shove all their talk about inflation is just that – talk. They’re just running six-twelve months behind. If you remember, the Fed wasn’t exactly keen to cut in December – yet 30 days later they’d cut by another 125bp. The market ain’t always right, but they’re pricing ECB cuts this year and the curve has steepened markedly. One look at Spain and Ireland (and the UK) housing market should be enough to scare anyone.
My real concern with Europe is that they have no central mechanism to bail out banks in the same manner as the Fed – can you imagine the uproar if German and French taxpayers are asked to fund Spanish and Irish banking problems? You’re now seeing the EU convergence trades being unwound, with (for example) default rates on Italian bonds being priced well through German etc etc. Warning flags. Again, this comes from me looking forward and projecting what might be, rather than observing where we are now. The danger in doing so is that I might be entirely wrong, but I don’t see any other way of avoiding landmines than looking ahead. I may of course end up the classic economist predicting nine of the last three recessions …
Your faith in the system is justified. After all, it can only unwind once. Every other crisis ends up an opportunity. The only solution I see is a government bailout – either of the banks, the mortgage servicers, the monolines, or all three – that short-circuits the credit destruction and gets the wheels turning again. There are some very interesting parallels with the Skandies’ banking crisis in the 1980’s (Norway, Sweden, Finland) – well worth chasing down.
posted by bookie at 3:28 AM on February 23, 2008
« Older Postum, we hardly knew ye | The People's Singer Newer »
This thread has been archived and is closed to new comments
Motherfuckers. New law: all people in the finance industry regularly tested for coke, because this has gotten out of hand. If only there was a test for "greedy and reckless."
posted by a robot made out of meat at 4:48 PM on February 18, 2008 [2 favorites]