Posted on 09/26/2008 5:42:27 PM PDT by supercat
In examining the various plans to deal with the financial crisis, there seems to be a common element: a desire to avoid at all cost the collapse of an interlocked collection of derivative securities which could be called the House of CarDS (credit default swaps). The fear is that the massively tangled web of credit default swaps and other derivative securities will explode like a powderkeg that will destroy the economy if things go sour; because of this fear, the collapse must be prevented at all costs.
That attitude is fundamentally wrong and dangerous. First of all, it allows Americans to be held hostage to any demands financial institutions might make. Fail to do as they say, and they'll drop a match. Secondly, the costs of keeping the House of CarDS from collapsing are going to increase exponentially until it does collapse. Since the collapse is inevitable, it would be foolish to spend trillions of dollars postponing it. Thirdly, a collapse of the House of CarDS would not cause a major loss of value in the assets therein; since the loss has already occurred and has simply not been realized, the collapse would simply represent the acknowledgment of the already-existing loss. Fourthly, the biggest factor in today's credit lockup is that nobody knows what any of the paper assets are worth. If the paper assets in one's account are only worth $0.05 on the dollar, it's better to liquidate them and have $0.05 on the dollar of real assets, than to keep pretending the assets are worth face value when everyone knows they're probably worth less but nobody knows how much.
The first point should be self-explanatory. The second point is not so self-explanatory, but it is both observable empirically and explainable theoretically. I'll return to it later. As for the third third point, consider the following analogy: Joe Banker opens up a bank. Individual account holders are limited to depositing $100,000. The first $10,000,000 that people deposit in are shown on display. Any money that's put in after that goes to the vault in the back. What Joe doesn't tell anyone is that he actually pockets 80% of deposits and send them to secret offshore accounts in Fredonia. Each individual account holders can see that the bank has over $10,000,000 in assets, which is clearly enough to pay him off. What the account holders don't see is that the same assets are being used to back many times their worth in deposits, so even though people have deposited a total of $1,000,000,000 in the bank, there are only about $210,000,000 worth of assets backing them up.
Would a run on the bank cause the people to lose money? Not really. A run on the bank would cause the later depositors to lose everything, but the major loss came when Joe pocketed 80% of the deposits and sent them off to Fredonia. While a bank run would arbitrarily redistribute the losses (so those who withdraw early pass their losses off to latecomers), depositors on average will have lost $0.79 on the dollar before the run even started. The only effect of the run will be a fight over the last $0.21.
Returning to the original second point (exponential cost to prop things up), assume that Joe's Bank hasn't crashed yet, but the reserves are getting low (people who deposit money sometimes have the audacity to withdraw it). So Joe decides he needs to get more depositors. Easy solution: offer higher interest rates. In response to the higher rates, more people deposit the money, and Joe keeps getting more and more money to put in his pocket. Each dollar that Joe takes in and then pays out must be replaced by more than $1. Even if Joe weren't pocketing anything, the payment of interest would require an increase in the rate of deposits. If Joe starts pocketing money for himself as well, that will cause things to escalate rapidly.
On to point number four. Suppose that Acme Plastics has recently borrowed a lot of money to purchase another company which, as it happens, had lots of assets of dubious worth. If those assets are worth $0.10 on the dollar, Acme Plastics is solvent. If they're worth less, it's not. Acme Plastics has an assembly line all set up to produce Tickle Me Paulson dolls, and stores are waiting to receive them. All Mr. Acme has to do is get $100,000 of raw plastic on credit and he'll soon have $1,000,000 worth of merchandise. Unfortunately, since potential creditors have no way of knowing whether Acme Plastics is solvent, they have little desire to lend money and risk having to fight other creditors for its return.
If the crash of the House of CarDS revealed the real value of Mr. Acme's dubious assets to be $0.15 on the dollar, the crash would help Acme Plastics get credit, since he could show that his business was solvent. Even if it showed the value of those dubious assets to be only $0.01 on the dollar, though, it could still be a good thing for the Acme Factory. Markets love gains, but they tolerate losses. What they don't like is question marks. If the assets are shown to be worth $0.01 on the dollar, and that is insufficient to meet obligations to existing creditors, there are many ways to keep the factory open. Creditors may accept a debt-for-equity exchange. Or the business could be liquidated with the factory, intact, bought out by someone who could then supply the raw plastics needed to begin production. Even if none of those desirable things happened and Acme Plastics was disbanded, that wouldn't be much worse than having the company go broke because it couldn't get the credit needed to produce products.
So what do all these points mean? The fundamental danger in today's marketplace is not that there will be a crash, but rather people will act irrationally in an effort to avoid one. Nobody is going to want to see his portfolio drop by $0.50 on the dollar overnight, but throwing in good money after bad in an effort to deny reality is no solution. A lot of the money put into the markets by investors is gone. No amount of hope or optimism will change that. The only way to restore confidence in the markets is to find how much money is gone and how much remains, and then move forward.
Ping. You were just explaining this to myself and a couple other FR Econ dummies last night on a thread and you were very informative. Any thoughts?
I gave a little chuckle at the "tickle me paulson dolls" barb.
If you believe that an asteroid is going to hit the earth within the next three years and destroy humanity, then the bailout might make sense (though even then I'd be skeptical). If not, then it doesn't. What the bailout will do is ensure that within three years' time we're in an even even worse situation than we are today.
Do you dispute my statement that the cost of postponing the CDS crash will increase exponentially? If the market is going to come down, what exactly is gained by delaying it?
Okay, maybe I did have a little humor in there. Maybe my next blog entry will feature "Nocturnal Airways" (a fly-by-night company).
LOL!
BUMP for you and every poster/commentator that agrees with you.
I agree.
supercat is right on. The fuse (mortgage and credit card debt defaulting to the point that bonds can't be serviced) has already detonated the dynamite (the house of CarDS). The explosion actually occurred in July 2007, and the mushroom cloud has been expanding in size. We don't yet know how large that mushroom cloud will be.
Let me tell you some sobering information. I worked for the last 7 years in the Investment Consulting industry (not as a consultant, so don't ask me for financial advice ;-)).
I specifically was involved with the CIMA (Certified Investment Management Analyst) certification program, and dealt with a lot of Presidents and VP's of the nation's major financial houses.
For those investment managers seeking to obtain the CIMA designation, they had to go through a thorough course of training - which ended with spending a week at the Wharton School at the Univ. of Pennsylvania. This school is the top echelon for those in the Investment Consulting industry.
I say all of this to draw your attention to an article that was published by Wharton in November, 2005. You can read it here:
The Ballooning Credit Derivatives Market: Easing Risk or Making It Worse?
In a nutshell, this article describes the history of the credit derivatives market, and why it was (and is) so popular with the investment community.
The article also exposes some "fear of the unknown" in regards to what these market instruments might bring about that nobody had really considered. As I said, pretty sobering.
What we are experiencing right now is what "nobody had considered" - not the investment houses, not the banks, not the insurance companies, and not our government.
We are in for some very difficult times, and this "plan" in Congress will be like a squirt gun on a forest fire.
ping to #27
LOL! I really liked that one last time you used it.
So your saying in effect socialism (government) caused this, and socialism )government will get us out?
So if we got stung by a scorpion a scorpion sting is what will cure us?
Why doesn't either of those ideas make sense?
The socialization of risk X the socialization of risk.
What a con, these white collar con-men foisted upon people.
I despise socialism, fascism, con-men & criminality.
The supremacy of finance capital over all other forms of capital means the predominance of the rentier and of the financial oligarchy; it means that a small number of financially “powerful” states stand out among all the rest. The extent to which this process is going on may be judged from the statistics on emissions, i.e., the issue of all kinds of securities. - Vladimir Ilyich Lenin
One huge problem that exists with today's market is valuation - and it would be very difficult to place real market value on the mortgage assets of the tranche (in terms of 'mark to market').
My .02
One thing I was wondering about with all the insane loans out there: given that--unlike ordinary insurance--one is not limited to buying CDS "insurance" on assets one actually owns, and given that there's no clearinghouse of CDS bets, what would prevent someone from "insuring" a bad loan for many times its worth? That would seem to offer an effective way for a scam artist to make a lot of money, at least until all the phony bets kill off the CDS firms.
The point of my plan, if the government rules allowed it, is that it wouldn't be necessary to make such valuations on the tranche as a whole. Just allocate the mortgages by lottery. Some people might be lucky and get good mortgages that were still paying off. Others might get properties that were bought at peak prices and then trashed so badly that they're worth less than vacant lots. That would be the luck of the draw. The expected initial value for each investor who opted for a random consolidation would be precisely equal to the average value of mortgages in the tranche; the fact that CDS would be replaced by a single mortgage would then give the holder the ability to do a proper evaluation of his property and figure out what it's worth and whether it would be useful to renegotiate the mortgage.
Thanks for responding. You have an amazing ability to communicate things and break them down and simplify them. After your thoughts last night I educated myself a little bit more today and found this link. It also explains why this isn’t just about the housing market:
“The Real Reason For The Global Financial Crisis...The Story No One’s Talking About.”
http://www.marketoracle.co.uk/Article6335.html
That's effectively what a Collateralized Debt Obligation (CDO) does. It can be a tranche composed of bond insurance "bets").
That's why the "seller" of the insurance takes it in the shorts, and that seller has, for the most part, been investment banks and insurance companies.
Speaking of insurance companies, I don't expect AMBAC to last much longer.
This sentence from the article that you posted sums it all up:
"In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world."
That is what we are looking at. I was pretty sad when the President that I twice voted for lied to me the other night.
Sept. 26 (Bloomberg) -- The failure of Washington Mutual Inc. will have a ``significant'' effect on collateralized debt obligations that made bets on the lender's creditworthiness, Standard & Poor's said.
Pieces of 1,526 synthetic CDOs worldwide sold default protection on Seattle-based WaMu, S&P said in a statement today. WaMu was seized yesterday by regulators after customers withdrew $16.7 billion over the past 10 days. After JPMorgan Chase & Co. bought WaMu's bank branch business, the holding company is likely to file for bankruptcy protection, S&P analyst Victoria Wagner said in a separate statement today.
Sellers of credit-default swap protection must pay the buyer face value in exchange for the underlying securities or the cash equivalent after a bankruptcy filing. Synthetic CDOs already have been roiled by last week's bankruptcy of Lehman Brothers Holdings Inc., which was included in 1,889 deals globally, and the government's takeover of American International Group Inc., which was downgraded three grades to A-. S&P said 1,619 CDOs made bets on AIG.
Many of the deals also will lose payments and loss cushions from contracts linked to Fannie Mae and Freddie Mac, the mortgage-finance companies seized by the government this month. The takeovers triggered a technical default on the credit swaps.
Of the CDOs that sold WaMu default protection, 514 were in the U.S., 752 were in Europe, 122 were in Japan and 138 were elsewhere in the Asia-Pacific region. The CDOs sell notes to investors that are repaid using the proceeds of credit-default swap premiums. Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt.
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