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.
“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?”
Yes. Action is needed to correct the harm done by govt interference. You’re assuming there is nothing that can stop the market from going down, thats a false assumption.
Why are so many people apparently wishing our economy would fall in the toilet? How are you gonna make money when that happens?
” So your saying in effect socialism (government) caused this, and socialism )government will get us out?”
Not all govt action is socialism.
“So if we got stung by a scorpion a scorpion sting is what will cure us?”
The economy isn’t a scorpion sting. The economy is a very complex system of objective and subjective factors.
Why are some people so anxious to see the economy fail? Whats good about that? That would only prove to the ignorant that Socialism is the only cure.
Keep watching the online news (Bloomberg.com, wsj.com, etc.). You will be hearing more and more about a credit derivatives problem as we move forward.
This all resulted when commercial banks, investment banks and insurance companies wanted a way to create 'liquidity' from all of the notes that they were holding. They weren't satisfied with just 'good' returns, they wanted returns in the stratosphere.
Some 'smart' people came up with the idea of credit derivatives back around 1995. The financial industry was able to make very complex strategies that put them at a great deal of financial risk, while still making it look like they were meeting regulatory requirements. Understand, they WANTED this risk - because it paid off extremely well while times were good in the housing market.
Then the housing market bubble 'popped' and these 'smart' people realized that they had created an untamed monster that was going to devour them.
The monster is just starting on the appetizers...
You are both economic Paul Reveres, I just don't know that most people will grasp this underlying issue before it is too late.
Thanks very much for the link at post #36. OUTSTANDING article.
Thanks very much for the link at post #36. OUTSTANDING article.
I don't either. But if it helps a few to understand then it was worth the calloused typing fingers.. ;-)
You’re welcome. I’m just now educating myself on the core problem.
“buy a car for your son or daughter, buy a house, borrow money to pay for college or replace a refrigerator, the heating/cooling system in your home.”
buy a car for your son or daughter, you’re f fool, that should never be done!
“borrow money to pay for college or replace a refrigerator, the heating/cooling system in your home.”
Out of the hundreds of employees that i’ve had over the years that is exactly what all of them did except maybe 6 or 7 and that is exactly why they never had anything more than a pot to pee in.
Save the money and pay for it!
!
“Maybe even a limited morotorium on forclosures for a the duration. (Family homes)”
People being forclosed on aren’t living in family homes, they are squatters on real estste using loans that they should never have been given.
Put them out in the street!
The absolute worst of this criminal bunch are those that refinanced and increased the loan and then went out and spent the money.
I call that fraud and theft!
Congress caused this mess, Congress needs to let the
President fix it.
Paulson is not proposing a ‘bailout’, he and the President are
proposing the purchase - at a discount - of working assets that are
unsaleable in the current market and therefore unavailable as capital
for financial firms to use in computing regulatory capital limits.
The ‘mark-to-market’ nonsense Congress foisted on the system in 2002
has failed. Soon, perhaps as soon as Monday, bank runs could start.
When that happens the President will have to shut down the banking
system in a Bank Holiday. This is serious and those who oppose the
President simply do not understand the issue, nor do they understand
the crisis at hand.
Let me be clear, failure could mean the collapse of the banking
system. The remediation of that could mean total nationalization of
all banks and even wars as the international system fails in a
collateral collapse.
Thank God adults in DC will get a deal done today and the above end
of the world as we know it scenario will be avoided. Sadly the
economic illiterates in Congress will probably get reelected. These
are the same as the inumerates who gave us the straight-jacket called
Sarbanes-Oxley (2002) and the Gramm-Leach-Blyley Act (1998).
Warmest regards,
I’d like your comments on my friends views in my post above.
That's what I don't get. We have an election coming up in a few weeks. The "layoffs and foreclosures for everyone" platform isn't exactly an vote-getter.
The bank where I do business in the last two weeks has seen in excess of $300M in DEPOSITS, mostly new accounts and the sale of CDs. This is a very well run, stable, midwestern bank that's been rumored to be a takeover target for years.
Could it be that the people out there are smart enough to move their money to stable institutions thereby letting the banks which are run badly evolve out of existence? Where's the problem in that?
Also, my retirement assets are with three different fund groups - two have decreased in this mess and the other has increased. Putting all one's eggs in the same basket is a bad idea overall (and I'm seriously debating what to do), but why wouldn't I move assets to what is most likely to help them grow rather than disappear?
Honestly, the more I read up on the whole mess, it seems to be a handful of BIG banks that did all the consolidating. A run on the banks, I know, is a big worry, but we aren't seeing banks fail at the rate they did in 1929. It seems overblown and could well become a self-fulfilling prophecy.
Your economist friend is ignoring the role of credit derivatives. They are the 'monster in the marketplace' right now.
Your friend wants money that can be used in the market to create liquidity - there's nothing wrong with that, per se - unless:
Paulson trots out with his pail of money and pays too little for some of these mortgage bundles - or a LOT of these mortgage bundles.
Remember, Paulson won't have a clue WHAT to pay because of 'mark to market' regulations.
If he pays too little, then the cash flow of any underlying bonds associated with those mortgage securites could be interrupted to the point where the bonds go into default. This could, and would, trigger massive debt obligations in the credit derivatives market to those who 'insured' those bonds - investment banks, insurance companies, commercial banks, pension funds, etc., etc., etc.
This $700 billion of bailout money, spent in a haphazard way, will trigger trillions of debt obligations in credit derivatives, and make our problem much worse than it already is.
If the $700 billion is spent wisely, which it won't be (because it would take years to figure out the 'value' of the underlying mortgage securites on that large of a scale) then it is a matter of about 1 week before the credit markets begin seizing up again, because the credit derivatives market is 'eating' all liquidity in its path.
P.S.:
I’m about to start posting a series of ‘Lessons’ on the Credit Derivatives Market, referencing a couple of published articles.
I’ll try to remember to ping you to the post. It might help explain things a little more.
Thanks. He did say he thought CDOs and CD swaps needed to be public and transparent. Needless to say that was just noise to me.
If the market for some type of financial instruments (like credit default swaps) is in imminent danger of collapse, that's a pretty strong sign that the assets are fundamentally not worth anything close to market price. The only way someone who holds such an asset can avoid 'losing' the difference between its current market price and its real value is to sell it to someone else for more than its real worth, in which case every dollar of loss not incurred the previous holder will be passed on to the new one.
Fundamentally, huge unacknowledged losses have already occurred. How can the market possibly function sensibly without acknowledging the losses (thus devaluing the assets that incurred the losses)? How can markets function effectively and realistically in a land of make-believe where nobody knows what anything's worth and nobody knows how the rules are going to change?
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