Posted on 09/18/2008 2:30:34 AM PDT by palmer
Some alleviation of the risk has been overseas, especially Europe who ended up as bagholders in this situation just as they were in the MBS fiasco. In both cases they were suckered by the ratings agencies who assumed there was no such thing as a housing market correction and no such thing as systemic risk.
But a good deal of blame lies with the people who established the moral hazard in the creation of Fannie and Freddie and the Fed who created the credit bubble in the first place and moral hazard by being the obvious backstop against systemic default.
At this point they are damned whatever they do, they simply have to backstop what they can and attempt to postpone the meltdown which will generally make it worse when it does finally happen.
bump
ping!
palmer, great article and post. Where is this going to end? Please comment.
Very interesting read. Thanks.
Eliot Spitzer forced AIG to fire its CEO back in March with the threat of an investigation if they didn’t.
It ends when credit unwinds from 350% of GDP to a more sustainable amount (think about how much of GDP goes into paying interest on debt at 5% interest). The remaining source of relatively cheap credit will end up being the federal government because their borrowing costs are the lowest, so expect the next president to run major deficits.
Ultimately interest rates are going to rise substantially to reflect the risk and inevitable inflation and the sooner that happens the less inflation there will be, but that will create a major recession like the early 80's (Probably worse since we have a lot more debt now). The only other alternative is to postpone the pain by creating more debt, but as has been pointed out over and over, that only makes it worse in the end.
They can only do so by assuming the risks themselves, and you know what that means.
Fascinating stuff, thank you. What I take from this is that the whole mess we are in is the result of the world’s largest Ponzi scheme, which was completely legal.
what do I win?
A brilliant article, thanks for posting it, Palmer.
I hadn’t quite understood what this credit derivatives thing was before, but the article puts it into very plain English.
It seems to be a variation on a theme: something like this happened at the House of Lloyds back in the 1990’s, when all of the syndicates re-insured with each other for an ever-dwindling piece of the insurance premium “pie”.
Crikey! And these financial boffins are supposed to be clever. What it seems that many of them really are is instatiable gamblers!
And not very good ones at that...
Note that the majority of other credit derivatives that exist such as interest rate swaps are less shady and risky. Those total some 1/2 quadrillion dollars and may add to the systemic risk, but don't create system risk (swapping payments for payments is generally risk free and easy to evaluate). But these particular credit default insurance schemes grossly underestimated risk and created the systemic risk that we now are forced to deal with.
I have seid it before and will say it again, forget the 401k, pay off the house, farm ect. Stay away from the market, proven right again.
In other words, AIG is part of an infrastructure that can be described as a "house of cards."
Thanks! Bump for later reading.
Bookmarked, thanks for posting.
> But these particular credit default insurance schemes grossly underestimated risk and created the systemic risk that we now are forced to deal with.
There’s a good case to be made for taking a non-probabilistic approach to risk management: unless one is named “Jimmy the Greek” very few people are good at estimating probability. It’s a crude, blunt instrument at best.
I find the writer’s recommendations particularly interesting. Our morally-bankrupt NZ Government (Labor Party under Helen Clark) has been preaching to the average Kiwi that real estate is a poor investment, and that we ought to be putting more of our money into the market...
And yet we have morons on this forum who still ignorantly believe that derivatives are just a "zero sum game" and post no risk to the world's financial markets. Unadulterated morons.
That out of the way, BRILLIANT article. Best I've ever read on the subject. Long read but crystal clear, concise and thorough. Exceptionally educational. EVERBODY ought to find the time to read the entire clearly-written article and not just scan it or read the first 2 paragraphs. You need to read the entire body to get the knowledge. Thanks. Awesome post!!! You did it again. If only we could get said morons to read it.
For those who refuse to read the entire article, I will repeat my example as to the danger that credit derivatives pose. It is NOT a zero sum game. It would be, if solvency was guaranteed in every transaction. But that is the point -- insolvency is all but guaranteed.
So what happens when one party can't pay on the derivative because they can't afford to pay? Joe defaults on Jack, now he can't pay Dave, and Dave needed that money to pay Paul, and Paul defaults on Bob, do Bob defaults on his obligations... on and on. The loss becomes systemic. It ripples like wildfire through company after company. It is NOT a zero sum game. The massive losses involved guarantee insolvency and the couterparties counting on getting paid in order to pay their bills default, and companies topple like dominoes into bankruptcy. So derivatives are just a zero sum game? Tell that to AIG, morons.
Palmer, if I got that wrong, please feel free to correct me. But that is my understanding of the danger in credit derivatives. It is not a zero sum game, but a severe systemic risk. That said, you are a SOLID ASSET to the knowledge base of this forum and your freely given knowledge is just a crucial benefit for all here at this critical time. Sorry for being so hard on the afore-referenced morons, but they are really doing a disservice with their disinformation that derivatives all cancel each other out to zero, when nothing could be further from the truth. Not that it matters. There ignorance won't change the impact when the assets underlying the derivatives go belly up.
Correct. And Every executive at the mega banks and brokerage firms were rewarded with untold millions.
With that said though, I think it's actually a pretty good, if slightly hyperbolic, depiction of the issues in the credit market.
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