AIG suffered huge losses when its credit rating was cut, thanks largely to complex financial transactions known as “credit default swaps.” AIG was a major seller of the swaps, which are a form of insurance, though they are not regulated that way.
The swap contracts promise payment to investors in mortgage bonds in the event of a default. AIG has been forced to raise billions of dollars in collateral to back up those guarantees. AIG stopped selling credit default swaps in 2005 to limit its exposure, but the damage was done.
Kendall, I know you’ve been flogging this CDS thing for a while, but it’s a symptom, not a cause. Absent the real estate balloon, there would have been no real estate crash and these CDS instruments would have been fine. Did AIG screw up and even possibly defraud investigators? Yes, and quite possibly. All the more reason to let them fail and send in the criminal investigators. But please don’t think this is a problem caused by credit default swaps.
Credit-default swaps are a legitimate financial tool. If you are a lender, they can provide a sort of insurance against default by your borrower. Credit-default swaps thus help lenders and other investors diversify and hedge against risk.
But market participants’ USE of credit-default swaps contributed to the current debacle.
Many users erroneously believed that they had adequately protected themselves against the risk that borrowers would default. They did not realize the extent to which the parties who provided the “insurance” might lacked the financial strength to make good on their guarantees. Undisclosed “debt chains” were part of the problem.
Sure, real estate was the heart of the bubble. But poorly informed use of credit-default swaps spread the damage in surprisingly painful ways.
I don’t want to get into overly complex material, but it is more complex than #1 says. The problem strictly speaking isn’t CDSes but how CDSes were allowed to function in the marketpalce thanks to the FASB.
The FASB allowed bilateral netting as an off balance sheet activity. This is crucial. There is no public market, there is no regulation AND they were allowed to do CDS’ off balance sheet and therefore with no margin requirements.
The reason in numerous cases “they did not realize the extent to which the parties who provided the “insurance†(as Irenaeus says) might lack the financial strength to make good on their guarantees” is because those involved didn’t want them do. But they were enabled to do this by the FASB. And then the SEC saw the market explode and the leverage explode and still did nothing about it.
Thus they are a central means by which the virus of poor mortgage debt and the risk associated with it was spread throughout the world financial system, and the means by which, through absurd levels of leverage, those issuing them could think they had more capital than they did, thereby allowing them to get into ever more risky ventures.
[blockquote]Many users erroneously believed that they had adequately protected themselves against the risk that borrowers would default. They did not realize the extent to which the parties who provided the “insurance†might lacked the financial strength to make good on their guarantees. Undisclosed “debt chains†were part of the problem.
Sure, real estate was the heart of the bubble. But poorly informed use of credit-default swaps spread the damage in surprisingly painful ways. [/blockquote]
I wonder where this epistemological certainty about the true risk of a particular insurance estimate is to come from, and why this knowledge would be more likely in the possession of a government regulator than those actually involved in the market. Invoking some perfect, seamless, undefined “regulation” as the preventive for this crisis ignores the obvious: Using the knowledge one would have had at the time, what would those regulations have said?
It’s obvious from the underlying collapse of Fannie and Freddie that many were sounding the alarm, yet those charged with writing the legislation upon which these miraculous regulations not only refused to act, but were actively hostile to reining in their cash cows.
So the FASB and SEC were asleep at the switch and the switchmen need to be replaced and given a new manual. Fair enough, but we seem already to have tons of regulations and tons of regulators and these meltdowns continue to occur. I submit that the market deals with these problems far more ruthlessly and efficiently than the bureaucratic model. Enron was brought down by a single query from a skeptical analyst during a conference call. If government were around providing secondary markets and otherwise backstopping the energy trades and traders, I’m confident Enron and its $1,000/hr lawyers would still be around jawing in conference rooms with regulators. Markets are painful, but fundamentally the problem would never get so macro if the Fed weren’t manipulating credit to keep the party going into the wee hours.
I don’t mean to belittle your excellent points. Heads should roll and standards should be given force of law, but the problem is deeper than that. “The whole head is sick …” Isa.
“I wonder…why this knowledge would be more likely in the possession of a government regulator” —Jeffersonian [#4]
I said nothing about regulation in #2, which you here purport to debunk. Nothing. You are seeing your own preconceptions.
I also think ownership of public companies has gotten way too attenuated and diffuse to hold management accountable. The government incentivizes this arrangement thru 401k’s, IRA’s, etc.
But what is the average schlep to do? The poor sod’s purchasing power is continually eroded by the Fed and Treasury so he can’t just rely on a simple savings account but has to give his money to 30-year old MBA’s to play with in the hope they’ll generate net gains.
Like I say, it’s all a huge, huge mess but we have been building this dystopia up for a long time.
[blockquote]I said nothing about regulation in #2, which you here purport to debunk. Nothing. You are seeing your own preconceptions. [/blockquote]
My apologies, I was substantially in agreement with you that these hedge instruments were improperly evaluated and priced for risk. My point in #1 was that AIG, and others who so erred in risk assessment and pricing ought to suffer the consequences of their mistakes, not get bailed out by the taxpayer.
My comments about the wonders of unwritten regulation were directed to Dr. Harmon, whose faith in government bureaucrats seems to approach the theological.
“So the FASB and SEC were asleep at the switch and the switchmen need to be replaced and given a new manual. Fair enough, but we seem already to have tons of regulations and tons of regulators and these meltdowns continue to occur†—Byzantine [#5]
Prudent regulation is not a matter of “more†or “less†regulation, as though regulation were a bulk commodity like soybeans or winter wheat.
The question is whether regulation is needed and, if so, what it should be.
Markets need reliable information. The securities laws promote efficient stock and bond markets by requiring securities issuers to disclose their financial condition and by punishing securities-related fraud. We are better off with these disclosure requirements and anti-fraud rules than we would be without them.
Credit default swaps and other derivative financial instruments are increasingly important to financial institutions and yet generally do not appear on those institutions’ balance sheets. The Financial Accounting Standards Board (FASB) requires firms to disclose derivative exposure in footnotes to firms’ balance sheets. The question is whether current disclosure is adequate (many experts believe not) and, if so, what additional disclosure should be required.
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Over the past two decades, FASB has made considerable progress toward making Generally Accepted Accounting Principles (GAAP) better reflect economic reality. Gone are the days when a sick savings and loan would finance dubious projects (e.g., a hotel surrounded on three sides by an oil refinery) because it could treat the loan-origination fees as an immediate boost to its income.
Yet FASB’s reforms have commonly faced strident industry opposition. Take the case of executive stock options. As a firm’s stock price rises, executives can use the options to buy stock from the firm at below-market prices. These purchases reduce the value of existing shares. FASB ultimately required firms to treat stock options as an expense when the firm granted them—but only after a decade in which firms caterwauled that expensing would not work and could disastrously discourage technological innovation. (It did work, and innovation continues.)
The SEC has had its failures, not least because two of its five members (Paul Atkins and Cynthia Glassman) are misguided, extreme ideologues. But the SEC is not, and probably should not be, responsible for keeping the financial system stable. SEC regulation has focused on disclosure, and that approach has generally worked well.
“Ownership of public companies has gotten way too attenuated and diffuse to hold management accountable†—Byzantine [#7]
True, but that has been the case at least since the 1920s. Adolph Berle and Gardiner Means focused on it in The Modern Corporation and Private Property (1932). Public corporations are controlled by managers who generally own an insignificant percentage of the corporations’ stock. Yet this is not a quirk of governmental policy: it occurs because modern corporations are so huge. Even amid the current market plunge, General Electric has a market capitalization of some $200 billion.
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Jeffersonian: Thank you for #8.
What’s the [i]a priori [/i] commitment here that no amount of factual material will penetrate? It seems to be this: Government is bad. Markets are good. Only when Government gets involved in Markets do things go wrong.
Surely, there can be nothing wrong with AIG executives who seek bailouts while planning their $400,000 trip to the spa to relax from the stress of it all. Surely, thinking such as theirs reflects how silly the notion of regulation might be.
[i]Kendall, I know you’ve been flogging this CDS thing for a while, but it’s a symptom, not a cause… please don’t think this is a problem caused by credit default swaps. [/i]
#1 This sense of moral cause and effect sounds like “My wife hit me, so I shot her.”
[blockquote]What’s the a priori commitment here that no amount of factual material will penetrate? It seems to be this: Government is bad. Markets are good. Only when Government gets involved in Markets do things go wrong. [/blockquote]
No, markets do the wrong thing all the time. That’s not the issue. It’s when government short-circuits the informational feedback that markets provide that is harmful. In our present predicament, the government and its surrogates provided incentives to actions that few sane actors in the market would have taken absent those incentives. On the other end of the pipe, the government is reducing or eliminating the pain and harm to reputation that the market would otherwise be inflicting on those who took those actions.
So what incentive is there to refrain from these actions in then future? None.
[blockquote] #1 This sense of moral cause and effect sounds like “My wife hit me, so I shot her.†[/blockquote]
No, it’s more along the lines of “The sun went down yesterday, and I turned on the lights. Therefore, if I turn on the lights today, the sun will go down.” The problems in the CDS market were that the premiums charged for the risk assumed did not cover said risk.
Albany, love it!!! Warren Buffett has been warning about the bubble called CDSs for years and years….it was all gravy for the financiers who made $$$ everytime one of those cr*p paper CDSs was sliced, diced and traded between each other. (The ONLY economic group whose income went UP during the past 10 years has been the very TOP 1% — a BAD sign for a democracy). And GOP Phil Gramm was the point-man for the lobbyists who created the CDS ‘market’ in the GOP-held Presidency and Congress. This is the very same Gramm who (until recorded blaming the American public for being ‘whiners’ about the economy) was McCain’s CHIEF economic advisor! (He’s no doubt still there, behind the scenese). No wonder McC is in trouble, we who have worked hard all our lives are sick and tired of the neocon ideologues whose policies that have brought the working and middle classes to their knees….NO McBUSH!!!
Jeffersonian,
Incentives do not provide moral excuses, no matter who causes the incentives. Criminals have incentives all of the time. To the extent that you are saying the Market “feedback” would punish offenders, I would on first glance find some comfort. But of course, the comfort is an illusion because it takes the rest of us for the ride.
LC, I think what you’re saying is that you are against the concept of insurance, which is what CDSs are. If taken to its logical conclusion, your argument says that we should prevent people and organizations from hedging risk in any way. Do you understand the repurcussions of what you are saying?
I will, however, agree that it does seem irrational for parties not involved in the actual hedge to be allowed to set up a CDS. That does appear to be a destablizing aspect of all this.
Albany, now take your metaphor of the criminal and put your local sheriff in the position of handing out crowbars and sacks to them while promising to refrain from patrols and arrests. That’s essentially what we’ve had here for a number of years with the federal government urging its catspaws Fannie and Freddie to greater heights of irresponsibilty.
In response to #1, Paul Craig Roberts has a different take:
Jeffersonian, insurance for some sort of asset with a verifiable market value, ok — insurance on paper floating between sophisticated financial fat-cats, with no market value except what those fat-cats assign it on a particular day so that their bank accounts will grow via some ridiculous fee or commission — NO. They call it ‘insurance’ — ha! Insurance is REGULATED, and that is the last thing the CDS crowd wanted. It was all part of their smirky ‘socialize the risk, privatize the profit’ philosophy, and it made many of them VERY wealthy. And now the little guy is being called upon to pay for it — along with our children and grandchildren.
=#19, GREAT post; CDSs are a MAJOR cause of the catastrophe engulfing working people, but the Wizard of the White House (and his party) want us to ignore them. Greenspan wimped out and gave in to the neocon ‘unfettered market is best’ crowd. He and his will not suffer, he has his fat pension, mansion(s) and wealthy wife, too. But the rest of us will PAY PAY PAY.
As I said before, Little Cabbage for President!
“As I said before, Little Cabbage for President!”
And no wisecracks about sauerkraut!
[blockquote]Jeffersonian, insurance for some sort of asset with a verifiable market value, ok—insurance on paper floating between sophisticated financial fat-cats, with no market value except what those fat-cats assign it on a particular day so that their bank accounts will grow via some ridiculous fee or commission—NO. They call it ‘insurance’—ha! Insurance is REGULATED, and that is the last thing the CDS crowd wanted. It was all part of their smirky ‘socialize the risk, privatize the profit’ philosophy, and it made many of them VERY wealthy. And now the little guy is being called upon to pay for it—along with our children and grandchildren. [/blockquote]
This makes no sense whatsoever. If these MBSs were just “paper floating between sophisticated financial fat-cats, with no market value except what those fat-cats assign it on a particular day,” then why don’t these fatcats just assign a nice, big value to them tomorrow morning and we’ll all be wading in gravy again on Saturday?
The reality is that these instruments do have a market value as well as an assessable risk, and are thus insurable. The idea is to diffuse the risk so the impact of a given default is hedged and dispersed. There’s nothing wrong with that in any way. The problem comes when a meta-event occurs, like the collapse of the egregious Fannie and Freddie, thus imposing costs that cannot be dispersed, like a hurricane wiping out all of South Florida.
And what is this magical regulation of which you speak? Who are these brilliant regulators that are so much more attuned to market risk than those dealing with it every day? Are you privy to some occult text of regulation that would have forestalled this? Please cite….we’re all dying to hear.
Oh, and I’ll agree with you on the bailout…it was nothing more than a grab for cash, from Congress to Wall Street. It never should have passed.
Cabbages, one point. “Unfettered free market” is more a paleocon idea than Neo. Neocons used to be the hawkish wing of the Democrats who were pushed out after 72 when the Dems went Pacifist. Socialy liberal but in favor of a crusading foriegn policy. Think Woodrow Wilson’s WWI policies or JFK’s “Bear any burden” speech.