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Robber Baron?
Even though [John] Paulson didn't actually own any Lehman bonds, he made more than $1 billion on that bet. It's as though he'd bought insurance policies on houses he didn't own along the Indian Ocean just moments before the tsunami hit. -- PortfolioWhat makes this political is: Are the taxpayers being asked to cover the other side of such bets?
I don't begrudge speculators short-selling markets and making out like bandits... except if the taxpayer gets to clean up the bloody mess, or if there was criminal activity involved. Portfolio's Dec. issue had a story partly about another player, Steve Eisman, who also learned how to bet against the failing trend. What concerns me is that the public has ended up, directly or indirectly, paying them off by "rescuing" banks (Citi and UBS are mentioned in passing), depositors (via FDIC insurance), or institutions such as AIG (ala last Sept. moral "way beyond hazard" move by Paulson and Bernanke).
There needs to be a limit. Will the government have to declare some contracts null and void, against the public interest, to deal with the fallout here?
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Declaring derivatives contracts null and void could probably not be done except under Presidential Emergency Powers.
Due to the international nature of the derivatives business, this would probably result in the seizure of all banks and local bank subsidiaries by nations around the world. At that point, international settlements would become political as much as financial. There would also be a period of heightened international tensions.
The disposition of assets in places like the Cayman Islands might be an interesting problem.
February 23, 2009 4:50 PM | Reply | Permalink
Thanks for the comment.
That is plausible.
Should we avoid it or embrace it? I think we should at the very least not shy away from it as an option. It should be "on the table" for public discussion and reasoned review, thus my recent comments and posts towards that end.
I don't have reason to believe that it would be something which would ignite a world war. I also don't believe that all such contracts need to be voided out of hand. But if ABS securities can be sliced and diced to apportion risk categories, why can't the resulting derivatives be frozen based on legal and political categories?
Maybe all the side bets are trivial amounts, but that ONE bet paid off at 45 to 1 or so, in the amount of $1B. Paulson clearly had other bets, and there were other gamblers too. Who covered the bets, and how is that affecting banking today?
As usual, I am fact-starved.
February 23, 2009 5:00 PM | Reply | Permalink
Facts are the problem, not only for bloggers, but for regulators too!
In theory, the $600+ trillion of derivatives contracts is finely balanced, so that one offsets another. Obviously that isn't so for every institution trading in them, and it may not be true in aggregate under conditions that represent severe abnormality.
However, one reason for the very high notional value is that rather than canceling a contract, either of the parties simply write an offsetting contract. Thus the total notional value is more like the sum of the trading, rather than the amount of trades outstanding.
I would support limiting and regulating derivatives, standardizing the contracts and limit trading to exchanges. Plus all firms trading contracts should be regulated. And the regulation should be world wide.
At that point, it may be possible to pick apart the Gordian knot strand by strand, rather than slicing it apart by declaring contracts void.
I think that is where the calls for regulation are headed.
February 23, 2009 5:44 PM | Reply | Permalink
Do you have a source for $600+? I've seen wildly varying numbers put out there for notional value, up to one quadrillion. I have some info from last summer about some banks, but they don't add up to near that amount.
Of course they are not all balanced, and not all are recoverable (unless the taxpayer ponies up like we did with AIG). A 0.1% imbalance would be a $600B issue if your notional value is correct.
I realize that contract nullification is a kind of last resort, but it's largely equivalent to bankruptcy or the kinder from, Intervention with debt restructuring etc. Given that CDS is very far from reality, I have no moral qualms about "restructuring" such debts by government fiat, if done sanely. And I don't see the ripple effects being catastrophic, as suggested already.
February 23, 2009 6:35 PM | Reply | Permalink
Semiannual OTC derivatives statistics at end-June 2008 from the Bank for International Settlement has some data.
According to Table 19 "Amounts outstanding of over-the-counter (OTC) derivatives by risk category and instrument" the total notional value of all types is $683,725 billion with a gross market value of $20,353 billion.
February 23, 2009 11:12 PM | Reply | Permalink
Okay but CDS is only $57T with a market value of about $3T. Interest rate contracts are the huge fraction, $460T notional with about $9T market value. 3 and 9 are still hefty amounts!
I guess it's important to know which contracts impact bank solvency, liquidity, and complexity. And I expect things have changed a lot since last June. The CDS growth had ended (but the market value grew into 2008!) in 2007, for instance.
February 24, 2009 5:23 AM | Reply | Permalink
Maybe you understand how market value is different from likely outcome value.
That is, it looks like CDS represents on the order of $3T of difference of opinion as to current and future value of various debt instruments, and similarly it looks like there is $9T difference of opinion on interest rates. I don't know if any of that cancels out -- how much of the $9T is "at risk" and how much of it is just the absolute value of offsetting positions. If debt/rates takes a sudden fundamental move, what happens to the 3T and 9T and to the gamblers who bet there wouldn't be a move? And how much leverage are they allowed (how much margin)?
And are people mostly betting that interest rates won't go up in the US? What if interest rates went down (negative, my pet notion), would that wipe out trillions in positions?
Got info or ideas?
February 24, 2009 3:27 PM | Reply | Permalink
There needs to be a limit. Will the government have to declare some contracts null and void, against the public interest, to deal with the fallout here?
YES
February 23, 2009 7:46 PM | Reply | Permalink
eds - just out of curiosity. What have you got on UBS? - you allude to it in your piece...
February 23, 2009 7:51 PM | Reply | Permalink
UBS - I did not mean to imply that the Feds are going to explicitly bail out UBS, only that the article mentioned them along with Citi as an ostensibly clueless bank:
"While Paulson was hardly the only fund manager to bet against subprime, he seems to have made the most money, most consistently, from the banking industry’s troubles. One reason for this is that Paulson was able to recognize and act on the unimaginable—that the banks, which took on most of the subprime risk, had no clue what they were holding or how much it was worth. Big banks like Merrill Lynch, UBS, and Citigroup held triple-A-rated securities, but these were backed by collateral that was subprime at best, making the rating of the securities almost irrelevant."
February 23, 2009 8:15 PM | Reply | Permalink
Thanks. UBS actually only really got into the game late - buying a huge chunk of MBS from Credit Suisse in '07! Talk about clueless...
February 23, 2009 11:15 PM | Reply | Permalink
Well that could have been a good or a bad move depending on the price and terms of the purchase. But the main question for me is the CDS etc. angles.
If UBS bought MBS at a discount and then bought effective CDS coverage, they could do just fine. It's not quite like arson but there is some similarity if not an A B C parallel.
February 24, 2009 3:15 PM | Reply | Permalink
Factoid: "last November, the government took control of many of AIG's credit default swaps and so a bankruptcy of the holding company might not pose the systemic risk it once did" from a David Faber http://www.cnbc.com//id/29353282?ref=fp2
February 23, 2009 8:07 PM | Reply | Permalink
Was this for me? Are you saying UBS was on the good end of these CDS's? Hadn't heard that...
February 23, 2009 8:11 PM | Reply | Permalink
Interesting question eds.
What would you want the gubmint to do here?
February 23, 2009 8:17 PM | Reply | Permalink
I don't want the government to cover those bets unless and until I know just how it is truly in my best interest. If you've followed my comments/blogs you will know that I believe that homeowners (and to some extent credit card users) effectively ripped off investors for trillions of dollars which then sustained a weak economy as if it were not worthy of something like BBB rating. Losses must be taken, not shifted en masse to present or future taxpayers at large.
If Paulson's bet was with AIG, then I'd want the government to attach Pauslon's assets (he has over $36B under management, I read) and freeze his accounts until a clawback arrangement could be worked out. For example. Of course if this bet paid off a year ago, it's not the best example, but it looks like the bet paid off when Lehman failed in Sept. which makes it a very timely example. It's illustrative, not normative.
I'm sorta with Stiglitz on this being largely a zero-sum game. Pain can be distributed or concentrated, but pretending to avoid it doesn't help in the long run. See Zero-sum addendum down the page. It isn't a linear zero-sum situation, but it's worth looking at it that way to some extent (it may be zero-sum in the complex plane).
February 23, 2009 9:32 PM | Reply | Permalink
Great question. I was just discussing with a friend. I think the government SHOULD destroy one whole industry in order to save capitalism. Deriviatives are the bigger culprit here, probably, but I'd like that industry to be Credit Cards & predatory consumer debt.
Wipe it out. Forgive the debts, and put a cap on Interest rates at 12% [Also, limit individuals from taking on a lot of debt]. BofA and Shitibank don't like it? F#ck 'em. Their business model was to bleed their customers dry. Well, they've done that. It ruined our economy, and their businesses.
It won't happen because you'd have to tear up contract law.
We're going to end up hyper-inflating our way out of this starting in DECEMBER 2012, after Obama gets re-elected.
February 23, 2009 8:36 PM | Reply | Permalink
I'm afraid you may be right about inflation, and maybe sooner than that. There is a huge amount of new "base money" in circulation (or somewhere anyway) and it hasn't yet hit the fractional reserve banking system where it will get inflated into maybe $10T of spending money. All that cash chasing finite production is sure to cause prices to rise (not to mention the fundamental causal factors such as rising worldwide standards of living putting upward pressure on consumer prices).
As for debt, my suggestion has been a cap at 12% for new credit card debt (with limited lines of credit if lenders don't want to take more risk), and a killer 5% temporary cap on older balances (subject to qualification and ongoing payment requirements). This would hit the lenders in the cash flow pocketbook, but would likely reduce bankruptcies while increasing the amount of income available to borrowers to spend on other stuff!
I'm afraid Obama is not progressive enough to take such ideas seriously, nevermind getting them past the lobbyists... but I will keep posting them for at least awhile.
Thanks for commenting.
February 24, 2009 4:39 AM | Reply | Permalink