Motus Mentis

7 Comments

1. chris g says

   I could only handle 8 minutes of that guy. I would call him a moron based on the first 8 minutes. I’d argue that swaps do provide benefit to society. Swaps did not cause the financial crisis.

   If you are exposed to a risk, you can enter into a swap agreement with a bank. The bank would take X risk away from you and in exchange you pay bank Y amount of dollars. It’s a swap! You swap something you don’t want for something you do want. The bank then can go into the financial markets and further hedge/offset that risk using securities (something they are experts at). They may employ statisticians and analysts who can use computers to find securities that have similar risk characteristics to offset/hedge. They may do like insurance companies do and take some of the risks (and all the premiums as well).

   But, from your perspective, all that matters is they made you a nice, easy to understand contract (a swap is a contract). Now your only risk is a counterparty risk… will the bank be able to pay you.

   So he wants the government to regulate that counter party risk? How can the government do that? How can swaps be “regulated” when many are, by nature, designed to be unique? The only regulation that will work, and the one that the greatest minds in finance espouse, is to incentivize management correctly. Make them continue to be responsible for the company after they leave, put’em in jail, etc.

   Posted July 18, 2011 at 12:42 am | Permalink
2. JK says

   Well chris, admittedly I’m no economics genius – heck I’m only an Arkansas Hillbilly so “genius” at anything is never applicable. One question:

   What did cause the meltdown?

   Posted July 18, 2011 at 9:56 am | Permalink
3. chris g says

   I’m no economics genius, either, but the cause of the financial crisis was simply securitization and lack of regulation (a deadly combination).

   Lenders lent money but they had no skin in the game. It is easy and profitable (initially) to lend money if you don’t have to worry about getting repaid. Regulators let it go on too long. Regulators didn’t regulate. So, securitization and lack of regulation were the magic formula. That magic formula created bad assets. When the chickens came home to roost, and people realized those assets were bad, all sorts of bad things started collapsing on top of them.

   So, as i mentioned, part of a cds or any swap might be some behind the scenes stuff that the bank does to hedge it’s side of the contract. All that behind the scenes stuff got messed up because of the bad assets. It’s not the trading instrument’s fault, it’s the bad assets fault.

   So, if you want to place blame, blame the bad assets. Blame what caused the bad assets. Swaps didn’t cause the bad assets. It’s been possible to make bets on credit quality for a hundred years via shorting stock. Bundling a bet on credit quality into a swap contract didn’t cause a financial crisis.

   And as far as regulation goes, there are already lots of “regulated” ways to bet on financial instruments (see any futures exchange), but market participants like the flexibility to create different kinds of contracts (swaps) to offset/participate in whatever kind of risk they can conjure up. If you standardize it then it won’t be so useful.

   Anyway, that interview sounds contrived. He’s selling fear so he can move his gold/silver/end-of-the-world stuff. The guy seems to think he unlocked some magic truth. Trillions of dollars in swaps are outstanding but that doesn’t mean anything. The actual cashflow behind those trillions of dollars of swaps will likely be a few pennies on the dollar. A swap might say I will pay you 3% of $1 BILLION dollars. That swap is a $billion dollar swap but the cashflow liability is not so big.

   Anyway, lots of things scare me but swaps and derivatives do not. The scariest thing I’ve seen recently is congress wanting to redefine CPI. If congress can redefine what inflation is then they can really control the fed. That is scary.

   Posted July 18, 2011 at 4:35 pm | Permalink
4. Jesse Kaplan says

   I’m taking the risk of writing without following the link, or even really thinking. I had expected Peter to be the commenter here, as I remember him once taking something like Chris’s position. I, too, agree with Chris, up to his last paragraph. That theoretically this is a reasonable market transaction seems obvious; I guess, though, that the math is logarithmic enough to raise considerations of this being a special case.

   Posted July 18, 2011 at 6:44 pm | Permalink
5. the one eyed man says

   Everything Chris says is true, but wait! There’s more!

   When Lehman Brothers, AIG, and Bear Stearns collapsed (with Citibank and Merrill Lynch threatening to follow), there was enormous counter-party risk which nearly brought down the whole system. Basically you had banks and investment houses levered to the hilt, which created a financial system which looked like an inverted pyramid. When the value of the credit default swaps soared to cover trading losses, nobody knew if the guy at the other end was good for his end of the bargain, and Humpty Dumpty looked like he was about to fall.

   As bad as this was, it had the consequence of freezing the commercial paper markets. Companies like GE pay their short term funding needs with the highly liquid CP market, but since many of the institutions which provided liquidity were shaky, credit became unavailable to some companies and prohibitively expensive to others. It was like eating a jelly donut over the hard drive of commerce. Everything got stuck. Add to this the specter of some of the world’s largest banks and financial institutions going down quicker than a dress on prom night, and you had a time when things looked like they would spin inexorably out of control.

   What happened was that TARP provided a backstop to the banks, and the Fed bought a lot of risky assets from the banks, both of which stabilized the system. Now that asset prices are higher, the Fed has been getting these assets off its balance sheet, thus far at a net profit. Credit is flowing again, the banks are delivered, and the patient is off the respirator. Bernanke, Paulson, and then Geithner took a lot of risky and aggressive steps to shock the system back into place, which by any standard have worked out very well. We ought to be building statues to these guys.

   As for being scared by swaps and derivatives: not me. They serve a useful purpose in hedging risk, just like an airline would buy oil futures to hedge in case energy prices soar. The problem is not with the derivatives themselves, but rather in the excessive risk taking which banks and financial institutions have taken since the repeal of Glass Steagall in 1999. It can be managed by regulating capital ratios and disclosure (a lot of the swaps were kept off the banks’ balance sheets, so investors and regulators didn’t know how large the risks were. No longer.)

   Posted July 18, 2011 at 6:57 pm | Permalink
6. JK says

   Being a simple-minded Hillbilly, isn’t “securitizing” something kinda like insuring it? I mean, when I hobble my donkey by tying it’s front legs together, I’m at least pretty much insuring the donkey will be pretty near where I hobbled my donkey just prior to crawling under the chuckwagon where I’d reined-in my chuckwagon drawing donkey (and in the fairly immediate vicinity of where I’d intended to awake).

   Hobbling the donkey insures when I awake, I’m reasonably certain I won’t injure myself crawling across the Little Bighorn River to re-hitch and continue on my way. Especially given, it’s widely acknowledged, “Hillbillies can’t swim.”

   Course since it’s plainly obvious Hillbillies can type a computer generated blog comment/question shouldn’t it (since the securitizing is digitally, algorithim devised) be similarly obvious it’s perfectly safe to securitize my donkey will be near my chuckwagon come morning since said Hillbilly typed a few lines requesting somebody in who knows the hell where – that, that somebody will know where my donkey is?

   And more importantly – be in the same timezone as me and my donkey so I can guarentee the specific guy I swapped the risk of my donkey getting lost will be available to pull the chuckwagon to where my cowboys are expecting lunch?

   Admittedly most of the donkeys I’ve known never demanded gold rather than grass – but most of the cowboys did kind of depend on having a lunch.

   Posted July 19, 2011 at 12:54 am | Permalink
7. chris g says

   No, I don’t think securitization is like insurance. A security is just a piece of paper that represents an asset. A stock is a security, representing ownership in a company. When a bank securitizes mortgages, they put a bunch of loans together into a pile and call that pile “the asset” (the pie), then they serve up pieces of the pie to who ever wants it, in a size they can digest. They got fancy and divided the pie into tranches such as that some would be safer, shorter duration, etc., but again, that fancy slicing and dicing stuff is not the problem. The loans that went into the pile, before securitization actually occurred, were fraudulent, bad, toxic, just plain stupid, etc. Those loans simply wouldn’t have been made if the lenders evaluating the individual borrowers knew, as lenders, they would be accountable for the loans. Because they were not accountable, they knew all they had to do was make loans. Quality didn’t matter. Nobody would have loaned their own money to 23 year old Casey Serin so he can buy 5 McMansions in 1 month with no money down.

   The 2nd part of the problem has to do with bank regulators. Regulators are supposed to stay on top of bank assets so they can judge capital requirements, protect depositors, etc.. They were asleep at the wheel while all these bad assets were being created.

   Posted July 19, 2011 at 9:25 am | Permalink