Financial Arsonists ?

Robert Waldmann

Many people are using the term “arsonists” as a loose metaphor for people who share the blame for the current financial crisis. They aren’t suggesting that anyone actually wanted a financial crisis. Cocking my tinfoil hat I will note that it is entirely possible that someone has been making out like a bandit — and might even be one (as far as I know almost legally). I stress as I have in these posts that I am ignorant and might be totally confused.

I remember when arson was a big profit center in New York. Many buildings in crime ridden neighborhoods were grossly over-insured, so, in case of fire, the owners received much more than the value of the building. Oddly there were many many fires.
The burning of New York was brought under control when the over-insurance was eliminated.

Currently, credit is a bit over insured. The amount to be paid if all insured debtors default is over $ 50,000,000,000,000 which is much greater than the total face value of insured credit.

Now the most likely explanation for this is that credit default swaps are an unregulated form of gambling which appeals to arrogant people who are convinced that they can beat the market — that they are side bets by people with different optinions on the probability of default or, more likely, future assessments of the probability of default.

However, over-insuring against risk can be very profitable.

Consider the partners of a partnership Bandit, Arsonist and Thief. What if they buy 2 dollars of credit default insurance on their bonds for every dollar of equity (note no regulation no disclosure requirements) then enter chapter 11 ? They make out like bandits. Now entering chapter 11 for no good reason creates suspicion, but, if you want to go bankrupt there are always people eager to help.

Or how about an evil banker who buys credit default insurance on a client firm having some difficulties then calls its loans and shuts off lines of credit ? I’d say there are a fair number of bankers who can force a fair number of firms to default.

Finally best of all, how about Bandit, Arsonist and Theif’s banker ? Working together they can create a cash flow problem, a chapter 11 filing, a big payout and a workout so Bandit Arsonist and Thief keep their firm and make out like bandits.

Unregulated insurance is a license to steal.

Does this explain the odd behavior of Bernanke Paulson and the Big Bad bankers ? Bernanke and Paulson have been arguing that they have to entice banks into agreeing to a bailout. Huh ? Could it be that the banks in question have bought so much credit default over-insurance that if one of them fails the total capital of all of them increases, because the disruption would be less than the value of over-insurance ? Or how about officers of the banks whose wealth is in blind trusts ?

Now a lot of these credit default policies will never be paid up, because the insurer will be bankrupt, but a lot will be and there is no limit (of which I know) on how much banks and their officers can legally buy and they can afford a huge amount.

Recall Ben and Hank have opened an $85,000,000,000 credit facility for AIG. Is it possible that, in the absence of the bailout, all of that money will go to owners of AIG credit default swaps ? Can the US Federal Government really put a subsidiary into chapter 11 ? If that is inconceivable the logic would be “better to pay 700 billion for stuff worth 650 billion than $85 billion for nothing.”

update: I am trying to follow the White House meeting bailout circus. It is obvious that McCain and the House Republicans kicked over the negotiating table proposing a magic free lunch plan at the last minute so they can vote no on an unpopular bailout and claim they could have saved the financial system a not cost. It is clear that McCain is an unpatriotic totally selfish reckless egomaniac. In fact, I doubt that Paulson is used to dealing with such a totally selfish reckless egomaniac given his background as an investment banker (and I never expected to write that).

However, it took me a while to figure out just how flaky the House Republican pony plan is. Of course they want to cut the capital gains tax and deregulated more (I think they didn’t put in drilling in ANWR or threatening to bomb Iran). However their main idea is that what the US financial system needs is *more* credit default insurance, since $ 50 trillion isn’t enough !!!

On Thursday, a small group of conservative House Republicans — including Texas’ Jeb Hensarling and Virginia’s Eric Cantor — offered their own alternative to the Bush proposal. Focused on mortgage insurance, the one-page alternative plan was presented to reporters at a briefing.

The plan calls for the U.S. government to offer insurance coverage for the roughly half of all mortgage-backed securities that it does not already insure. The Treasury Department would charge premiums to holders of the securities, under the plan.

OK now explain to me how that would have saved AIG ?ù

I don’t know if financial arsonists are a significant factor in the crisis, I don’t even *know* that any exist. However, there is no doubt that political arsonists are a huge problem.

update II: Look I’m ignorant. I don’t know anything about new financial instruments. However, I can’t manage to find any reason to doubt that the House Republicans’ plan would destroy the US financial system. If all mortgage backed securities are insured by the US government, which will not go bankrupt any time soon, many many agents will be over-insured so that they would benefit from defaults and some will be in a position to cause defaults. They will have to cause huge transfers among private agents and huge financial distress costs in order to get their public money and that won’t stop all of them.

Also, as with buying assets, the problem is the price, in this case the premium. If it is vastly less than the probability of default, the House Republicans have found a way to throw money at bankers and financial arsonists instead of just bankers. If it is actuarily fair, it will force liquidity constrained firms to unload the securities — they could wait and hope for no default, but they can’t pay actuarily fair premiums. When you are insolvent, risk, variance, double or nothing is your only hope of survival. Corporate recovery assistance is available for companies in financial distress. Thus aside from the contribution to financial arson (which I guess will be huge) the plan would also force distressed banks etc to unload mortgage backed securities at fire-sale prices. Now I don’t think the current problem is mainly due to systemic margin calls due to mark to market and capital requirements, but making that problem vastly worse would hasten the collapse of the US financial system even without financial arson.

Vladimir Lenin is kicking himself in his grave for not thinking of such a simple way to destroy capitalism.