Relevant and even prescient commentary on news, politics and the economy.

US government funds Brazilian GM plants?


I have no idea how this transfer would be done if the funding happens for high mileage gpm and alternative fueled cars ($25 billion), or if it is accurate as an idea. Not having read the bill I would not know if money is restricted to the US. It does make sense to fund the best plants and technology from GM’s point of view, and Brazil is clearly ahead.

But I do know it is probably easier for the financial companies who are not being ‘micro-managed’. I remind you of cactus’s post on welfare.

The Latin American Herald Tribune says the president of GM Brazil reveals plans:

General Motors (GM) plans to invest $1 billion in Brazil to avoid the kind of problems the U.S. automaker is facing in its home market, said the beleaguered car maker.

According to the president of GM Brazil-Mercosur, Jaime Ardila, the funding will come from the package of financial aid that the manufacturer will receive from the U.S. government and will be used to “complete the renovation of the line of products up to 2012.”

“It wouldn’t be logical to withdraw the investment from where we’re growing, and our goal is to protect investments in emerging markets,” he said in a statement published by the business daily Gazeta Mercantil.

Meanwhile, he cut the company’s revenue forecast for this year by 14% to $9.5 billion from $11 billion, as the economic crisis began to cause rapid slowdowns in sales.

GM already announced three programs of paid leave, and Ardila added that GM Brazil “is going to wait and see how the market behaves in order to know what decision to take” with regard to possible layoffs.

For Ardila, the injection in Brazil’s automobile sector of 8 billion reais ($3.51 billion) recently announced by the federal and state governments of Sao Paulo “has already begun to revive sales,” which fell by 12% in October.

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synthetic bonds

By Robert Waldmann

Felix Salmon explains how to make a synthetic bond.

you buy a synthetic IBM five-year bond instead, taking advantage of the much more liquid CDS market. Essentially, you take the $100 million that you were going to spend on IBM bonds, and you put it into a special-purpose entity called, say, Fred. (In reality, it’ll be called something really boring like Synthetic Technology Invetments Cayman III Limited, but Fred is easier to remember.) First, Fred takes the $100 million and invests it in 5-year Treasury bonds.

Next thing, Fred goes out and sells $100 million of credit protection on IBM in the CDS market, using the $100 million of Treasury bonds as collateral. The buyer of protection will pay $1.5 million per year (150 basis points) to Fred, and in return Fred promises to pay $100 million to the buyer in the event IBM defaults, less the value of IBM’s bonds at the time. The buyer knows that Fred is good for the money, because it’s already there, tied up in Treasury bonds.

He ends with teaser which frustrated super senior blogger Kevin Drum

“That’s the story of the super-senior tranche, and will have to wait for another day.”

Given this story about the use of CDSs, I understand why Felix Salmon is convinced that they are not financial WMDs and why he is so angry that AIG was allowed by counterparties to issue CDSs without posting collateral. I also think that the story is very different from CDS reality.

Over at his blog, I asked Felix Salmon three questions

1) Why wouldn’t interest rate swaps serve just as well ?

2) Why set up Fred when Fred’s assets must be worth more than Fred’s liabilities so there is no obvious point limited liability 100% share ownership of Fred.

3) Also if 100% collateral is posted, how can the notional value of CDSs be greater than the US national debt ?

update: The title was supposed to be a joke “Frederal reserves” but Blogger appears to automatically correct misspelled titles.

Felix Salmon explains thing to me in a comment, which I pull back after the jump.

After the jump, I explain why I find these questions challenging

1) If I want to be long IBM bonds and Own Treasury bonds I can make a synthetic IBM bond with interest rate swaps can’t I ? I think the cash flows with my counterparty are exactly the same, if neither of us goes bankrupt. Thus, I think that the immense popularity of CDSs must be based either on bankruptcy law (related to the super senior tranche ?) or on accounting standards and capital requirements, or both.

2) Why set up a a special purpose entity. I mean that has to cost something. They are set up for a reason, either to limit liability or to make balance sheets look better.

3) Clearly not every dollar in CDS was collateralized 100% by US debt. There isn’t enough US debt. I think it must be true that most were only partially collateralized. AIG might be an extreme case, but I think it just must be true that CDSs were used to leverage up and not just to synthesize bonds.

OK now my efforts at answers. Remember I am very ignorant and mostly guessing.

On bankruptcy law, you have to realize that it’s not your father’s bankruptcy code.
Bo Peng explains

Generally speaking, in bankruptcy code, derivatives counterparty claim[s] can go right through Chapter 11 protection and force liquidation. Chicago Fed in fact had a research paper in 2004 (thanks to Seeking Alpha reader emrald) analyzing the original rationale behind and the unintended consequences — cliche of the month? — of this exceptional treatment of derivatives.

oh my.

I think this means that if Fred’s parent (I’ll call it Zeke) goes bankrupt, Fred’s counter-party gets to grab the T-bills and no bankruptcy court can stop it. This would not be automatic from the definition of CDS, but Zeke and Fred’s counter-party would both benefit from writing the contract that way.

Now if equity in Fred is counted as one of Zeke’s assets and Zeke has a binding capital constraint, a fast one has been pulled. These assets are not part of the pool split up among creditors in the case of bankruptcy, because Fred’s losses (value of collateral minus value of the CDS) go 100 cents on the dollar to the counter-party. Also if equity in Fred appears on Zeke’s balance sheet, then Zeke’s creditors may be mislead. If they assume that all equity in special purpose entities is quite likely worthless now, then a whole lot of crisis can be explained.

Clearly not all CDSs were used to make sythetic bonds. For one thing Lehman brothers had liabilities including CDSs on its balance sheet (OK its 10-Q report). For another they were listed at fair market value which was vastly below notional value until recently. Now it seems to me clear that if firms can goose their equity to debt ration they will and clear that CDSs are very useful for that purpose so long as they are not 100% collateralized.

I’d guess that Fred wouldn’t own Treasury securities equal to 100% of notional value, but rather a lower ratio with a trigger that if the market price CDS reached ninety something percent of the value of the collateral, the collateral could be seized immediately. This means Fred could suck money out of Zeke or Zeke would have to lose 100-ninety something suddenly. Now a totally unexpected actual default would not be insured by Fred (which would go bankrupt). That is, this use of the CDS market would be to take opposite bets on the CDS price, not to insure risk. But, I mean we know that was going on.

OK finally my guess as to what “the super senior tranche” is. I think this refers to the money counterparties can seize immediately from a firm in Chapter 11 — the little exception to the bankruptcy code. Since not quite everyone knows about this, it is an excellent way to dilute the positions of bond holders which, ex ante, profits both parties which wrote the financial derivative contract.

Felix answers.

Hi Robert — I really was just trying to explain synthetic bonds, not anything about the larger CDS market. And synthetic bonds are really a very small part of the CDS market.

I’m not sure how you could possibly create a synthetic IBM bond using interest-rate swaps alone — where would you get the credit-risk component from?

As for Fred’s structure, it’s worth remembering that these are synthetic bonds we’re talking about here — and the whole point of a synthetic bond is that it can be bought and sold in the secondary market, just like a normal bond. You can’t talk about “Fred’s parent” because no one ever needs to know who Fred’s shareholder(s) might be.

So Felix notes that he was just talking about synthetic bonds, not claiming that making them was the main use of CDS. I should have said that I thought his example hinted at a reason for his calm views about CDSs, since the example he had in mind was of a very safe use. I was over psychoanalyzing a blog post, since the example was an answer to a question.

Felix also says that the purpose of the special purpose entity is that Zeke can sell Fred, Fred’s assets on Zeke’s books would have to be packaged into a SPE (Fred) for sale. It’s still not so clear to my why st up the SPE immediately. I mean the story began with Zeke wants to buy IBM bonds, so Zeke creates Fred whose shares are, in effect, IBM bonds. Then Zeke sells Fred, apparently immediately (why pay to set up the SPE in advance of selling its shares ?).

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AIG as a symbol of ?


Financial Times shows us that

One day after announcing strict limits on salaries and bonuses for its top tier of executives, AIG revealed that some of those executives will receive millions in “retention bonuses” next year.Inflatable Tiger Tunnel bady

In a regulatory filing on Wednesday, the insurance group disclosed that Jay Wintrob, an executive vice-president, had put off receiving the first installment of his $3m retention bonus from December to April 2009.

He will receive the second installment, originally scheduled to be paid out in December 2009, in April 2010. David Herzog, AIG’s chief financial officer, also opted for the later payment schedule.

The retention bonuses for 130 key executives were disclosed by AIG in September, after the US government rescued the firm from bankruptcy by purchasing 79.9 per cent of the company for $85bn. After the government takeover, Edward Liddy, the former Allstate chairman, was named chief executive and AIG offered retention bonuses to Mr Wintrob, head of AIG’s retirement services division, among others.

In October, AIG’s management was embarrassed by the disclosure that the company spent $440,000 on a weekend retreat in California for senior performers.

The company announced on Tuesday that Mr Liddy would be paid a salary of $1 for 2008 and 2009, and that Paula Rosput Reynolds, who joined AIG as chief restructuring officer in October, would receive no salary or bonus for 2008.

The company said the other five members of AIG’s seven-member leadership group would not receive annual bonuses for 2008 or salary increases through 2009.

AIG also said that the company’s senior partners, about 60 executives, would not earn long-term performance awards in 2008, not earn salary increases in 2009, and that the group’s annual bonuses would be limited.

An AIG spokesman said on Wednesday that retention bonuses were different from the annual bonuses included in Tuesday’s statement. In September, Mr Liddy pledged to sell off significant portions of AIG’s international operations in order to pay back the government loan. The company said at the time that retention bonuses would be necessary to maintain continuity and value at various AIG units.

“Retention bonuses are a better alternative for the repricing of option awards so long as they are reasonable, fully disclosed and truly needed to retain talent,” said Richard Ferlauto, director of corporate governance and pension investment at the American Federation of State, County and Municipal Employees union.

“But in this market we don’t see much clamor for executives who made big bets, cannot make risk and were paid more than they are worth,” he added.

My initial reaction was simply “My God, they just can’t help themselves, can they?”

Anybody know how this might be worth it to keep the men? Is inside expertise for the short term of a couple years worthwhile for a transition? How do we separate chaff from the wheat, so to speak? Also see Naked Capitalism.

Update: Comment section cleaned up.

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Limiting executive pay after bailouts


Here is a look at the history of limiting paychecks after a bailout…not such a promising outlook for those wanting to do so.

Tax History Project

Too Much: The Historical Link Between Bailouts and Pay Caps
Date: Oct. 6, 2008

Full Text Published by Tax AnalystsTM

by Joseph J. Thorndike

Complaints about outsized executive pay have prompted Congress to include compensation limits in the recently passed Wall Street bailout measure. Are the limits a good idea? Maybe. Will it work? If history is any guide, probably not.

In dollar terms, executive compensation is trivial. Even the huge paychecks common on Wall Street shrink to insignificance when compared to the size of the proposed bailout (or the liabilities of financial firms now in peril). To be sure, some compensation schemes reward short-term profit at the expense of long-term prudence. But the most salient arguments for executive pay caps — at least in the political arena — are moral, not practical.

Complaints about outsized paychecks have been a recurring feature of American politics. Sometimes, populist indignation has led to legislative action. But rarely have pay limits had the desired effect. Why else would we keep having the same arguments over and over again?

Still, it can be instructive to revisit past arguments, if only to appreciate current possibilities. In particular, we might look to the early 1930s (isn’t everyone these days?). In those early years of the Depression, lawmakers tried to cap pay at companies seeking handouts from the Reconstruction Finance Corporation (RFC), a federal agency created to stabilize markets and rescue ailing banks. Sound familiar?

Follow the link for the complete post.

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The Best and the Brightest Meme — Eight Years Too Late?

Ken Houghton

CR beat me to commenting on this Mankiw whine post, partially because I couldn’t think of anything reasonable to say about it. (CR could. That’s why he gets the big bucks.)

But now that CR has done the heavy lifting, let’s look at the other aspect: Mankiw’s standard:

Based a standard ranking of economists’ academic accomplishments as of October 2008…[emphasis mine]

    11. Larry Summers
    21. Greg Mankiw
    35. Ben Bernanke
    99. Eddie Lazear
    132. Glenn Hubbard
    249. Harvey Rosen
    391. Christy Romer*
    653. Austan Goolsbee

[emphases Mankiw’s; Bush administration officials]

Leaving aside whether the ranking used makes sense, we ask the next question: What does this have to do the performance of the individual in a government role?

So I realised we’ve been thinking about the Obama Administration in exactly the wrong way.

Several people are referencing the late David Halberstam’s The Best and the Brightest, a biography of the Kennedy Administration’s well-educated pedigree and their policy missteps. Krugman used it as a cautionary phrase in the exact post about which Mankiw whimpered. As John McCain once wrote:

The term “best and brightest” has become an insult, not an accolade, thanks largely to Halberstam’s magnificent, scabrous epic about the policymaking blunders that swept the United States into Vietnam. This classic work is part of the Vietnam canon, but it is not really about Vietnam; it is very much a Washington book, focused on the surety of the hawks stateside rather than the misery and warfare in Indochina. [italics mine]

But look at (most of*) Obama’s picks:

    Orszag – Currently at the OMB. Prior experience at CEA, and then as a Special Assistant to the President during the Clinton Administration.
    Summers – veteran of the Clinton Administration
    Geithner – veteran of the Clinton Administration
    Paul Volcker – veteran of the Carter and Reagan AdministrationsModule Water Slide best, named Chair of the Federal Reserve by Carter.
    Melody Barnes – Eight years as Chief Counsel to Senator Kennedy on the Senate Judiciary Committee
    Heather Higginbottom – Eight years as legislative director for Senator Kerry

The list goes on, but what is notable is that—with the exceptions of the Advisors Goolsbee and C. Romer—all have extensive government policy experience.

Let’s look at the Bush people:

    Mankiw – columnist for Fortune, textbook author. As Bruce Bartlett noted in 2003, “Mankiw endorsed the election of George W. Bush because, unlike Al Gore, he would cut taxes, reform Social Security and antitrust policy, and try to implement school choice.” Spent one year as a CEA staff member—twenty years prior to being named CEA Chair.
    Lazear – No policy-making experience prior to being named to the CEA.
    Hubbard – No policy-making experience prior to being named Chair of the CEA.
    Harvey S. Rosen – Deputy Assistant Secretary (Tax Analysis), Department of the Treasury, 1989-91, then no government experience again until named to the CEA in 2003. (Fairness note: the interim is largely a Democratic Administration. No indication what he did from 1991 to 1993, save possibly returning to Princeton to teach). Note that he officially did exactly that in 2005, though he had warned that might happen.

Comparing the actual policy experience of the two Administrations, references to Halberstam’s work are much more applicable to the Bush Administration than the incoming Obama Administration.

Despite having a relative disadvantage in looking for people with policy-making experience (eight years with a Democrat in the executive branch over the past 28 years v. Bush’s twelve of the previous twenty), the Bush Administration’s combined highlights list has less total experience in policy-making than Summers alone.

Knowing how to make sausage is a Comparative Advantage when one is working in a sausage-making environment. Otherwise, you just end up with a “hack.”

*Mankiw uses Greg and Ben and Eddie as well, so I assume the use of “Christy” is not meant to pejorative. Firedoglake’s mileage may vary.
**Goolsbee is the notable exception, and he is in a Senior Advisory role, specifically the Economic Recovery Advisory Board, where he will be working with Paul Volcker.

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Volcker: Does Trade Matter? The Old Guy Says, "Yes"

By Stormy

That Obama named “Mr. Volcker to lead the President’s Economic Recovery Advisory Board” suggest that trade might finally matter. Consider Fed Chairman Volcker’s remarks to the House Banking and Committee in 1986; consider also ex-Fed Chairman’s 2005 piece in the Washington Post.

At the time of his remarks to the House Banking Committee in 1986, U.S. trade deficit had dipped sharply to about $125 billion, far less than where it stands now.

Volcker saw the 1986 trade and fiscal deficits as “interrelated.” Those “deficits in our budget and trade accounts will take years to correct.”

Take for instance, the trade problem. The dollar had risen to extraordinary high levels by early 1985, with the effect of undercutting our trade position vis-à-vis major industrial competitor…The net result was to drive our trade deficit to a rate of close to $150 billion by the end of last year and to about $125 billion for the year as a whole.

In fact, the rate of demand increase, if maintained, would probably be beyond our long-term growth potential. In that sense we continued to live beyond our means, at the expense of a widening trade deficit.

Now consider his remarkable 2005 piece in the Washington Post. To many, those were boom years. For Volcker, there were “disturbing trends: huge imbalances, disequilibria, risks…”

It’s all quite comfortable for us. We fill our shops and our garages with goods from abroad, and the competition has been a powerful restraint on our internal prices. It’s surely helped keep interest rates exceptionally low despite our vanishing savings and rapid growth.

And it’s comfortable for our trading partners and for those supplying the capital. Some, such as China, depend heavily on our expanding domestic markets. And for the most part, the central banks of the emerging world have been willing to hold more and more dollars, which are, after all, the closest thing the world has to a truly international currency

The growth was a mirage; we produced little, imported almost double what we exported. Imports exceeded exports by a 2:1 ratio.

It’s not that it is so difficult intellectually to set out a scenario for a “soft landing” and sustained growth. There is a wide area of agreement among establishment economists about a textbook pretty picture: China and other continental Asian economies should permit and encourage a substantial exchange rate appreciation against the dollar. Japan and Europe should work promptly and aggressively toward domestic stimulus and deal more effectively and speedily with structural obstacles to growth. And the United States, by some combination of measures, should forcibly increase its rate of internal saving, thereby reducing its import demand. [Italics mine]

Volcker saw the problem as “intractable”–and perhaps sarcastically recognized the “establishment” solution for what it was: “pretty,” not very realistic.

Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.

Fond dreams fed such pretty pictures. Did establishment economists really think any of the following would just miraculously happen?

  1. Asian economies would permit and encourage a substantial exchange rate appreciation? China had and still has no interest in such an appreciation if that appreciation hurt its exports. (Recently, China tightened its dollar exchange rate to protect some of its sensitive industries.) Furthermore, China is a country with a plan of rapid, non-stop, catch-up industrialization. Exports are its strategy for rapid growth. Import raw materials; export finished goods.
  2. Japan and Europe would stimulate their economies? Japan, which depends on exports, now is starting to run a trade deficit. Europe, to a lesser extend, had the same problem with China, a growing trade imbalance. Only this part of the picture, however, had any likelihood of occurring.

  3. The United States, by some combination of measures, would “forcibly increase its rate of internal savings, thereby reducing its import demand?” Very unlikely, given the corporate and financial honchos now in the U.S. saddle.

This last part of the pretty picture needs elaboration, for it is the part we can control–if we had the will to do so. But first, we should at least recognize some aspects of the game that has been played.

Those parts of corporate American that set up shop in China enjoyed enormous profits, from its great retailers–such as Walmart, which now should proudly and publicly flash it’s “Made in China” label–to its great manufacturers of drugs, auto parts, IT, and many others. Did we worry? No. We glowed over the stock market boom.

The yuan peg, together with cheap labor, export tax rebates, no environmental overhead–all of this increased profit margins. Business was good. If a goods could be manufactured where overhead is low and then sold to a country where the currency is much, much stronger, well, what CEO would not pay himself a handsome bonus for the wisdom of seeing that kind of light?

Remember when many complained not so long ago about the loss of our textile industry to China? Schumer demanded reports on the currency mismatch. How quickly that fuss ended. Once the shops were torn up in the U.S. and replanted in China–and the displaced workers were absorbed back into the U.S. work force–, who really cared? Industry after industry have left our shores. It is not that we desperately need a textile industry, but we do need a net trade balance.

Another part of the “pretty picture” we should understand is that our leaders have been primarily focused on the consumer–not the worker. What was Paulson’s and other leaders–Democrat and Republican–first response to the present crisis? Send out rebate checks! Get the consumer spending again!

Talk about grabbing the wrong end of the stick. What did Bush want in exchange for support for a loan to the Big Three? Free trade with Columbia! Regardless of how we viable we think our auto industry is, look at the priorities. Can we argue that free trade with drug-ridden, gangland Columbia is going to improve our net trade balance? Did it with Mexico? With no environmental or labor safeguards it failed miserably in Mexico.

In 2007, net trade (millions of dollars) with Mexico was $-77,590; with Columbia $-1,237, with South and Central America, $-106,463; and with the European Union, $-113,936 Again, can anyone argue that our recent trade agreements have improved our net trade balance–or that any subsequent ones will?

Or has anyone come up with an idea of how to force the American consumer to save more? Give him more credit cards? Lower interest rates? Pour money into banks so that the banks can lend more?

An eighty-year old straight-shooting geezer trundles forward, ready, I hope, to tell the truth to the President’s panel of Economic Advisors. Oh, to be fly on that wall. No more young pups with fond hopes and pretty pictures. No more squishy, left-wingers painting teary pictures of poor struggling Columbian florists. No more grim-faced, tight-lipped right-wing hard ballers pumping for a stronger dollar, less regulation, and a trade policy that has been a disaster..

Let’s take Volcker’s old-fashioned view: Think about trade.

Quick globalization has become a terrible mess.

Maybe we should export our financial wizards, our corporate honchos, our lobby-dizzy politicians.

Let them plant rice fields or work for Nike. At least we would be rid of their “get-me-rich-quick” schemes. With them, we should send their Jesuit-style, free trade apologists, those economists who proclaimed that quick globalization promises endless bounty for everyone.

Furthermore, we could finally put those high salaries and stunning bonuses to good use. Those economists could explain to their CEO and financial masters that every CEO working for peanuts in a Chinese Nike plant or painfully planting a Chinese rice field creates thousands of productive jobs in America.

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What’Swap: Accounting for Financial Innovation

Robert Waldmann

has become interested in Credit Default Swaps. I’m not just wondering whether they played a major role in destroying the world financial system or were just along for the housing bubble, MBS, CDO ride. I also wonder whether the acronym for the plural should be CDS or CDSs or even CDSes. I’m glad to see I’m not the only one.

But more even that that, I wonder why credit default insurance is called a credit default swap when the contract is as asymmetric as a financial contract can be. I have no information on the history of the term and will just speculate. I assure the impatient reader that this post is not totally pointless (as far as I know) and leads to a practical proposal for regulatory reform.

After the jump, I will argue that the main motivation for the invention of new financial instruments was to evade relax capital requirements, that this relaxation was reasonable in the case of interest rate swaps, that it was unreasonable in the case of credit default swaps and that credit default swaps should be recorded in balance sheets as if they were interest rate swaps (which they are in disguise).

I will start with interest rate swaps, which are clearly swaps. In an interest rate swap contract to entities agree to exchange a constant times interest paid on one bond during the term of the interest rate swap contract for a constant times interest paid on another bond during that period. For old timers, it is as if they were buying and selling coupons not bonds. Why would they do that ?

First it is possible to construct an interest rate swap using a portfolio of older assets, bonds, bond futures, short positions on bonds and short positions on bond futures. Instead of buying interest paid on a bond this year I can buy the bond and sell short the bond a year from now.

My first claim is that the new instruments exist, because if they appear in balance sheets total assets and total debt are smaller numbers — that is for accounting and regulatory reasons. This is not the most common explanation for the existence of interest rate swaps. The explanation is that corporate bonds are not liquid, that is, the market for them is thin (or illiquid in financial operator speak). This means that if I send huge orders for bonds and short orders for bond futures to the double auction market, I will pay a huge price for the bonds and get a low price for the futures. Thus it is better for each of two firms for them to negotiate a bilateral deal with an agreed price and quantity. This gets us as far as “swap” but doesn’t explain why these contracts are written as exchanges of interest payments and not as exchanges of bonds and bond futures. So far, it seems that it would make no difference.

If the firms are banks with binding capital requirements it makes a huge difference. A huge long position in a bond is a huge asset and a huge short position in the futures is a huge liability. A position recorded as a portfolio of bonds and bond futures would imply that a huge amount of wealth must be set aside to satisfy capital requirements. If it is recorded as a much smaller position in interest paid on bonds, then banks are not required to have so much idle capital to satisfy capital requirements.

In this case the new accounting is reasonable. The risk in holding a long term bond for, say, a year is almost entirely in its price at the end of the year. So long as the issuing firm doesn’t default in the course of the year, (nominal) interest payments are safe. The the long position in the bond and the short future position are an almost perfect hedge. The two sources of risk cancel. It would make no sense to evaluate the total riskiness of the position at the sum of the two risks as if two almost perfectly correlated positions were uncorrelated.

Now with an acute sense of how existing regulations have nothing to do with portfolio theory or 20th century risk management, regulatory authorities were willing to the innovative accounting.

The next step is almost logical. If interest paid on a bond is scheduled interest (a known constant) minus losses due to default, one could rephrase an interest rate swap as a credit default swap. I pay you the interest paid on Bond A and you pay me the interest paid on bond B = I pay you a constant (which can be negative) plus losses due to default on B and you pay me losses due to default on A. Now that we already have the constant, there is no reason to make the positions in both bond A, so an interest rate swap becomes two credit default insurance contracts. I think this is why credit default insurance is called a credit default swap.

OK so still there is no change in possible financial transactions. CDSs like interest rate swaps are redundant assets which can be created out of portfolios of bonds, futures on bonds and short positions of them. So what is the point ?

Well the accounting innovation has become an accounting innovation squared. As the interest rate swap meant that the value of the bond at the end of the term no longer appears as an asset, the CDS means that scheduled interest payments no longer appear as an asset. The CDS appears in balance sheets at its fair market value, not as a large position in a bond and a short position in cash (or debt of the firm which bought the credit default insurance if its required payments are spread out over time). By introducing interest rate swaps and CDSs into accounting, firms have managed to rewrite immensely huge positions in bonds etc to merely huge positions in interet rate swaps to merely tens of billions in CDSs.

Now this second bit of innovative accounting is totally unreasonable. The part which no longer appears in accounts, the scheduled interest rate, is not an apparent source of risk which is hedged. It is the safe part. Writing a CDS is a way of bearing all the risk with a very small number recorded as the value of liability.

In the case of interest rate swaps, firms had a way to hedge risk which was not automatically recognized as such by accountants and regulators. So they changed the accounts so that large apparent risks which cancelled didn’t appear.

With credit default swaps, firms found a way to describe the exact same transaction so that the numbers on their balance sheets were different and so that their required capital was smaller.

Now it is fairly easy to argue financial market innovation is socially useful, but few people would argue with a straight face that we need more innovative approaches to accounting. However, it appears that many people were willing to argue that innovative accounting *was* innovative finance. They convinced Gramm and Clinton went along (who was his treasury secretary at the time ?).

Now to me the reform is obvious. My proposed regulation follows.

People can trade what they want, but accountants must write accounts based on standard assets. New assets can be accepted into accounting only once their risk to value ratio is determined by the Basel III standing committee (Oh and the USA participates in Basel III). CDSs are not standard assets and CDS positions must be rewritten as interest rate swap positions.

An exception to the above shall be allowed. If a firm really insists on putting an unrated asset into its accounts, then it can. However, the number written as “liabilities” must be the present value of the maximum conceivable payments on its position and the number written as “assets” must be the present value of the minimum possible payments it will receive.

Believe me, bankers will find a way to express most new assets as portfolios of standard Basel III acceptable assets.

I admit that, under this plan, an authenticly genuinely new non-redundant instrument will be rated as extremely risky until diplomats and bureaucrats are convinced that it isn’t. I consider that a feature not a bug.

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Revising history in living memory

Glenn Greenwald at Salon opines on the nature of BDS and the necessity of having major players agree and augment his statements and viewpoints, including the NYT. BDS has much merit in objective terms on many issues, but as one man, even the President, he hardly did his stuff alone, or against major headwinds from the bosses.

So again, why is Chavez suspicious of the US? Because he is socialist? or because of other things like the US backing a coup to get rid of him? Duh.

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