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

Default Events, Legal Contracts, Derivatives, and Greece

Barry Ritholtz, who generally knows better, blew a gasket at ISDA for yesterday’s ruling that Greek bonds are not yet in default. Specifically,

“The International Swaps and Derivatives Association said on Thursday that based on current evidence the Greek bailout would not prompt payments on the credit default swaps.”


Here is a question for the crowd: Exactly how brain damaged, foolish and stupid must a trader be to ever buy one of these embarrassingly laughable instruments called derivatives?

The claim that Greece has not defaulted — despite refusing to make good on their obligations in full or on time — is utterly laughable.

Let’s sidebar the reality—that there is no true “market” for CDS in general, let alone Sovereign Debt CDS; Donald R. van Deventer of Kamakura Corporation has been all over this, both on his blog and especially on Twitter—and just note that ISDA made the correct decision.

Greece has not, to borrow Barry’s phrase, “refus[ed] to make good on their obligations in full or on time.” ISDA did not declare a Default Event yesterday because there has not yet been a Default Event.

Default Event is a very specific term. The sample in Janet Tavakoli‘s Credit Derivatives and Synthetic Structures (a book to which I have referred before and undoubtedly will again) runs pretty much three full pages (pp. 88-91). But the general concept is straightforward: there is a minimum threshold (say, 10% of an issue), the principal or interest due of which the entity explicitly refuses to pay or fails to pay that then materially impacts the buyer of Credit Protection (CDS).

Greece has not yet refused to pay anything.*

There is a payment due on 20 March—19 days still in the future. The financial markets—heck, everyone who runs a diner in Queens—may well believe that no payment will be made on 20 March, but that hasn’t happened yet. And the Greek government specifically has not said it won’t make the payment; it has said, “Hey, take these bonds instead.”

It is true that, cet. par., the market value of the bonds being offered is about 25% the supposed economic value of the current ones. So anyone taking the deal would have to be assuming that the market value of the current bonds is somewhere around 25, just as the French and German banks have them marked.

The market may also agree that one of the reasons people may well accept the offer is that, otherwise, they expect that the Greeks will default on the current bonds.

But they haven’t yet, and this is not Minority Report (though we can all agree Phil Dick would recognize, if not approve of, the current financial world).

So ISDA correctly ruled—the key phrase is “based on current evidence”—that there is not yet a Default Event. If everyone says “we will tender our securities due 20 March for the exchange offered,” there will not be a default of those bonds.

You, I, and Bill Gross can all agree that the likelihood of this happening is about equal to the chance that Rick Perry will be elected U.S. President this year. But there has not been a Default Event.

Wait two or three weeks.

The thing Barry most overlooks is that yesterday’s ISDA ruling is, if anything, good for CDS buyers.

What will be the economic difference of waiting to holders of the CDSes? I don’t know for certain, but if you’re looking at the standard ISDA CDS contract, there’s a reasonable assumption that (1) the market price of the bond will not change for the better and (2) it is a certainty that the Accrued Interest on the bond will be greater when they declare a Default Event than it is now.

Keep in mind: in a standard CDS, declaration of default terminates the contract. Accruals end, market pricing is to be determined by calling a few dealers, and the only thing left is to go through the pockets and look for loose change.**

Yesterday’s ISDA ruling means the CDS buyers will be owed more Accrued Interest when (in two, or at most three, weeks) a Default Event is declared.

What about the principal repayment due? Recall again that the payment due is generally the net of the current market price subtracted from the initial principal amount (assumed to be par—100—but in any event greater than the current market value).

I’m inclined to argue there is optimism in the current market that will not be there in two weeks: it’s not that liquid a market, there is a floor on the price of the economic equivalent of the new offer, and there is time value in the option to convert.***

If ISDA had declared default yesterday—that is, assumed that Greece wasn’t just “mostly dead”****—they would have taken the current market price [P0]. Even before the delays and roundelays, that was likely to be greater than the market price of those bonds in a week or two[P1, when default is declared.

That is, P0 is greater than P1. And since the payment due is based on [100*****-Pt], the principal amount due to CDS holders when default is declared will also be greater.

ISDA followed the letter of the contract: the Greeks have not yet defaulted on an obligation, nor have they stated that they intend to do so. When they do—there are few, if any, in the market who would treat the clause as a possible “If”—a Default Event will be declared and the CDS contracts will be expected to pay as they are due. And that payment will, in all likelihood, be higher than the payment that would have been due if ISDA had ruled differently yesterday.

And if they don’t, then I’ll be agreeing with Barry that the whole thing was a scam from the start—though I would still argue that JPMorganChaseBear stealing more than $1,000,000,000 in customer funds from MF Global clients is a bigger one, which is something like saying that coprophagia is even worse in liquid form.

When the CDS contracts actually have to be paid, then the fun will begin. If potential for insolvency is your idea of fun. But that’s another story.

*They have seen S&P downgrade their credit rating, but that’s a separate issue.

**Obligatory reference. It will pay off.

***The Worst Case scenario is that you assume the new bonds are the only value in the transaction, and discount their value back over the cost of basically two-week money. The best case scenario is some combination of the price of the new bonds and expectations of either getting a better deal later and/or post-litigation gains. The lattice may be ugly, but it yields an expected value higher than the Worst Case, and therefore higher than the market price of the bonds as the time to exercise approaches.

****See ** above.

*****Or the other initial contract price; in any case, a fixed value greater than Pt.

Tags: , , , , , , , , Comments (3) | |

Notes Toward Modeling a Risk-Free Rate with Default Possibilities

Brad DeLong asks why it hasn’t been done, if it hasn’t been done.  The biggest problem I can see is that you don’t know how insane the participants are—and that will have a major effect on how much damage is done when.

Don’t get me wrong; the damage is already being done; it has been since at least May, and if Barack H. Obama weren’t an idiot, he would have been mentioning that over the past two months.  Unfortunately, the sun is yellow on our world, and counterfactuals are masturbatory, not participatory, acts.

So let’s start with what we know:

i= r + πe

Nick Rowe apparently would have us believe his (completely understandable) claim that i would not be directly affected by a short-term default. This strikes me as absurd.
Even when the economy is working on all cylinders–where G contributes something around 10-15% of growth at most—reducing G to zero for a week is about 2% of 15% or 0.2%-0.3%—noticeable, but arguably rounding error against the difference between π and πe. So, if you assume a short-term issue, you get something like those legendary two weeks from 11-22 September 2001, when only the Saudi Royal Family was spending anything, writ somewhat smaller only because Gunderstates the effect on r.)

We can concede that inflation expectations themselves aren’t going to go up independently: any additional borrowing cost will be a drag on r, so it’s not unreasonable to assume that i will be fairly steady—again, working a very short-term issue.

But, as often happens, we leave out a variable in our assumptions, simply because we define i as the risk-free rate of return.  Let’s put it back in:

i= (r + πe)*(1+ Pd)

Where (1+Pd) is 100% plus the probability that there will not be a default. (Note that in a model environment, Pd=0, otherwise, we would not call it risk-free: actors have the power to make and manage budgets, including the power to tax to pay for services desired by their plutocrats constituents.)

Finance people will recognize this reduced form equation:.  (1+ Pd)= β, the risk of the stock or portfolio in excess of the risk of the market.  For convenience, let’s just call this version Ω. So,

i= (r + πe)*Ω

Next comes the hard part: term structure.  Or, as Robert said in a similar context, are you talking about the Federal Funds rate, or the rate on three-month Treasury Bills?

Well, that depends on how long we expect the issue to be an issue.  If Barack “I’m an idiot who stands for nothing and you’ll vote for me anyway because my opponent will be insane” Obama treated this “crisis” the way he treated the last (real) one, he would insist on getting a clean bill raising the debt ceiling passed through both Houses and on his desk for signing by the end of next week.  If he takes it as another chance to blow Cass Sunstein and the rest of his University of Chicago buddies, then it’s a complicated bill that will get a few Congressmen killed* and several others de-elected, and we might be talking weeks.

Right now, the markets are assuming the former.  Let’s be optimistic and assume they’re correct.

Four weeks ago, there was a Treasury Bill auction that produced a yield of  0.00%.  Extending that bill does no harm at all—not even to expected debt totals. (Investors mileage may vary, but they bought it with full knowledge of the timing.  And there were 10% again behind them bidding at the same rate.)

Some specific Notes and probably Bonds—it is August—will have coupon payments due on the 15th. But those are coupons, not principal repayment, so again we’re not talking much value of the Note or Bond itself, once you hit five years or so.

Bills will be a problem.  Short-term notes will be a problem.  Fed Funds is uncharted territory.  Tripartite Repo specifically, and Repo in general will be a major problem due to questions of collateral value.  And guess who uses those the most?  Hedge fundsThe people who have been financing John Boehner’s and Eric Cantor’s campaigns.

So the term structure looks like it would if you’re going into a recession: short-term rates rise significantly, while the longer term securities shift upward a bit. (Select Notes and Bonds with near-term coupons kink the curve, but there’s no certain arbitrage there, especially with transaction costs.  Cheapest-to-deliver calculation is also affected in the futures market. I could go on, but let’s just pretend—correctly—that these are minor issues.)

Because now our “baseline” rate is no longer risk-free—and we’re not certain what Pd is over time.  We know it will return to zero at some point, and we presume (at least at the beginning) that it will be soon. But we also know that there already are follow-on effects, and that they will only get worse. Even if we ignore the effect on G (and therefore i) of a short-term default, we lose our bearings for a while.

So the big question is collateral and spreads.  Been posting Treasuries to borrow against?  Yields up due to Pd > 0, so prices down, so less flow. And probably haircuts due to uncertainty of any return to “risk-free.” Posting Treasuries with a coupon due?  Haircut! Posting Treasuries with a near-term coupon?  Haircut! Posting Munis?  Think Michael Jordan (or Telly Savalas, if you’re Of a Certain Age).  So you can borrow less, and probably have to sell some of your assets.

Which ones?  If we’re lucky, it’s longer-term Treasuries, and some of the yield curve inversion mentioned earlier is reduced.  But the market is going to be less liquid than usual, so maybe some of those other bonds get sold—corporates, for instance.  The bid-offer on Munis is basically going to be zero-coupon bonds at a high discount. (Think fast about how many state and local municipal projects depend on some form of Federal funding.  Then realize that your estimate is probably low by an order of magnitude.)  Or corporations that are dependent on government funds (DoD providers, automobile fleets, interstate paving contractors, power supply and distribution companies, etc.)

In a ridiculously oversimplified model, the spreads simply expand by Ω, with a possible adjustment downward based on direct exposure to government financing. This, again, probably understates the effect.

So, in a closed economy, everyone gets to pretend things are close to the same—just more expensive, with a lot of damage to hedge funds and municipalities and borrowing costs and credit lines. So money supply drops significantly (multiplier effect reduction) even without Fed intervention.  You get an Economic Miracle: reduced supply and higher yields.

But we don’t live in a closed economy.  So there’s another factor.  And I’m running out of Greek letters, so let’s just use an abbreviation everyone knows:

i= (r + πe)*Ω*d(FXd)

where d(FXd) is the change in the FX rate due to the default adding uncertainty to cash flows.

That’s right: we get not one but two economic miracles:  (1) domestically, a reduced supply of risk-free securities produces higher yields and (2) internationally, higher yields lead to a depreciation of the domestic currency.

Anyone still wonder why no one wants to build the full model?

*No, I don’t want this to be the scenario.  But if you offered me the bet, I wouldn’t take the under at 0.99.

Tags: , , , , Comments (1) | |

Financial Services Intermediation

Traditionally, non-commercial banking (i.e., everything except savings deposits and consumer loans) was about one of two things:

  1. Tax arbitrage or
  2. Regulatory arbitrage

    The rest is window dressing; that is, it was basic financial intermediation, usually for the purpose of helping Corporate and/or High Net Worth clients.*

    That was until the late 1990s and the Noughts, when the third level came to liquidity-prominence:

  3. Credit rating arbitrage

The third is the most chimerical of all, becausemdash;unless you’re selling to or buying from the company that is involved (which has correlation issues, as I noted long ago)—neither party (in theory) has control over the outcome of events. It’s asymmetric information on both sides: not so much gambling against the house as shooting craps in the alley, not certain whether there is a bobby down the block.

All of which is an indirect way of saying: Go Read Kash Mansori. Especially if you think US institutions are managing better than the EU is. (Hint: it may be true on the governance level, but the financial institutions’s exposure appears to tell another story.)

*Think corporate deposits, lines of credit, commercial loans, IPOs that are often used in part to pay off debt, and the like. Normal course of business options, with the selection influenced by tax or regulatory considerations.

Tags: , , , Comments (1) | |

There’s a reason they talk about 2 August: What the Republican Mainstream Hath Wrought

Reuters reports that the mainstream Republican Party has decided to jump the shark admit it is insane:

David Frum, a former speechwriter for President George W. Bush and a Republican advocate for raising the debt limit, said he holds regular question-and-answer sessions with Republican congressman over a beer.

“I have yet to meet one Republican who actually says a failure to raise the debt limit scares them,” Frum said. “It is deeply, deeply troubling the number of Republicans I now talk to – and I include the mainstream – who think a technical default is manageable.”

Many on Wall Street disagree.

They fear even the briefest default would cause a steep climb in interest rates worldwide and a tumbling U.S. dollar, which would tip a fragile economy back into recession and cause financial market upheaval on a scale not seen since the collapse of Lehman Bros.

Let us be clear: a “technical default” is manageable. It is being managed right now. We’ve been in “technical default” since around May 15th. Vendors are seeing payments delayed, contract signings are being put off, funding is being delayed. We can not pay soldiers, after all. They’re getting food and lodging in Afghanistan or Iraq or Libya anyway; they don’t need money.

Pat Toomey appears to believe that would be a good idea:

Republican Senator Pat Toomey has even introduced legislation directing the U.S. Treasury to prioritize debt service over other payments if the debt limit is not raised. It has 22 Republican co-sponsors in the Senate and 98 in the House of Representatives, although no members of the Republican leadership have backed it.

Good thing Toomey thinks those ungrateful Chinese bondholders are important. But who are they more important than?

Short answer: Republican voters.

Longer answer: Social Security recipients, who traditionally receive their checks and direct deposits on the 3rd of the month.

Which means the funding has to be available—to authorize scheduled ACH transfers, if nothing else—on the 2nd.

Which means— since for purposes of the “deficit,” Social Security is part of the “unified budget”—that Social Security’s EOD balance will decline on August 2nd, since there will be no coupon receipts or security redemptions that day.

In short, Toomey wants to pay bondholders and screw Social Security recipients. And he has at 110 Senators and Representatives who believe that is a good idea.

I want to see all 111 of them meet with all of their SocSec recipients on 3 August 2011 and tell them, “Well, we had to balance the suffering. And it was either you or the Chinese government. And they mean more to us than you do.”

UPDATE: Felix focuses on the same paragraph, reaching half of the same conclusion. Take the next step, mate.

Tags: , , Comments (44) | |

Greece will not be ‘allowed’ to default until policy shores up the Irish bond market

Just look at Tracy Alloway’s imagery at FT Alphaville, and you’ll know what’s expected: an imminent Greek default. I still argue no, although European policy tactics are quite enigmatic and their next move is really anyone’s guess. Alas, here’s mine.

Assuming that Greece does not secede from the Euro area, I give you three reasons why Greece will not be allowed to default soon (at least the next 12 months, given current market conditions). I say ‘allowed’ because true to the IMF legacy, EU/Euro area officials very likely see restructuring as a ‘gift’ for good fiscal behavior.

(1) Moral hazard is an important issue in Europe, and Greece has only begun its austerity program. We’ll need confirmation that they are not on track in order to assess the timing of default, in my view.

Ironically, the EU/IMF/Euro area are sticking to the ‘exports will grow the Greek economy’ story. I say ironically because Greece was exporting a larger share of GDP before the recession, average 22.6% spanning 2005-2007, than it is now, 19.8% in 2010 (average Q1-Q3).

(2) The banking system’s not ready. Unless the Germans want to instantly recapitalize the Landesbanks this year, I’d argue that the Euro banking system remains overly exposed to mark-to-market accounting (i.e. holding the assets at fair value not wishful thinking) for all of the crappy debt that it holds on balance.

In fact, the German banks purchased 11bn 1.1bn euro in Greek sovereign bonds in January. That’s the most current data available; but I bet they’re simply moving debt out of the Greek banks and corporates and into the sovereign as the probability of default rises (see chart below).

(3) This one’s critical: policy makers must shore up Ireland and Portugal in order to avoid a quick contagion across the European banking system. They haven’t done that yet. In fact, the Finnish election results exposed the tenuous negotiation process overall.

See, the Greek yield curve is inverted – so are the Portuguese and Irish yield curves, albeit to a much lesser degree. The point is, that Portugal and Ireland are very close to the Greek brink.
(read more after the jump!)

Inversion matters. Currently a Greek 10yr bond yields 14.5% with a euro price of 59, while a 2-yr bond yields 21.4% with a euro price of 73. Bond investors are going for the cheapest bond not the highest yield (at the end of the yield curve) as a bet on a binary situation: haircut or no haircut. When a curve is inverted, it’s all about price not yield.

Portugal and Ireland are already inverted and close to the Greek brink. If Greece were to restructure without a full-fledged backstop from the Euro area governments, the Portuguese and Irish curves would swiftly turn over. And if European policy makers could stop the contagion there, then that would be a true feat….

Spain, the economic ‘line in the sand’, would be next. We saw last week how markets view the Spanish sovereign, still risky. Bond yields on the Spanish 10yr broke out of a 4-month trading band, hitting 5.55% on April 18 (latest number is 5.47%).

More on Ireland

I assure you, that it’s too early to deem the Irish sovereign as impervious to the Irish banking system’s fake asset base. The banking system is living on emergency liquidity assistance (ELA) and the ECB’s marginal refinancing operations (currently Irish banks can borrow as much as they want on a short-term basis from the ECB at the current rate, 1.25%).

By my calculations, the Central Bank of Ireland (via the ELA) and the ECB are subsidizing – I say subsidizing because market funding costs are proxied by the sovereign borrowing costs of 10% – 16% of the Irish banking system’s balance sheet. As such, profit margins are thin, and mortgage rates are running low at 3-4%. (see CBI website for plenty of data.) These funding costs are not sustainable – not to mention the Irish stress tests assume that they remain fixed at Q4 2010 levels (see exhibit 2 in Appendix C of the stress test documentation). Nonperforming loans will rise.

I leave you with this illustration of possible non-performing loans when mortgage rates rise on the following:

(A) ECB rate hikes – mortgages are tied to 12-month euribor and most Irish mortgages are variable.
(B) the dissipation of record-low bank borrowing costs (this also is another post, but the ECB has yet to release its medium-term funding program for Ireland).

Note: if/when they do default, Kash at the Street Light blog provides an overview of some technical considerations.

Rebecca Wilder

Tags: , , , , Comments (3) | |

Reducing household financial leverage: the easy way and the hard way

In case you haven’t noticed, I have become slightly less “optimistic” about the prospects of a sustainable U.S. recovery. I used to think that the household deleveraging story was more of a decade-long project, and the economy would cycle throughout. But recent deficit hysteria has me worried; income growth might lapse.

What differentiates this recovery from every other cycle since 1929 is the lingering debt deflationary pressures. There is a very large overhang of U.S. household financial leverage that’s going down one of two ways: the easy way, through nominal income growth, or the hard way, by default. Unfortunately, the hard way is rearing its ugly head.

The chart above illustrates private-sector financial leverage (debt burden). Not a surprise; but, the real leverage problem is in the household sector, and to a much lesser degree, the non-financial business sector. Household debt burden is the ratio of the debt stock (generally mortgages outstanding plus consumer credit) to income flow (personal disposable income), while “de-leveraging” is reducing this debt burden.

Given that the burden has a numerator (debt stock) and a denominator (income), de-leveraging can occur through either variable. As such, I see three (general) de-leveraging scenarios (See an earlier McKinsey study on the consumer for a broader discussion):

1. If there is no income growth, then households must manually pay down debt at the cost of current consumption. The consumption decline drags the economy, and some default results.

2. If income growth is positive, then the degree to which households must pay down debt at the cost of current consumption will depend on the pace of income generation. This is the most macroeconomically-benign scenario.

3. If income growth is negative, i.e., deflation, then real debt burden rises. 30-yr mortgage payments, for example, are fixed in nominal terms and become more difficult to meet as income declines. In this case, widespread default is likely.

Of course, these are just three broad categories, but I believe that my point has been made. Clearly, choice 2. is optimal. However, evidence is pointing to a de-leveraging process that is more of the 1. and/or 3. type, especially as the federal stimulus effects run dry (although I have noted before that there is room for error in the measurement of the income data).

The chart illustrates annual growth of disposable personal income minus annual growth of disposable personal income less government transfer receipts (DPI – DPIexT). The variable DPIexT proxies the personal income growth currently generated by the private sector only. Note: this is a calculated number, based on the BEA’s monthly personal income report (Excel data here). The spread has never been wider, 2.1% Y/Y DPI growth over DPIexT growth in February, spanning every recession since 1980.

The government is propping up income (as it should be). Spanning February 2009 to February 2010, DPI averaged 1.2% Y/Y growth per month, while DPIexT averaged -1.1% Y/Y per month. Further, since the onset of the recession DPIexT fell an average 0.03% M/M (over the previous month), while DPI grew 0.18% M/M.

The economy has crossed the threshold and is expanding – phew! However, without a burst of export income, it’s going to take a lot more than 123,000 private payroll jobs per month to free the economy of its fiscal crutch. (I debated whether or not to use the term “crutch” when applying it to fiscal policy because fiscal policy is not a crutch; but the metaphor works.)

Households WILL drop leverage further; it’s just a matter of how smoothly.

Rebecca Wilder

Tags: , , Comments (8) | |

Name the Year: Declining Home Prices and Equity Removal

UPDATE: In this context, Dr. Black catches Jamie Dimon expressing what is at best ignorance:

However, [Dimon] cautioned, until the market meltdown “you never saw losses in these products, because home prices were going up.”

All that research in 1984 and 1990 was for naught, apparently.

I’m still away (things are better, but still not completely back to normal), but this is too good not to post:

Unfortunately, many default models using original LTV [Loan-to-Value] have underestimated the level of delinquencies in recent years. Measurement of the amount of equity borrowers have in their home is the chief cause. Such mismeasurement is due to two factors: declining home prices and removal of equity via second mortgages or home equity lines of credit.

Is this from:

  1. 2008-2010?
  2. 2004-2006?
  3. 1996?
  4. officially 1996, but other textual evidence indicates it was written between 1989 and 1993?

My answer is (4); the official one is (3), since it’s from the Third Edition of Frank J. Fabozzi’s Bond Markets, Analysis and Strategies (now in its 7th edition).  But if anyone out there has the first or second edition and wants to check the chapter on Mortgage Loans, I’ll give odds the paragraph is virtually identical in the Second Edition.

Tags: , , , , Comments (3) | |

Why Can Asset Prices Fall

Robert Waldmann

Brad DeLong boldly attempts to exhaustively list the factors which can affect the value of a fixed income asset. This is some Mac generated i document and I can’t cut and paste. Go here and search for “there are four”.

The four are called “default”, “the safe real interest rate”, “risk”, and adverse selection.

I view the assertion that “there are four” as a challenge and quibble after the jump.

First the instruments in question promise nominal payments so the safe interest rate in question is the safe nominal interest rate not the safe real interest rate. The word “real” is essentially a typo.

Second “default” and “risk” are the same things for fixed income instruments (clearly what Brad is discussing). By “risk” I assume he means “risk bearing capacity” or “risk aversion”. However, default is a much broader problem than Brad seems willing to admit. He counts exactly two sources of default risk — 1 trillion in housing related defaults and 3 more trillion from defaults caused by the recession. This leaves out other sources of changes in estimated default risk (not risk aversion or risk bearing caspacity but risk).

That is, I see a fifth cause of the decline in asset values. I think many assets were over-valued in the past, because the ratings agencies were tricked or cashing in on their late lamented excellent reputations (or both). The loss of confidence in said agencies causes an increase in estimated risk not because risk has increased or risk aversion has increased but because the old estimates are now known to be bogus.

More generally, risk modeling by traders was similarly complete nonsense. I don’t know to what extent the traders were tricked and to what extent they were in on the scam (nor I suspect do they).

Structured finance created a huge illusion of wealth by creating an illusion of safety. The financial engineers knew how the agencies rated (the agencies explained for a consulting fee) and how traders estimate “value at risk”. They knew people assumed (or pretended to assume) that all stochastic variables are normally distributed. Thus it was profitable to sell instruments with skewed returns (fat lower tails) unless the rare negative event occurred during the testing period (in which case the instruments could be re-engineered). A senior tranche of a pool of moderately risky assets has a skewed distribution.

Similarly money could be made by reducing own variance for a given beta by pooling assets and issuing claims on the pool. The variance of an average is less than the average variance. The covariance of an average and the market portfolio is the average covariance. Thus a claim on a pool of BBB rated corporate bonds was rated AAA. Turning BBB to AAA is worth a lot of money except for the fact that it was a scam (investors could pool themselves — they don’t seem to have understood that pre-pooling reduces the benefit to them of their own pooling — or they were in on the scam).

That is there were trillions of fantasy dollars created out of nothing by financial engineering (on top of whatever real wealth had been created by financial engineering which genuinely made better insurance and diversification possible). The loss of that illusion can’t be estimated easily as “housing related defaults” (and note my example has nothing to do with housing or recessions).

The risk of a nationwide decline in house prices was estimated at 0 by S&P (I am not exaggerating). Now there has been such a decline, and they must admit that there is the risk of another such decline in the future. Even if the current decline costs just $ 1 trillion, the future possible declines also cost money.

So much of the wealth was an illusion which won’t come back soon. This end of systematic miss-estimation of risk is not on your list.

Also institutions took huge gigantic bets against each other (as in AIG lost writing CDSs). This increases counter party risk. No one knows if a counter party is solvent. That reduces the value of a huge number of instruments. The damage could have been done without involving the housing industry or the stock market if, say, investment bank CEOs played a really high stakes poker game and all claimed to have won money. Also bankruptcy is costly. Even if the CEOs had played hundred billion ante poker on camera, wealth would have been destroyed and more wealth would have been shifted from investors to lawyers. This is another item not on your list.

Finally, much of the strange new finance was designed to help agents avoid prudential rules and regulations which they considered to be costly. Now they have learned two things. First that the regulations weren’t so pointless so they will have to pay that cost to avoid bankruptcy. Second they will be audited by banking regulators, trustees etc and found wanting. This last point is semi redundant as it amounts to an increase in perceived risk or a reduction in perceived capacity to bear risk (default or risk in Brad’s terms). However, it explains why I keep speculating that this that or the other operator was in on the scam.

UPDATE: DeLong indirectly replies here. [klh]

Tags: , , , , , Comments (0) | |