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“Concentrations of risk, plagued with deadly correlations”

by Brad Setser
March 17, 2009

The FT’s Gillian Tett makes a simple but important point: AIG’s role in the credit default swap market meant that a lot of risk that the bank regulators thought had been dispersed into many strong hands ended up in a single weak hand.

Tett:

What is equally striking, however, is the all-encompassing list of names which purchased insurance on mortgage instruments from AIG, via credit derivatives. After all, during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks.

But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Société Générale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else. Unfortunately, most of those banks have been shedding risks in almost the same way – namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street.

Far from promoting “dispersion” or “diversification”, innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG’s inability to honour its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers.

If the US creates a “systemic risk” regulator, it should be on the lookout for similar concentrations of risk.

One other point. The fact that several of AIG’s largest counterparties are European financial firms is by now well known. What is I think less well known is that the expansion of the dollar balance sheets of “European” financial firms — the BIS reports that the dollar-denominated balance sheets of major European financial institutions (UK, Swiss and Eurozone) increased from a little over $2 trillion in 2000 to something like $8 trillion (see the first graph in this report) — played a large role in the US credit boom.

As the BIS (Baba, McCauley and Ramaswamy) reports, many European banks were growing their dollar balance sheets so quickly that many started to rely heavily on US money market funds for financing. And if an institution is borrowing from US money market funds to buy securitized US mortgage credit, in a lot of ways it is a US bank, or at least a shadow US bank.

Consequently I think it is possible to think of AIG as the insurer-of-last resort to the United States’ own shadow financial system. That shadow financial system just operated offshore. There was a reason why investors in the UK were buying so many US asset backed securities during the peak years of the credit boom.

UPDATE: I want to second those in the comments who recommended this post on AIG by a credit trader. Those familiar with some of the technicalities of risk management should particularly enjoy it.

A simple historical example of “wrong way risk” is buying insurance against a big fall in the value of the ruble from Russia’s government (or Russian banks). The problem with the insurance? A big fall in the ruble is likely to be correlated with bad things happening in Russia, which would tend to make it less likely that Russia would be able to honor its promises. This was exactly the case in 1998.

The credit trader notes that writing insurance against a default on a lot of different high quality CDOs backed by mortgages is ultimately different than writing a lot of insurance against say fires. The odds of a large nation-wide fall in home prices is a lot higher than the odds of a fire that sweeps across a lot of geographically dispersed cities. I continue to be struck by the damage done by the historical data that seemed to suggest that a nation-wide fall in home prices was rare. Surely a large rise in home prices correlated across several regions would increase the odds? Moreover, it wasn’t hard to realize that the structure of the market had changed over time. When I was growing up — not so long ago — interstate banking was a novelty. Kansas and Missouri had different banks. That meant Kansas banks were very exposed to a downturn in the Kansas economy, but it also tended to reduce the correlation among different housing markets.

107 Comments

  • Posted by DJC.

    - Politically-connected AIG executives knew the US Treasury would come to the rescue if any financial problem arose. AIG is registered as the largest counterparty to “crony capitalist” Goldman Sachs that de facto controls the US Treasury Dept to the detriment of the broader taxpayer interest.

    - Under US Dollar hegemony, European banks are entrapped in their dollar-denominated balance sheets. Everyone needs US Dollars because only dollars can be used for the purchase of oil that is essential for the functioning of any industrial economy. The US Dollar is de facto backed by the energy reserves of the Gulf Arab states under the security protection of the overseas deployed US military forces.

    - The China PBoC retains an equally concentrated risk in its balance sheet of US Dollars. The US is de facto defaulting on its debt obligations by diluting the “purchasing power” value of its currency through what Fed Chairman Bernanke describes as, “the modern high-technology of the printing press”. Base M-1 money supply is rapidly increasing at an over 30% annual rate.

  • Posted by Rajesh

    It is not clear what a “systemic risk regulator” would do. Systemic risk is due to unanticipated connections between different parts of the system. No one could have foreseen that the bankruptcy of Lehman would result in a run on money market funds. There was no obvious connection and if Lehman had declared bankruptcy either a few weeks before or a few weeks afters, the Prime Reserve fund might not have been affected.

    In the case of AIG, the question comes up whether the banks that bought the billions of dollars of credit default swaps from AIG gave any thought to counter-party risk. One supposes that the triple-A rating of AIG was the reason they assumed that the multi-billion dollar liability was not a danger to their liquidity. Clearly, having a clearing house act as a central counter-party will address some of the issues with CDS that the AIG failure exposed.

    Government officials are always full of good intent to regulate the financial system. But no fixed set of rules will be able to handle a continually changing financial system.

  • Posted by DJC.

    GUANGZHOU, China — The global economic downturn, and efforts to reverse it, will probably make China an even stronger economic competitor than it was before the crisis.

    China, the world’s third-largest economy behind the United States and Japan, had already become more assertive; now it is exploiting its unusual position as a country with piles of cash and a strong banking system, at a time when many countries have neither, to acquire natural resources and make new friends.

    China’s leaders are turning economic crisis to competitive advantage, said economic analysts.

    The country is using its nearly $600 billion economic stimulus package to make its companies better able to compete in markets at home and abroad, to retrain migrant workers on an immense scale and to rapidly expand subsidies for research and development.

    Construction has already begun on new highways and rail lines that are likely to permanently reduce transportation costs.

    “The recent tweaks to the stimulus package indicate a sharper focus on the long-term competitiveness of Chinese industry. Higher expenditures on education and research and development, along with amounts already committed to infrastructure investment, will boost the economy’s productivity.”

    http://www.nytimes.com/2009/03/17/business/worldbusiness/17compete.html?_r=1&ref=asia

  • Posted by Don the libertarian Democrat

    From A Credit Trader:

    http://www.acredittrader.com/?p=65

    ” * A bank buys CDS protection from an insurance company (wrong-way because credit spreads tend to be correlated suggesting that when the trade is positive mtm to the bank, the insurance co’s credit spread is wider)

    Did you catch that last one? This is what happened with AIG.

    In fact, I would argue that the credit quality of AIG was not just somewhat correlated to the credit quality of the insured CDOs but was in fact 100% correlated, especially in the case that matters i.e. impairment of super-senior tranches. By the time this happens AIG will have gone bankrupt posting collateral and even if it survived up to this point the very high correlation between the super-senior tranches it wrote protection on means AIG would have to pony up an unbelievable amount of cash.

    So, where does that leave us? Making the back-of-the-envelope assumptions above of 100% correlation in credit quality between AIG and its insured CDO as well as zero recovery, the value of protection that investment banks bought was zero. Remember that the correct value of the trade is the risk-free valuation less the credit exposure. In our case, the credit exposure would be equal to the risk-free value of the trade.

    Why did Banks buy Protection from AIG?
    Did the banks realize the value of its protection held against AIG was zero? Of course they did – they aren’t as dumb as the media suggests. The reason they continued to pay the full market CDS offer (rather than a much lower level due to AIG’s massive wrong-wayness) to AIG was because they considered it a cost that allowed them to continue originating CDOs. If they could not offload super-senior risk to someone, their originating desks would be effectively shut down.

    So, while the trading desks continued to buy super-senior protection from AIG, the risk management desks, realizing that the protection was effectively worthless, bought protection on AIG itself from the street and clients in large size. In fact, I would imagine the size they needed to buy was too large and they likely ended up buying puts on the AIG stock or just shorting outright. Let’s hope the Fed unwinds of AIG’s trades took into account the huge gains these banks took on the AIG hedges.

    Onwards and Upwards: the CDS Clearinghouse
    In the better late than never column, market participants are establishing a CDS Clearinghouse whose members will face the clearinghouse on all trades, rather than each other as is the case now. This will help in assigning trades, posting collateral, unwinding trades etc. This will hopefully do away with zero-collateral posting by AAA counterparties, which means that selling protection in massive size will be less of a “free money” trade than before.”

    And Tett:

    “And therein lies an important moral. Notwithstanding the disaster at AIG, the basic idea of using derivatives contracts to share risk is not stupid; on the contrary, risk dispersion remains a sensible idea, if used in a prudent, modest manner.

    But diversification can only occur if potential correlations are monitored – and that oversight can only take place if the business of risk transfer is made as visible as possible. That means that regulators and investors should demand dramatically more disclosure about credit derivatives deals and about their counterparties, too. The type of transparency seen at AIG this week, in other words, is not just badly overdue; it now needs to be replicated on a much bigger scale.”

    I agree with Tett. CDSs and CDOs can be very useful in certain marginal investments. What occurred here was the result of human decisions. I consider them fraud or negligence, while others disagree.

  • Posted by babar

    > In the case of AIG, the question comes up whether the banks that bought the billions of dollars of credit default swaps from AIG gave any thought to counter-party risk

    of course they did. they knew there was likely no payout — that if things got bad enough that these would payout there would be no money at AIG. credit traders consider this sort of thing all the time.

    the reason they bought swaps from AIG was to hide risk from internal and external regulators so that they could increase the leverage of their books.

  • Posted by Uncle Billy, Mental Widget

    Don, fantastic analysis. But…

    Can’t we just obviate the need for more corrupt watchers of watchers by getting rid of derivatives? This whole sick apparatus was set up to suck money up without risk. Doesn’t seem to work any way you slice it.

  • Posted by ReformerRay

    Good comments above. Once the correct understanding of what created our current problems, a useful resolution can be developed.

    What follows is long. Whether it is useful is for others to decide.

    The experts at the Federal Reserve Board and the U.S. Treasury Dept. have
    not been able to resolve the problems in the U.S. finanical system. Six
    months trial is long enough to show that their approach is wrong. They are
    trying to put band aids on the system rather than fixing it. Expensive band
    aids but nevertheless only temporary patches.

    The authorities must figure out how to satisfy both gamblers and savers.
    Coming out of the Depression, everybody was a saver. After the Depression
    became a faded memory and the U.S. became really rich, more and more people
    wanted to become gamblers. All of the legislative changes since the
    Depression have been in the direction of losening up the staid old financial
    system to accommodate gamblers.

    Clever gamblers do not like gambling in Las Vegas. At Las Vegas, the odds
    are stacked against you and you must put up your own money before you can
    gamble. The influential people in the finance industry were able to
    persuade legislators to construct a system where they could tilt the odds of
    winning in their favor and they could gamble with someone else’s money.

    The ability to purchase insurance that provides you compensation if you lose
    is very attractive to conservative gamblers. Heads you win, tails you win.
    Second, the ability to borrow money meant that your gamble could be larger
    than your assets. That is labeled “leverage”

    A workable solution must allow gamblers to continue to gamble – but the
    terms must be changed. The desire to gamble will find an outlet.. Better
    to allow it rather than try to eliminate the activity. But the gambling
    must be done under terms set to protect the interests of savers. The new
    legislation must concentrate on protecting savers by separating the two
    activities.

    Gambling activities must be separated from saving activities. Saving
    activities should be confined to the regulated banking system and the
    regulated insurance system. Yes, regulation of both banking and insurance
    firms is necessary. And the regulation must be done at the Federal level.
    It must ignore the needs of the gamblers. Regulation should be concerned
    only with protecting the interests of savers. And the full faith and credit
    of the Federal government must back the contracts signed between private
    parties in the regulated system. That obligates the Federal government to
    carefully construct the rules for the regulated system – to insure that
    regulated private firms will continue to survive, even under depression like
    conditions. Survival of firms is the responsibility of the Federal
    government. But that responsibility can only be assumed when the regulatory
    system is designed to place survival first among priorities. Our inherited
    regulatory system placed high profits equal to or ahead of survival. That
    priority must be changed.

    News reports of ideas of re-regulation being explored in the Congress are
    discouraging. They seem to think everything should be regulated. I
    disagree. Attempts to regulate hedge funds is a mistake. Hedge funds,
    credit default swaps, all kinds of derivatives should continue to exist
    outside the regulated system. People participating in these kinds of
    activities should recognize that they are gambling in a system that is not
    backed by the full faith and credit of the U.S. government. Gambling must
    include the possibility that the gambler will lose and pay the consequences.
    Allowing AIG to sell credit default swaps is a perfect example of the kind
    of activity that must be outlawed in the new regulatory system

    The assets of the regulated banking and insurance firms must be walled off
    from the gambling activities. Gamblers can still buy insurance – from
    unregulated firms – but not insurance that puts at risk the assets of the
    regulated banking and insurance firms. Gamblers should be able to borrow
    money from the regulated firms – but only under special terms that
    compensate the regulated firms for the risks inherent in this kind of loan.
    These special terms must be set by law to protect the assets of the
    regulated firms – and to force all regulated firms to play by the same set
    of rules.

    So, two systems to satisfy two kinds of people – savers who want their
    assets to remain protected and safe and gamblers who want to take risks in
    the hopes of higher returns. What must be excluded is allow gamblers to set
    up a system like they one that exploded – one that provides high returns and
    simultaneously reduces the risks if the gamble fails.

    The authorities should begin work on the kind of financial system we need to
    succeed the one that failed. Once the outlines of the new system is
    established, the process of moving toward the new can be the means of
    escaping the unsustainable system our laws permitted.

  • Posted by John

    We need to find out when the CDS were written. I’ll bet on late 2007, making the payouts a collusive agreement between banks and taxpayers. It would also be highly illegal and if true will send Paulson along with many others to jail.

  • Posted by babar

    john, according to the press on this, most of the CDSs were written in 2005 or earlier.

  • Posted by babar

    another good read on AIG (besides the link that don gave above, which is excellent) is this:

    http://zerohedge.blogspot.com/2009/03/aigs-secret-21-page-memo-revealed.html

    this includes the “secret” AIG memo (2/2009) which tallies the risks to the financial system from AIG.

    it’s useful for understanding their business and their impact in terms of $ size.

  • Posted by jonathan

    I was annoyed to read the AIG list because:

    1. The US taxpayer is doing the work foreign governments should do for their own banks. Why do “we” pay German, French and Swiss institutions? If they have problems, let their governments and taxpayers bail them out.
    2. If US institutions like Goldman took taxpayer money through AIG, they need to be dealt with. If they didn’t disclose this to the government, they should be penalized heavily. The US government should tell these US companies they expect the taxpayers will be made whole.
    3. I do not understand why AIG then used taxpayer money to buy the underlying securities, mostly because I don’t trust in any way what AIG does. If they purchased these instruments from companies like Goldman, that is yet another hidden bailout that needs to be addressed politically.

  • Posted by ReformerRay

    Bernanke is receiving praise in some quarters for his recent speech. Bloomberg said he did a good job of explaining and justifing the position of the administration.

    He did nothing of the sort. He provided no real justification for his repeated assertion that allowing AIG to fail would have undesirable consequences. I can see only good consequences from allowing AIG to fail. The only other financial firms that would be harmed by this action are those firms that bought protection for AIG. For that mistake, they should be allowed to fail.

    No, the reason his speech encouraged the stock market was his clarification of his determination to provide all the assistance within his power to prevent more failures – meaning that federal money will continue to be used to bail out people who should suffer from their mistakes.

    Obama must escape from the trap in which Paulson, Bernanke and Larry Summers have encased him.

  • Posted by ReformerRay

    “protection from” rather than “for” in second paragraph, above.

  • Posted by DJC.

    From London FT, foreigners net sellers of US Dollar by $43 billion in January. Dollar strength entirely due to Federal Reserve’s $115 billion swap of currencies with foreign central banks.

    http://www.ft.com/cms/s/0/40305320-1293-11de-b816-0000779fd2ac.html

    Foreign investors cut their holdings of US long-term securities in January although China and Japan purchased more Treasury bonds, according to data released by the Treasury on Monday.

    The latest Treasury International Capital report, known as Tic, revealed net sales of $43bn in long-term US securities in January, following purchases of $34.7bn in December.
    The big reversal in January was not accompanied by a drop in the dollar. The dollar index rallied nearly 6 per cent in the month, marked by a notable decline in the euro.

    Alan Ruskin, strategist at RBS Greenwich Capital, said: “Sizeable net long-term outflows, with very weak net short-term inflows would normally smack of dollar weakness.” One way to explain the dollar’s strength in January may be the role played by dollar swap lines set up by the Federal Reserve. In January, the Fed’s balance sheet showed a contraction of $115bn in dollar swap lines with other central banks.

    Traders said this may explain how the drop in net dollar liabilities had not unsettled the dollar.

  • Posted by Mark Foley

    Why would regulators think the risk was dispersed? Weren’t regulators aware that these banks were subtracting the risk from their capitalization because of the AIG guarantee. Shouldn’t regulators of European banks in particular picked up on the fact that AIG was being used for regulatory arbitrage? After all this was disclosed regulatory arbitrage. The regulators were also blind to the risk because of the ratings.

  • Posted by Nathan

    The “A Credit Trader” post on the AIG CDS hedging trades done by the major banks is fascinating. I would submit one additional explanation for why they would take this massive “wrong-way” counterparty risk: they correctly anticipated the government response if AIG ever did get in danger of defaulting on its contracts. This is why the policy of TBTF (Too Big To Fail) feeds the very cycle of boom/bust/bailout that it is intended to alleviate, as so presciently explained in George Akerlof and Paul Romer’s paper “Looting”. See David Leonhardt’s NY Times article about it here: http://www.nytimes.com/2009/03/11/business/economy/11leonhardt.html

  • Posted by ReformerRay

    The new regulatory architecture proposed above at 12:05 has thus far drawn no responses. Maybe the post was too long to be read. Maybe the readers are not interested in proposed solutions. Maybe the proposal is not worth discussing. Savers and gamblers may not be the best approach to a new regulatory structure.

    Whatever. I would like to see the understanding developed by the above comments turned into a proposal for what should be done.

    I will be out of the loop for a few hours, hopefully i will have received some reactions when I return.

  • Posted by M.G. in Progress
  • Posted by anon

    “concretations”

    really?

  • Posted by Yoda

    http://www.bloomberg.com/apps/news?pid=20601009&sid=aurLtN1UYQ4k&refer=bond
    Fed ‘Disinclined’ to Purchase Treasuries, Goldman Sachs Says

    who is gonna stand behind the Treasuries? answer is not FED!! Ouch for those treasury bond holders. That gotta hurt!!!

  • Posted by Twofish

    Rajesh: It is not clear what a “systemic risk regulator” would do.

    Rajesh: No one could have foreseen that the bankruptcy of Lehman would result in a run on money market funds.

    The purpose of a regulator is to forsee these sorts of connections and try to prevent them. In fact, the default of Lehman causing a run on money market funds is something that could and should have been forseen.

    There was no obvious connection and if Lehman had declared bankruptcy either a few weeks before or a few weeks afters, the Prime Reserve fund might not have been affected.

  • Posted by bsetser

    i desperately need a blog interface that spell checks titles. either that or i have to compose in word. and please point out my errors more quickly.

    nathan — where can i find a credit traders post on aig? thanks

  • Posted by beezer

    reformer ray

    Separate in every way investment banks from commercial banks. Provide FDIC insurance to commercial banks, and no guarantee whatsoever to investment banks. Establish strong transparent capital structures on commercial banks. Limit their loans to equity plus government treasuries and cash. No more.

  • Posted by Twofish

    Billy: Can’t we just obviate the need for more corrupt watchers of watchers by getting rid of derivatives? This whole sick apparatus was set up to suck money up without risk. Doesn’t seem to work any way you slice it.

    Probably not. The trouble with derivatives is that they are so useful that they tend to come into existence anyway if you try to ban them, and if you ban then, then they end up being completely unmonitored and unregulated.

    Banking and finance is hard and messy. It’s hard and messy in large part because people will act like people, and not saints.

    babar: of course they did. they knew there was likely no payout — that if things got bad enough that these would payout there would be no money at AIG. credit traders consider this sort of thing all the time.

    And the next step is figure that if there was no payout at AIG, then it would create such a huge problem that the government would come in and intervene. This is actually the same bet people are making with the dollar.

    jonathan: 1. The US taxpayer is doing the work foreign governments should do for their own banks. Why do “we” pay German, French and Swiss institutions? If they have problems, let their governments and taxpayers bail them out.

    The trouble is everyone is so interconnected that you can’t have the German banking system collapse without killing the US banking system. If it was Mexico or Indonesia, the US would wash its hands of the whole mess, but in the case of Europe, it just can’t.

    jonathan: 2. If US institutions like Goldman took taxpayer money through AIG, they need to be dealt with.

    AIG got massive amounts of money because it owed money to otther people, so when you give money to someone that has lots of debts, chances are that they won’t get much of it, and their creditors will.

    The next step is to ask who else AIG and Goldman-Sachs owes money to, and it’s not that many steps before you get to the “taxpayer.”

  • Posted by anon

    you’re welcome

    compose in word

  • Posted by beezer

    Also, no government guarantee of an asset can be carried forward to a security based upon that asset.

  • Posted by Twofish

    beezer: Separate in every way investment banks from commercial banks.

    It’s not clear how this would have helped, since the initial problems came from investment banks that had nothing to do with commercial banks, and commercial banks that had nothing to do with investment banks. Bear-Stearns and Lehman had nothing to do with commercial banks. Washington Mutual had no investment banking operations.

    beezer: Establish strong transparent capital structures on commercial banks. Limit their loans to equity plus government treasuries and cash.

    So where do I deposit my paycheck? What do you do with bank deposits that are already in the system? When someone writes you a check, it’s not backed by cash or government treasuries or equity.

    You also again run into the problem of driving banking underground. If you have overly strict regulation, then what happens is that people start creating things that are effectively banks but are not called banks, and you run into the same sorts of problems all over again.

  • Posted by anon

    now all that remains is to get economist’s view to change the title as well

  • Posted by john c. halasz

    Prof. Setser:

    It’s called google.
    http://www.acredittrader.com/?p=65

  • Posted by Twofish

    beezer: Also, no government guarantee of an asset can be carried forward to a security based upon that asset

    The trouble with guarantees is that sometimes people thing that you have a guarantee even if you are screaming up and down that there is no guaranteee.

    Before Freddie/Fannie and the money market funds went under, there was no explicit government guarantee, but people figured one was implicitly there because if the government didn’t to a bailout, it would have destroyed the world. So if the consequence of not having a guarantee is that you destroy the world, people will assume that you have a guarantee even if you swear up and down that you don’t.

    If you end up in a situation where one button says “blow up the world” and the next button says “go back on my promises to let the world blow up” u then something broke. If you got yourself in a position where you have to blow up the world to convince people that you are serious about the next time, then this is a bad situation because

    a) there will be no next time, and

    b) people just won’t believe that you are willing to blow up the world, and to convince them otherwise you actually do have to blow up the world.

  • Posted by beezer

    Time to do some exploding. The world isn’t going to blow up. Nope. You’re right. Bernanke keeps telling everyone there is a guarantee. Crap.

  • Posted by Twofish

    The problem with having two systems a regulated savings one and an unregulated gambling one is that it was precisely the system that just broke. The problems are:

    1) the unregulated system will pay more money, so there are huge incentives and profits made from moving money from the unregulated system to the regulated system, at which point you have the worst of both worlds.

    2) because the unregulated system pays more interest it attracts more money to the point where it becomes larger than the regulated system and also becomes “too big to fail.” Once it becomes “too big to fail” then people will put even more money in with the belief (and the correct belief) that they will not lose their money because if they lose their money, the world ends.

    This is what happened with money market funds. Why get zero percent interest in an FDIC insured checking account when you could get 4% in an money fund?

  • Posted by beezer

    “Define “safe banks” as those whose assets comprise only government securities and cash, who accept no more deposits than liquidation value of assets at any point in time and who issue no liability (like debt and notes) other than preferred stock and common stock.”

    How’s that? A “utility” commercial bank. From a proposal here http://www.pro-prosperity.com/usa/safe%20Banking.pdf

    This guy wants to get totally away from FDIC, but I’d still give it to depositors of this kind of bank. Everyone else can go hang.

  • Posted by beezer

    Why can’t the gov strip out the illiquid assets and send them to a vapor warehouse entitled “Stupid Ass Derivatives” or SAD. Then put up sign that says “Call when Dow hits 11,000″

    No need to prepay for SAD stuff. It’s a free service. The now stripped bank is smaller and cleaner. If it needs capital, provide it.

    As SAD stuff sells, pay taxpayer first. Banks stay in operation. This can’t be more expensive than what we’re doing now.

  • Posted by observer

    Twofish: The problem with having two systems a regulated savings one and an unregulated gambling one is that it was precisely the system that just broke.

    Not quite. The regulated banks were not sufficiently insulated from the unregulated ones. The regulated ones were allowed to take risks that should only be taken by unregulated banks and were also allowed to be exposed to hedge funds and other gambler types.

    The only way to ensure a safe banking system is to recognize that without risk there are no windfall profits. Turn banks into utilities and cap their profit rates and compensation. Make them boring again. Let the so-called brilliant trader types go somewhere else. Good riddance and don’t let the door hit you on the ass on the way out. You won’t be missed.

  • Posted by ReformerRay

    observer responds:
    Twofish: The problem with having two systems a regulated savings one and an unregulated gambling one is that it was precisely the system that just broke”.

    Not quite. The regulated banks were not sufficiently insulated from the unregulated ones. The regulated ones were allowed to take risks that should only be taken by unregulated banks and were also allowed to be exposed to hedge funds and other gambler types.

    I would add that the system that broke was deliberately constructed to allow the regulated boys to play in the unregulated play house.

    What is proposed and what is needed is intelligent and purposeful regulation that limits what the regulated guys can do – and also limits the responsibility of the regulators. Bankers will scream bloody murder but no one will listen.

  • Posted by ReformerRay

    Twopfish says: “If you end up in a situation where one button says “blow up the world” and the next button says “go back on my promises to let the world blow up” u then something broke.”

    This is the story I hear over over again, not only from TwoFish but from Bernanke..

    It probably had validity on Sept. 17, 2008. It no longer has validity today. Smart bankers have protected themselves to some degree in the past 6 months (yes, it has been that long). The massive amount of money that has been transferred to the various banks and AIG has reduced the volume of toxic assets. And those that remain should remain upsupported by the government by allowing AIG to fail and then we will see that Bernanke is now crying wolf when no wolf is present.

  • Posted by beezer

    Twofish.

    Investment bankers did get access to additional capital from commercial bankers, after Glass Steagall was re-written, who were really pissed off the IB guys got such great pay and flew private jets too.

    That was the deal. Commercial execs got to fly private and get big bonuses. All they had to do was stop saying “no” when the IB came in looking for a loan to leverage.

    Took eight years to blow the whole thing into the stratosphere.

  • Posted by ReformerRay

    Twofish says: “) because the unregulated system pays more interest it attracts more money to the point where it becomes larger than the regulated system and also becomes “too big to fail.” Once it becomes “too big to fail” then people will put even more money in with the belief (and the correct belief) that they will not lose their money because if they lose their money, the world ends”.

    No matter how big the unregulated system becomes, it cannot become too big to fail. Remember, the regulated, boring system is insulated from the unregulated. When the unregulated blows up, the regulated sytem will remain. The only people to be hurt when the unreagulated ssytem blows up are the players in the game.

    Let’s remember the demise of Long Terms ?, the hedge fund that was let down slowly by the intrusion of major Wall Street firms to prevent bankruptcy? These firms were protecting their own investment.

    All the problems with “too big to fail” are created because the counterparties to the firms that are said to be too big to fail are thought to be essential to the operation of the regulated banking system.

    If the counterparties are only some other unregualated firms, the Federal government will be quite content to allow them to fail.

  • Posted by ReformerRay

    ” The trouble with derivatives is that they are so useful that they tend to come into existence anyway if you try to ban them, and if you ban then, then they end up being completely unmonitored and unregulated.”

    I agree with TwoFish. Let them thrive unmonitored and unregulated. But prohibit them from putting at risk assets in the regulated ssytem.

    This separation can be achieved, IF the Congres wants to do it. As Bernanke famously said in the wrong context, all that is needed is the will.

  • Posted by observer

    ReformerRay: No matter how big the unregulated system becomes, it cannot become too big to fail. Remember, the regulated, boring system is insulated from the unregulated. When the unregulated blows up, the regulated sytem will remain. The only people to be hurt when the unreagulated ssytem blows up are the players in the game.

    Which is why financiers are fighting tooth and nail to prevent insulating the regulated banks from the hedge funds. They will claim that it is “impossible” to separate them. Or a whole bunch of other utterly bogus reasons.

    The real reason is that if the taxpayer is not in the game who else are they going to make money from?

  • Posted by ReformerRay

    Beezer has a responsible proposal “beezer responds:
    Why can’t the gov strip out the illiquid assets and send them to a vapor warehouse entitled “Stupid Ass Derivatives” or SAD. Then put up sign that says “Call when Dow hits 11,000″

    Like all good ideas, this one has, I think, some weaknesses. It would work only if the illiquid assets never become active. But the illiquid assets are a complicated bunch. Some consist of insurance against defaults. Other consist of mortgages. Most of both classes are inactive in that the underlying asset has not yet gone into default. However, when the underlying asset does go into default, how do the contracts remain unfulfilled?

    I am not saying that this problem is insurmontable. If the “powers that be” wanted to make it work, they could. However, all prefer to sit still and continue to allow Uncle Sam to pay the bill.

    Allowing AIG to go broke would produce some creative thinking on the part of the private sector banks and insurance companies.

  • Posted by Michael

    The completely appropriate description of un (or minimally) regulated capitalism is caveat emptor. AIG was defrauding every financial institution to whom it sold CDS insurance once its CDS liabilities exceeded its assets available for CDS payment. In a regulated system, there would have been reserve requirements for such a seller of CDS, and other safeguards. Perhaps such regulation will be forthcoming in the future for CDS sellers, especially since the U.S. Government corrrectly saw the disaster potential in CDS counterparty failures – starting with Bear Stearns and continuing through the present – and jumped off the cliff of bailouts to prevent that disaster. It should come as no shock that Goldman and others are reaping the benefits of the AIG bailouts, as they are the biggest counterparties (i.e. the biggest suckers who bought the most worthless CDS from AIG). Never fool yourself: the whole bailout system has been about preventing the CDS system (still about $55 trillion) from unraveling, and it is far, far from over.

  • Posted by Michael

    Reformer Ray & Beezer,

    It’s not sufficient regulation to simply separate commercial banking from all other financial transacting. No matter how much regulation and government guaranteeing you provide for deposit-based banking, everyone who interfaces at any distance with the global financial system (which is virtually everyone on the planet) is powerfully affected if the overleveraged gamblers in the unregulated non-banking world operate stupidly, wildly, and fraudulently – all of which are endemic to unregulated finance capitalism. Either you have to closely regulate and control the whole system (good luck!!) or you’re going to have to face every time exactly what we have faced in this episode: let the whole world economy collapse into a depression or borrow and print to bail out the stupid, wild, and crazy crooks.

  • Posted by MakeMeTreasurySecretary

    I am awaiting with eager anticipation to read the best seller book “Flight of the Albatross: The Duping of a Nation”, to be published circa 2014, where we will read in great detail how a few smart guys liberated tons of money from the pockets of the great unwashed. It will be a great historical document, which will reveal all, in addition to being immensely entertaining. A movie will follow in 2016, with some minor changes… like it will certainly have a happy ending, justice will triumph, and the only bad guys will be the government. That’s entertainment!

  • Posted by Twofish

    bezer: Why can’t the gov strip out the illiquid assets and send them to a vapor warehouse entitled “Stupid Ass Derivatives” or SAD. Then put up sign that says “Call when Dow hits 11,000″

    That’s exactly what is being proposed with the good bank/bad bank proposal. The trouble is that it takes a while to figure out what are the good assets and the bad assets. The other problem is that if you have assets that are obviously bad, then no one is interested in buying them right now.

    observer: The regulated ones were allowed to take risks that should only be taken by unregulated banks and were also allowed to be exposed to hedge funds and other gambler types.

    It worked both ways. Washington Mutual didn’t get into trouble by playing with derivatives. Also, I don’t think you can blame the hedge funds too much for this mess. The good thing about a hedge fund is that when the fund loses money, you lose money, and hedge funds did lose rather large sums of money. This is different from a bank that can’t tell depositors to go away.

  • Posted by observer

    Michael: It should come as no shock that Goldman and others are reaping the benefits of the AIG bailouts, as they are the biggest counterparties (i.e. the biggest suckers who bought the most worthless CDS from AIG). Never fool yourself: the whole bailout system has been about preventing the CDS system (still about $55 trillion) from unraveling, and it is far, far from over.

    I agree about the CDSes being at the core of the bailout. But Goldman, Merrill and the others can hardly be described as suckers. They knew full well that they had the political connections to force the Treasury to bail them out ultimately. The AIG CDSes were more of a CYA than anything else.

  • Posted by Twofish

    observer: Which is why financiers are fighting tooth and nail to prevent insulating the regulated banks from the hedge funds. They will claim that it is “impossible” to separate them. Or a whole bunch of other utterly bogus reasons.

    As far as I know, no one is opposed to separating commercial banks from hedge funds, because commercial banks are pretty separate from the hedge funds, and hedge funds really weren’t involved very deeply from the current blow up. Internal hedge funds hurt Bear-Stearns, but they weren’t the really big problem.

    People have been asking whether it was a good idea or not to allow investment bank to merge with commercial banks, but that’s a completely different issue since investment banks and hedge funds are not the same thing. And AIG was neither an investment bank or a hedge fund. it was an insurance company.

  • Posted by observer

    Twofish: It worked both ways. Washington Mutual didn’t get into trouble by playing with derivatives.

    Which is why it was possible to allow WaMu to fail with zero cost to taxpayers. You just proved my point.

    Twofish: Also, I don’t think you can blame the hedge funds too much for this mess. The good thing about a hedge fund is that when the fund loses money, you lose money, and hedge funds did lose rather large sums of money.

    You are ignoring the elephant in the room. Which is that hedge funds are indirectly getting bailed out by the government through AIG etc. Where do you think the billions that John Paulson made betting against subprime mortgages came from? That’s right, the taxpayer.

    Twofish: This is different from a bank that can’t tell depositors to go away.

    This is an irrelevant distraction. Depositors are protected by the FDIC. The problem was never about depositors losing money. It was always bond-holders and counter-parties who are unsecured and come behind the depositors in bankruptcy. They are the beneficiaries of the bailout. It is misleading and dishonest to pool these classes of creditors together with depositors.

  • Posted by observer

    Twofish: As far as I know, no one is opposed to separating commercial banks from hedge funds, because commercial banks are pretty separate from the hedge funds

    “separate from hedge funds” is not good enough. They have to be insulated as in having no exposure to hedge funds. As in no loans, no counter-party risks and not even counter-parties who are exposed to hedge funds. We most certainly don’t have this level of isolation now.

    Twofish: hedge funds really weren’t involved very deeply from the current blow up. Internal hedge funds hurt Bear-Stearns, but they weren’t the really big problem.

    Hedge funds are big players in CDS and that makes them part of the problem. How big a part we can argue about.

    Twofish: People have been asking whether it was a good idea or not to allow investment bank to merge with commercial banks,

    That doesn’t go far enough. See above.

    Twofish: And AIG was neither an investment bank or a hedge fund. it was an insurance company.

    Wrong. AIG FP *was* a hedge fund. It was specifically set up as a non-insurance operation.

  • Posted by Twofish

    beezer: Investment bankers did get access to additional capital from commercial bankers, after Glass Steagall was re-written, who were really pissed off the IB guys got such great pay and flew private jets too.

    If you look at the IB-CB mergers that happened after Glass-Steagall, that for the most part didn’t happen. The thing that argues against Glass-Steagall being responsible for this is suppose that Glass-Steagall didn’t pass, and you have separate investment banks and commercial banks.

    Would that have prevented Lehman? Bear-Stearns? AIG? the mess at Citigroup? Washington Mutual? If you look at all of the people that got themselves in trouble, there is only one (Citigroup) that was a combined IB-CB, and in that situation seems unrelated to the merger.

    In some places it actually worked the other way. The commerical bankers came in and then whipped the investment bankers into shape.

    ReformerRay: I agree with TwoFish. Let them thrive unmonitored and unregulated. But prohibit them from putting at risk assets in the regulated system.

    Unless you track down every dollar bill, I don’t think that this is feasible. Basically you’d have to prohibit someone taking a home equity loan and going off to Vegas to play the slot machines, which I don’t think is feasible or necessarily desirable.

    It seems to me to be a much better approach to just regulate everything. Personally, I think it is a very bad thing to have a unregulated financial system. The reason I point out that having something half regulated/half unreguated won’t work is that I think that the whole thing needs to be rather tightly regulated, and that AIG should have been shut down years and years ago. Once it blows up, it’s too late.

    It’s impractical to blow up the world when things go bad, so you need to tightly regulate institutions to make sure that you never get into a situation where you are in a position the failure of one institution puts the world at risk.

  • Posted by Twofish

    observer: As in no loans, no counter-party risks and not even counter-parties who are exposed to hedge funds. We most certainly don’t have this level of isolation now.

    I don’t think that is possible as long as you have a single financial system. Someone will lend money to hedge funds and if that person borrows money from anyone else, you have a source of risk.

    observer: You are ignoring the elephant in the room. Which is that hedge funds are indirectly getting bailed out by the government through AIG etc.

    Some made good bets and are. Most made bad bets and aren’t. Hedge funds are crashing like flies. If it was just hedge funds that were counterparties to AIG, they could have been allowed to go bust. One reason Washington Mutual could go bust was that the main shareholder was a hedge fund that lost pretty huge amounts of money.

    Investment banks and hedge funds generally hate each other.

    observer: Where do you think the billions that John Paulson made betting against subprime mortgages came from? That’s right, the taxpayer.

    And there are plenty of hedge fund managers that made the opposite bet that got killed. If it was just propping up hedge funds then sure, let the thing fall apart. The trouble is that John Paulson handcuffed himself to insurance contracts and pension funds.

    John Paulson won the lottery and made a few billion. TPG lost a few billion because of WaMu. Some people won big but most headge funds lost.

  • Posted by Michael

    Observer,

    Agreed – Goldman and the other beneficiaries of bailout funds channeled through AIG are far from suckers. They are (not so) stupid, wild, (not so) crazy crooks…er, finance capitalists.

  • Posted by observer

    Twofish: I don’t think that is possible as long as you have a single financial system. Someone will lend money to hedge funds and if that person borrows money from anyone else, you have a source of risk.

    Bingo! That’s exactly what I expected a defender of the financial system to say. See my earlier message in this post.

    But sorry, you are wrong. It’d be trivially easy to force bankers to be prudent. Simply cap profits and compensations for anyone who works for a FDIC insured institution. That takes away all the incentive for risk-taking. Let’s see then, who is willing to risk exposure to hedge funds.

    A financial system that siphons off 40% of all corporate profits (as it did in 2007) is out of control. It should never have been permitted.

  • Posted by Twofish

    observer: This is an irrelevant distraction. Depositors are protected by the FDIC. The problem was never about depositors losing money.

    FDIC has about $50 billion insuring several trillion dollars in deposits and probably $2-3 trillion in losses. Once you agree with the principle that FDIC insured banks will not go bust, then that money has to come from somewhere.

    observer: It was always bond-holders and counter-parties who are unsecured and come behind the depositors in bankruptcy.

    If you look at the total losses it would have overwhelmed the bondholders and counterparties. Even after wiping out bondholders and counterparties, Chase had to put several billion dollars into WaMu.

    observer: They are the beneficiaries of the bailout. It is misleading and dishonest to pool these classes of creditors together with depositors.

    Look at the amount of money that FDIC has ($50 billion). Look at the amount of money that has been destroyed by the house bubble ($2-3 trillion) and look at the amount of capital reserve that a bank has (10%).

    There is no way that you can avoid a government bailout without soaking depositors. The numbers just do not work out. They aren’t even close.

  • Posted by observer

    Twofish: The trouble is that John Paulson handcuffed himself to insurance contracts and pension funds.

    Yes, exactly. Pension funds make such wonderful hostages, don’t they?

  • Posted by observer

    Twofish: FDIC has about $50 billion insuring several trillion dollars in deposits and probably $2-3 trillion in losses. Once you agree with the principle that FDIC insured banks will not go bust, then that money has to come from somewhere.

    Once again this is misleading and dishonest. The banks – even the most incompetently run ones – had enough assets to cover most of their deposit liabilities. The FDIC may have needed more than $50B, but so what? If it takes $200B to make depositors whole that is still 1% of the $20T that this will probably end up costing taxpayers in lost GDP etc.

    It is complete nonsense to suggest that depositors cannot be saved without also saving unsecured creditors. They are two completely different classes of creditors.

  • Posted by Twofish

    observer: Simply cap profits and compensations for anyone who works for a FDIC insured institution. That takes away all the incentive for risk-taking.

    It also takes away all incentive for doing a decent job. If you aren’t going to make money, and whatever you do you are going to be bailed out by the government, then what’s the point of doing anything.

    observer: Let’s see then, who is willing to risk exposure to hedge funds.

    Why not? I’m getting paid lousy money and this hedge fund is willing to give me nice trips to Bermuda. Since I’m getting paid crap, then they might be offering me this nice job after I leave the bank.

    It’s not my money, and it’s not as if I’m going to make any more money by being competent.

    You want an incentive system that rewards competence and punishes incompetence. Everyone that didn’t get a government bailout, you all get lots of money this year. Everyone that got a bailout, you don’t.

    Also I think that government regulators need to make a *LOT* more money.

  • Posted by observer

    Twofish: It also takes away all incentive for doing a decent job. If you aren’t going to make money, and whatever you do you are going to be bailed out by the government, then what’s the point of doing anything.

    No, it doesn’t take away *ALL* incentive. It merely caps it to a reasonable level. There is a big difference.

    Twofish: Why not? I’m getting paid lousy money and this hedge fund is willing to give me nice trips to Bermuda. Since I’m getting paid crap, then they might be offering me this nice job after I leave the bank.

    That’s called bribery and corruption. Which come to think of it would be an improvement to the current ethical standards among bankers.

  • Posted by Twofish

    observer: The banks – even the most incompetently run ones – had enough assets to cover most of their deposit liabilities.

    Covering *most* of your deposit liabilities isn’t good enough. Also the asset numbers were questionable. If you use funky accounting to value those assets, then sure….. You have enough assets to cover your deposits since you are making up numbers.

    If you look at liquidation value, no way. Part of the reason you really don’t want to save money right now is that if your focus is on saving money, there is a huge incentive to use funky accounting to permanently avoid dealing with the problem.

    observer: The FDIC may have needed more than $50B, but so what? If it takes $200B to make depositors whole that is still 1% of the $20T that this will probably end up costing taxpayers in lost GDP etc.

    Where does this $20 trillion number come from? The total cost looks to me to be in the $1-2 trillion range based on the drop in housing prices.

    Also FDIC will get its funds from the “taxpayer.” At that point is not a matter of who pays but how.

  • Posted by Twofish

    observer: No, it doesn’t take away *ALL* incentive. It merely caps it to a reasonable level. There is a big difference.

    Personally, instead of salary caps for banks that aren’t under government supervision, I think it would be better to let people make large sums of money and then tax the hell out of them.

    observer: That’s called bribery and corruption. Which come to think of it would be an improvement to the current ethical standards among bankers.

    Money and power are inherently corrupting, and if you have a system of finance or government that depends critically on *anyone* being a saint, then it’s unworkable.

  • Posted by observer

    Twofish: Covering *most* of your deposit liabilities isn’t good enough.

    Please go back and reread my comment. I never said depositors would not be *fully* covered. Only that the FDIC’s cost would be only a small fraction of the deposit base.

    Twofish: Also the asset numbers were questionable. If you use funky accounting to value those assets, then sure….. You have enough assets to cover your deposits since you are making up numbers.

    Now you are just making things up. Do you have any data or estimates for how much bank assets were compared to deposits?

    In any case all this is beside the point. The important thing is protecting depositors has absolutely nothing to do with bailing out unsecured creditors. So let’s not pool them together please?

  • Posted by observer

    Twofish: Personally, instead of salary caps for banks that aren’t under government supervision, I think it would be better to let people make large sums of money and then tax the hell out of them.

    No that won’t work. It still creates poor risk-taking incentives. I don’t see why bankers with a FDIC protection should be making large sums of money.

    Twofish: Money and power are inherently corrupting, and if you have a system of finance or government that depends critically on *anyone* being a saint, then it’s unworkable.

    Congressmen are exposed to the same temptations and many indeed are corrupt, but on the whole our government seems to be working ok. So this type of fatalism is without any basis.

  • Posted by D Gross

    Yes- the European Banks always loved the preferential capital treatment for so-called “AAA” securities. Their balance sheets are a mess (not even counting their domestic mortgage troubles)

    It is ironic that BIS regulation (enticing banks to seek out “AAA” securities that yield “just a bit more” than treasuries) and activities of governments (the Fed’s expansionary monetary policy, China’s mercantilist policies and massive purchases of conventional AAA securities) helped cause this disaster.

    A cautionary tale for those arguing for more regulation (it will be arbitraged and lead to unintended consequences).

    More disclosure about potential risks, asset types and liability types would have helped. Also would have been nice if existing banking, brokerage and insurance regulators actually had a clue. Too many people assumed that AAA investments did not need close examination.

  • Posted by ReformerRay

    TwoFish keeps coming back to his conviction that the fiancial system cannot be neatly separated into two parts.

    The effort, I must remind him, is not to restrict all transactions but only to restrict transactions entered into by regulated private financial firms, including all banks and all insurance firms.

    It is obvious that restriction of what banks can be are enforcable. Banks have been operating under restrictions for years. It is not a great stretch to say you must have adequate capital to protect depositors to saying you can only lend money to certain classes of firms and individuals under the following set of restrictions.

    Any restrictions on banks that are necessary to insure that the banks will remain solvent can be justified. Experience has shown us that restrictions are needed on the ability of banks to lend unlimited funds to hedge funds or to insure bets made outside the regulated banking system.

    I do not pretend to know which set of restrictions are required under what conditions. I do think recent experience provides evidence that can be used to develop appropriate rules to prevent a reoccurance of what happened in the last 3 years.

    Trying to regulate all financial activity will lead to inability to regulate effectively that part that is most important. Any regualtory scheme must allow some escape value. In this case, the unregualted system may become bigger than the regulated one.

    However, the new system will not be like the old. If access to funds in the regulated system is denied the unregulated system, my expectation is that the unregulaged system will soon be starved for players. There must be someone to pay for the losses.

  • Posted by ReformerRay

    ” cautionary tale for those arguing for more regulation (it will be arbitraged and lead to unintended consequences).

    The notion that regulations can always be avoided by the clever is frequently true but not always.

    Jack Kennedy’s dad was able to establish regulations about what could be done in the stock market that eliminated many of the sins that were committed by he and others before 1933.

    Public support for the regulation is the first requirment. It is amazing how court decisions to enforce regulations varies with the degree of public support for the regulations. The obvious need for better enforcement of regulations will aid the quality of the regulations developed and the enforcement of them.

    Arbitrage does not undermine regulations. It merely contributes to the development of the law of one price.

  • Posted by ReformerRay

    Can I sum up? TwoFish and many others, including some prominent politicians, want to try to bring hedge funds and derivatives into the regulated system. Observer and I think that will overload the regulatory system. We see great merit in the old idea that the essential parts of the financial system should be regulated and the unessential parts allowed to do whatever they want to do.

    Bernanke and perhaps the Obama camp seem to want to keep on feeding governmental funds to the firms that created the problem because they fear “the collapse of the financial system”. I fear the consequences of more governmental debt more than the death of some firms that ought to die because they have caused so much harm. The finanical system will be greatly improved by some funerals.

    Does anyone know what kind of the financial system Bernanke and/or the Obama officials would hope to see after the depression-recession is over? I cannot understand how anyone can be content to just preserve the firms that created the problem. We are using scare governmental resources to make good on contracts that never should have been written.

  • Posted by ReformerRay

    The Lehman experience is should be an essential part of this discussion. Because shock paralized the credit system after the failure of Lehman tells us nothing about what would happen today if AIG were to fail. Certainly the shock would not be present (stock price of under one dollar indicates the expectation of AIG’s future).

    All the credit default swaps to which Lehman was a part were settled by an exchange of 5.2 billion dollars between buyers and sellers of protection. Some people thought Lehman had an exposure to credit default swaps of over 100 billion.

    How I wish it were possible to deny more funds to AIG so we could get a test of the proposition that the financial system will collapse with the collapse of AIG.

  • Posted by ReformerRay

    Way back up yonder, Michael says: “Never fool yourself: the whole bailout system has been about preventing the CDS system (still about $55 trillion) from unraveling, and it is far, far from over”.

    But we want the CDS system to unravel. It was a mistake to allow it. It should disappear – and all the firms that participated in the system should disappear.

  • Posted by Twofish

    observer: Please go back and reread my comment. I never said depositors would not be *fully* covered. Only that the FDIC’s cost would be only a small fraction of the deposit base.

    And in a bad bank situation where you have to liquidate, that won’t work. You can avoid dipping into FDIC funds when you have a larger bank willing to absorb the cash losses.

    observer: Now you are just making things up. Do you have any data or estimates for how much bank assets were compared to deposits?

    Pull up a balance sheet for any bank. You’ll see that almost all of the assets are loans which cannot be liquidated quickly and assets are cash deposits which can be.

    To see how bad things can get, take a look at Washington Mutual before it collapsed. On paper, it had a good balance sheet, but that was on paper because a lot of the loans were bad and in any case you couldn’t liquidate the loans quickly.

    observer: No that won’t work. It still creates poor risk-taking incentives. I don’t see why bankers with a FDIC protection should be making large sums of money.

    Because they can create a hell of a mess if they screw up.

    You want the government to regulate the hell out of banks to avoid any risk taking, but if a bank follows the rules and ends up making money, the people responsible should be rewarded.

  • Posted by Twofish

    ReformerRay: Can I sum up? TwoFish and many others, including some prominent politicians, want to try to bring hedge funds and derivatives into the regulated system.

    It’s not a matter of wanting to or not. As long as you have a single market, then you can move things from one part of the system to another.

    Where you get big messes is when you have Frankenstein monsters like AIG. AIG was a New York state insurance company operating an English hedge fund. If it was solely an insurance company, no problem. If it was solely a hedge fund, no problem. Hedge funds are actually quite heavily regulated to prevent blowups like LTCM, it’s indirect regulation, but regulations.

    Similarly, what AIG was doing would have likely been illegal if it just did it in New York state. It also would have been likely illegal if it was solely an English company. So what you ended up with was a financial structure that completely went under everyone’s radar.

    This is bad. *Everything* needs to be regulated.

    ReformerRay: Bernanke and perhaps the Obama camp seem to want to keep on feeding governmental funds to the firms that created the problem because they fear “the collapse of the financial system”.

    And it’s because everything is too late. The bombs have already gone off.

    ReformerRay: Does anyone know what kind of the financial system Bernanke and/or the Obama officials would hope to see after the depression-recession is over?

    I don’t think they know. Right now people are too busy trying to fix the economy to give much thought on what happens afterwards. The one thing is that it won’t be an Bernanke/Obama decision. If Obama comes up with anything and the Europeans, Chinese, and Arabs won’t go along, then it is useless.

  • Posted by Twofish

    ReformerRay: How I wish it were possible to deny more funds to AIG so we could get a test of the proposition that the financial system will collapse with the collapse of AIG.

    I’m not in a mood to play Russian roulette, and neither are most people. This is the problem with “too big to fail.” As long as people have good reason to believe that they will will die if you die, then they aren’t going to pull the trigger.

    Also, there are lots of people who would be interested to have replayed history to see what would have happened, if the Fed had bailed out Lehman.

    ReformerRay: We see great merit in the old idea that the essential parts of the financial system should be regulated and the unessential parts allowed to do whatever they want to do.

    And I just don’t see how this is going to work. Everything is so intertwined that everything has to be regulated. What is regulated and how it is regulated is a different issue, but if you have something that is totally unregulated with no limits at all, that’s something that needs to be looked at. Also regulators need to be very highly paid, and there needs to be a lot more of them.

    If you don’t pay regulators a lot of money, then you end up with this revolving door non-sense.

    D Gross: Also would have been nice if existing banking, brokerage and insurance regulators actually had a clue. Too many people assumed that AAA investments did not need close examination.

    That’s because anyone that had clue also quickly figured out that they would make a lot more money doing something other then being a government regulator. You can make up for money by giving a lot of social status, but even there the pre-crash system worked against you. Two years ago, if you mentioned that you were a bank regulator, people would immediately think “useless bureaucrat.”

    So you end up in a thankless job which pays nothing meanwhile you could send out your resume and make 10x as much money and do something that people looked up to (remember this was pre-crash).

  • Posted by Indian Investor

    Is it possible to clarify if my understanding below is correct, thanks in advance?
    The “Dollar claims of European banks” items in the BIS papers represent total dollar denominated claims, irrespective of geography. I’m not clear that, going back into a geographical perspective, that we can connect that with the US mortgage boom. The BIS locational statistics, in the first place show geographical distributions of the bank financials. The authors of the above papers have worked on that data to arrive at totals in terms of currency composition of those items.The ‘dollar claims’ can as well represent loans to steel mills in Eastern Europe, made out as foreign currency debt from Western Europe banks.

  • Posted by adiemuso

    if only CDS issue is an zero sum game, we can just tear the contracts up n all parties are back to square one.

    Correlational Risk is the most understated n grossly undermined factor during the boom days where some smart financial engineers could slice n dice everything into low risk good return products. we all know, by now, that was flawed, seriously flawed.

    Im think, in future, tough regulations is not going to work. However, restrictions on banks to go into heavy leveraged trading business should be banned. i.e AIG should not try being a Hedge Fund, likewise Hedge Funds should not be banks.

  • Posted by locococo

    Yes they backstopped FPs fiat insurance system of an “end game” with the credit from the debit of the public account. For their counterparties that shorted this one credit event nakedly into existence. But no, they did not stop the fiat insurance scheming of these counterparties ability to still exist. All the new contracts awarded aside, a certain ms out there (self)intrusted her institution with the task of not one of these parties bondholder left out in the open. Hence she »insures« them all fiatly over and over as only an insurance-wise unregulated quasi regulator can, to replace the 3ple A rating system of not existing senior-securities with the new, but narrowed-in, »by the faith in FDIC« – one to close certain fiat CDSs spreads (now that securitization met the wall) on all that fiat “debt” that Chinese view less and less as an (yield generating) »asset«. This plus the Treasury s ex, present (remember who together with an ex counterparty guy lead the future public debt assault into the then aig) and the presently not yet existing “staff” coupled with ben, the man for all regime changes, all together with occ state in a written manner that it is us that, basically »insure« (these other parties financiers) that the taxpayer will stay in this “game” as long as anyone has any of them golden teeth left to pull (the capital adequacy of the marked to the new model level 3 “assets”) rabbit out of that hat.

    It is not for me to judge this toothfairy system to fail or prevail. we ll see.

  • Posted by ReformerRay

    Twofish continues to insist that the regulated system cannot be separated from the non-regulated system. Why? Because they are a single system. Everything is so intertwined. If I have added correctly, this will post and I well answer in a subsquent post.

  • Posted by ReformerRay

    Our current system is a single system. It was set up to be a single system. The laws insisted that it be a single system. No prohibition against regulated banks playing in the unregulated system exists.

    LAWS CAN CHANGE. Banks have always been heavily regulated. Now that we know that banks and insurance system should not be allowed to issue contracts dealing with consequences in the un-regulated system, those kind of contracts can be forebidden. Banks and insurance companies are law abiding.

    Of course, banking regulators were not in high repute so long as everyone believe the Ronald Regan slogans that free enterprise needed no regulation. We now know that banks and insurance companies need heavy regulation. But the laws must come first.

  • Posted by ReformerRay

    Twofish continues to be afraid that the failure of AIG would have immense consequences.

    I just don’t think AIG can bring down anyone other than those firms that were heavy participants in the kinds of activities that should have been illegal. Those firms are not necessary in the post-crisis era.

    In the post-crisis era, the follies of the present will be forbidden. Banks will have to retreat to the boring business of providing funds to enable non-financial firms to exist and expand. Insurance firms will be confined to providing insurance to farms, homes and businesses – real things rather than deriatives of real things.

    The fastest way to move to the desired future is to wipe out all the previous firms that participated so heavily in the undersirable behavior.

    LET AIG GO !!!

  • Posted by Ken

    (Retry – I can add 2 and 2, but I’m beginning to wonder about the post software!)

    In the ReformerRay/observer/Twofish exchanges above, I think all have valid points. Two other examples (in addition to FDIC) of attempts to separate financials into safe and unsafe come to mind:

    1) Ratings – whereby some banks, pension funds, etc. will only hold AAA securities, either as a matter of law or as a corporate policy.

    2) Fannie/Freddie conformance – whereby those entities would only buy loans that met certain standards, intended to improve the probability of repayment.

    So the idea of a “safe” economy (suitable for government backing) being separated from an “unsafe” (and unbacked) economy is out there. But as these examples show, it’s in the interests of those involved to game the rules into meaninglessness.

    By “interest” in the last sentence, I mean of course individual interest, as reflected in pay and bonuses. I certainly don’t mean the public interest (however you define that), or even the interests of the corporations. As recent events have shown, people will gladly destroy their companies, if it increases their pay. I hope someone develops a way to structure compensation to align individual interests with those of the company; hopefully it can even extend to aligning with the public interest.

  • Posted by ReformerRay

    The Federal government has already invested something like $170 billion in AIG. If AIG goes broke, most of that investment will go down the tubes.

    That $170 is what we call a sunk cost. It has been spent. It did reduce the amount of toxic assets on the books of AIG. Now AIG can fail without destroying Goldman Sacks or other firms that have gotten money from AIG.

    Ignore the sunk costs. The best expenditure going forward is to let AIG fail and then let the courts decide who gets what out of the debris.

  • Posted by Twofish

    ReformerRay: LAWS CAN CHANGE. Banks have always been heavily regulated. Now that we know that banks and insurance system should not be allowed to issue contracts dealing with consequences in the un-regulated system, those kind of contracts can be forebidden.

    Changing laws have consequences….

    The trouble is that you are dealing with multiple countries each with their own different financial systems. If we were dealing in a US-only world, what AIG would have done would have been impossible because US law heavily restricts issuance of derivative contracts. What AIG did would have been illegal/impossible if they did it in the US.

    However, the subsidiary that AIG was running was in London, and the rules regarding derivative contracts in Europe are completely different. The reason for this is that derivative contracts in Europe function in the same way as mutual funds in the US. In the US, if you want to invest in an index fund, you go to Fidelity and Vanguard and buy shares in a mutual fund. If you want to do the same thing in Europe, you go to a bank and buy a derivative contract.

    So banning or heavily restricting derivative contracts is something you can consider in the United States, which is why New York is *NOT* a major center of derivatives trading, but to have an airtight system you have to go to England, and convince them to restructure their financial system to be like the US, which is not going to happen. You might convince Congress to reintroduce Glass-Steagall, but it’s pointless if you don’t get the Germans to do the same thing, and they just won’t, because Germany has never separated investment and commercial banking and they see no reason to start now.

    The problem is not that European financial regulation is bad. England has a different system of finance and financial regulation than the United States. They also drive on a different side of the road. What they do works for England, and an English insurance company would not have been able to get away with what AIG did. The problem with AIG is that they found a flaw in the financial system that let them get away with something that would not have been able to do had they been completely in the US or completely in England, and changing US law just will not fix the problem.

    One other wrinkle in this is that the reason AIG was able to get away with this is that insurance is not federally regulated. All of the insurance regulation is at the state level. English bank regulators do talk with Federal regulators, but I doubt that before this mess anyone ever thought of calling up New York state insurance regulators.

    The problem with coming up with a “grand scheme” to fix the problem is that to prevent AIG from happening again, you have to get US Federal, US state, English, German, EU, Mainland China, Hong Kong, Dubai, Swiss, etc. etc. officials to coordinate actions. If you try to come up with a “grand scheme” to fix everything once and for all, someone is going to say no, at which point you haven’t fixed the problem. The next AIG will happen in Dubai rather than in London.

    So what you need to figure out is the *minimal* necessary to fix the problem, since convincing 20 different countries to change their regulations is going to be hard, and if you have something that isn’t absolutely necessary, then nothing is going to get done.

    One alternative is to do what China is doing and have a financial system that is basically shut itself off from the rest of the world. China doesn’t have to worry about what other countries do with RMB since it is effectively illegal to own Chinese currency outside of China.

    The problem with this is that China has no desire to be the global superpower whereas the US does, and if you close your financial system in the way that China has then you cannot act as a global economic superpower.

  • Posted by ReformerRay

    Ken – thanks for your excellent contribution.

    Fannie and Freddie were able to follow good procedures until they were changed into profit seeking companies by adding stock holder. I expect and hope that they will continue to be governmental entities, charged not with making a profit but with providing insurance for mortgages that are properly constructed.

    Much discussion about ratings. These rating companies get their funding from the companies they rate. That is not a good system. Perhaps they should be funded by a % of the final payment of interest on a bond they rate. If the bond fails that they rated highly, they get no funding.

    Ken is correct that separation of the two kinds of systems has not worked well in the past. I must remind him that in the past no serious effort was made to protect the regulated system from the unregulated.

    What has happened in the past can be avoided. I will agree with all the cynics that some new unanticipated problem will arise in the future. In the future, we will have to deal with it.

    The fact that the limitations on stock market trading made in the 1930′s did not prevent the bubble of the 2000′s does not mean that the actions of the thirties were wrong. They were right, they were necessary and they were valuable.

    We must take care of todays’ problems so as to leave a stronger country better able to face the problems that will arise in 2020.

  • Posted by Twofish

    ReformerRay: That $170 is what we call a sunk cost. It has been spent. It did reduce the amount of toxic assets on the books of AIG. Now AIG can fail without destroying Goldman Sacks or other firms that have gotten money from AIG.

    Except that AIG is an insurance company and manages 401(k). The second AIG goes belly up, all of the insurance contracts and money funds that AIG operates become worthless. If your house has an AIG contract and catches on fire the day after AIG goes belly up, get in line with all of the creditors.

    This is where the conspiracy theories fail. If it was just a matter of saving Goldman-Sachs, then you could pay off GS, and let AIG fail. The thing about bribery is that often its not that expensive.

    That’s not the problem. The trouble is AIG is involved in insurance. Congressmen do not like people screaming at them for the AIG bailout and they only reason they are going along with it, is that when you have another major Gulf coast hurricane and people find that they no longer have insurance, there is going to be even more screaming.

  • Posted by ReformerRay

    After reading the above post by Twofish, I am of the opinion that he knows more about the financial system than I do. Nevertheless, the view of an outsider is sometimes helpful.

    Whatever the reality, there is a better way to organize things that the system that is now legal in the U.S.

    I do think both banks and insurance firms will come to be regulated at the national level by laws established by the Congress.

    My assumption, contrary to Twofish, is that the U.S. can protect itself from repeating the current mess without forcing any other country to change its rules.

    His last paragraph is important: “The problem with this is that China has no desire to be the global superpower whereas the US does, and if you close your financial system in the way that China has then you cannot act as a global economic superpower.

    The debacle at Lehman and I hope at AIG says to the rest of the world that the financial giants in New York cannot be trusted to safeguard your money. No way the U.S. can continue to be a financial superpower when it owes everybody in the world. We were forced to give up the Bush-Chaney dream of world conquest by militay might. We can also give up the dream of world leadership in the financial realm.

    I want U.S. banks and insurance companies to downsize to the point that they can focus energies on funding non-financial activities in the U.S.

    If they can make good investments overseas, fine, but they should no longer try to control world financing just as the U.S. must give up trying to control military activities all over the world. Our ambitions must fit our abilities.

  • Posted by ReformerRay

    Which U.S. law heavily restricts issuance of deriative contracts? A legal advisory to the International Swaps and Derivatives Association told me that the Commodities Futures Modernization Act of 2000 simultaneously made contracts based on this law enforcable in U.S. courts and forbade federal regulation of these contracts. The only limitations mention was fraud, manipualtion and insider trading. Do we have post-2000 law that limits issuance of these contracts?

  • Posted by ReformerRay

    i know that AIG has normal insurance operations. I also know that those operations, if separated from the rest of AIG, would continue to be perfectly safe and a continuing activity.

    I believe that those operations will be taken over by another insurance company, just as has happened when other insurance companies go out of business.

    Scare tactics work if they are in accordance with recent experience. This scare tactic will not work.

  • Posted by ReformerRay

    T he U.S. authorties should have no wish to control deriative contracts. Let England do what its wants to do. Lax regulation of financial activities in London made London the center of the financial manipulations, a bigger finance center than New York. So be it. We will see what happens to London finance after the crisis is over.

    The U.S. must restrict the activites of the regulated banks and insurance firms to protect U.S. citizens who want to have a safe place to store their wealth. Those firms that do not want to operate under those restrictions should not apply to become banks and insurance companies in the U.S.

  • Posted by ReformerRay

    Twofish says you change one thing other things change. I agree, provided the thing that changes is important.

    Suppose the London branch of AIG that wrote all this insurance on deriative contracts had been set up as a separate company, without the ability to rely on the assets owned by the parent company. That would have changed the number of contracts they could have written. Customers would want some assurance that this new and independent company had enough assets to pay off the contracts.

    If we succeed in isolating the regulated system from the unregulated, that would drastically reduce the business an AIG spin-off would be able to do in London.

    Changing laws in the U.S. is all that is needed to prevent the U.S. from repeating our past failure.

  • Posted by ReformerRay

    “Although we have wound down more than $1 trillion in the portfolio of the AIG Financial Products unit that is at the root of the company’s troubles, there remains substantial risk in that portfolio. The financial downside for taxpayers is potentially very large, and that’s why we’re winding down this business”.

    The above quote is from an article in today’s Washington Post by Mr. Liddy, CEO of AIG, defending the notion that AIG should be allowed to stay in business so it can pay back what it owes the U.S. government.

    Mr. Liddy does not address the important question: What kind of recovery could the U.S. government expect if AIG is shut down towmorrow? Why do you think the amount will be greater is AIG is allowed to continue in business?

    He says they are transferring assets to the U.S. government, etc. But he does not promise no more requests for governmental funds.

    Read his article for yourself. I remain committed to shutting them down.

  • Posted by ReformerRay

    should be “if” instead of “is”.

  • Posted by babar

    it should be possible to restructure AIG so that only AIGFP fails, no?

  • Posted by observer

    I want to answer one canard persistently put forth by Twofish. For e.g.

    Twofish: Pull up a balance sheet for any bank. You’ll see that almost all of the assets are loans which cannot be liquidated quickly and assets are cash deposits which can be.

    Here’s one recent list:
    Bank failures

    Note that in each case, the assets exceed deposit liabilities. So depositors have no danger of losing anything. Under FDIC protection there is no liquidity problem either. Your ATMs and checks continue to work as normal.

    The FDIC is in no rush to liquidate, so when they either do liquidate or sell off to a healthier institution, FDIC’s costs are a fraction of the total deposit liabilities.

    I challenge Twofish or anyone else to produce a counter-example.

    Bottomline, saving the depositors is relatively inexpensive.

    The real bailout money is for the benefit of unsecured creditors and counter-parties including hedge fund gamblers etc.

    It is misleading and dishonest to suggest that somehow it is impossible to protect depositors without simultaneously bailing out all other kinds of bank creditors.

    So can we please put this one to rest and not mix up depositors and counter-parties again?

  • Posted by adiemuso

    AIG minus its foray into financial market making (or shd i say CDS mkt) is undeniably a good company.

    Letting AIG go based on the current mess per se is not a good move.

  • Posted by Michael

    As to the question regarding the intentions of Bernanke and Obama for the future of CDS: Bernanke uses the historical/present status quo of total global financial CDS intertwinement to explain why bailouts have been undertaken and will continue; he doesn’t mention future resolution of the mess. Obama claims the global CDS intertwinement requires bailouts in the present so that the CDS relationships can be “unwound” going forward (he doesn’t say how or when). There are many who assert that that CDS are necessary and desirable, not only to hedge risk (hahaha) but also to “value” risk; they say a nice neat transparent CDS exchange will solve all problems; let’s shoot these guys first.

    To quote Danny DeVito in “Other People’s Money” (if you haven’t seen it you should):

    [substitute the word "CDS" for "lawyers" to get my point]

    “The problem with lawyers is they’re like nuclear missles. The other guys got ‘em, so you gotta have ‘em. But, as soon as anybody starts using ‘em, it f**k’s everybody up!”

  • Posted by Twofish

    observer: Note that in each case, the assets exceed deposit liabilities.

    And if you look at what the assets are, they turn out to be illiquid loans. Note also that all of these banks are tiny (less than a billion in assets).

    The assets are illiquid and can’t be converted to cash quickly. The deposits are cash deposits. Standard operating practice when a small bank fails is to merge it with a larger bank. This creates a problem when a large bank fails.

    observer: Under FDIC protection there is no liquidity problem either. Your ATMs and checks continue to work as normal.

    And I suppose that this is the result of money fairies. If you can find a big bank to absorb the losses of a small bank, then you are in good shape. However, what eventually happens is that you end up with big banks with losses, in which point this no longer works.

    observer: Bottomline, saving the depositors is relatively inexpensive.

    It’s actually not. You end up hiding a lot of the costs. It’s a pay now, pay later situation. Often, pay later is better than paying now, but you still end up with costs that need to be resolved.

    observer: The FDIC is in no rush to liquidate, so when they either do liquidate or sell off to a healthier institution, FDIC’s costs are a fraction of the total deposit liabilities.

    What happens when you run out of healthy institutions, which has basically happened?

    observer: It is misleading and dishonest to suggest that somehow it is impossible to protect depositors without simultaneously bailing out all other kinds of bank creditors.

    It’s also true. If you look at all of those assets that they bank has, they are mostly loans. They are worthless if you can’t convert them into cash, which is what all these things like TARP are about.

    observer: So can we please put this one to rest and not mix up depositors and counter-parties again?

    Not until you tell me

    1) how you can convert the assets on the banks books into cash without invoking money fairies.

    2) if you fix the situation by having small banks getting eaten up by bigger banks, what happens when the bigger banks get into trouble in part by eating up smaller banks

  • Posted by Twofish

    Michael: As to the question regarding the intentions of Bernanke and Obama for the future of CDS: Bernanke uses the historical/present status quo of total global financial CDS intertwinement to explain why bailouts have been undertaken and will continue; he doesn’t mention future resolution of the mess.

    I think the CDS mess will largely resolve itself. As old CDS’s expire and new one’s aren’t issued or are only issued under adult supervision, the situation will fix itself. The big thing is to avoid large numbers of bankruptcies, and that’s important for its own sake.

    The CDS is where the fire started, but it’s really a minor issue at this point. The big issue right now is unemployment and lack of credit is making previously good assets bad.

  • Posted by Twofish

    More on commercial banks failures.

    Suppose you are a commercial bank and you have loans as assets, but you want cash, either to make loans or to pay depositors.

    What do you do? You get on the phone to Freddie and Fannie offering to sell these residential loans for cash or you get on the phone to Goldman-Sachs to offer to sell credit card debt or auto loans for cash. Under normal circumstances, Freddie/Fannie or GS would then find some hedge fund, or Chinese central banker to get cash which then gets send to the commercial bank, which they goes to the depositor or to new loans.

    Without that mechanism to convert assets to cash, all of those assets are basically worthless. It’s like being in the middle of the ocean without fresh water.

    The trouble is that the system has largely broken down, and the for the most part the only major institution that is willing to convert loans to cash is the Federal Reserve.

    The other thing about the assets on the ooks of commercial banks is that they are even less “mark to market” than derivative securities. Suppose a bank loaned money to build a shopping mall. Now, everyone knows that the second the mall opens, it will be dead, because with this economy there aren’t that many shoppers. However, the account rules are that this loan is marked good as long as the borrower is paying, which he is, for now. But everyone knows that the asset value is bogus, however since commercial banks are not required to “mark to market” they can keep these bogus valuations, until people start showing up at the teller window wanting their money….

    You can see what happened if you look at the values for one failed bank…..

    http://www.fdic.gov/news/news/press/2009/pr09005.html

    On paper, the bank looked solvent, but once people started taking their money out the game was up.

  • Posted by ReformerRay

    When big banks fail, the FDIC should turn the issues over to the bankruptcy courts and 7 years latter all the lawsuits will be resolved. Everybody involved loses, except the lawyers.

    The alternative to letting big banks fail is to continually provide federal money to pay off debts that would never have been allowed to be created if we had a good system.

    Keeping big banks alive with federal funds is leading us directly into the Japanese trap. Banks that exist but are unwilling to make loans.

    The 1 plus trillion that the Federal Reserve says they are going to insert into the system is premature. Later. All they will do is reduce the log jam at the top of the system. The real problem is that those of us at the bottom do not want credit now. And we should not.

    Consumers must build up their balance sheet before banks.

  • Posted by ReformerRay

    Today is the best time to withdraw federal funds from AIG and let it sink or swim. The sooner the Federal government gives up the effort to keep a big banks alive, the sooner the deflation will sort itself out. House prices have not hit bottom. Consumers have not yet restored their balance sheets. Debt does not feel comfortable yet. So, let nature take its course.

    When house prices come into agreement with income and personal assets for consumers, then the turn around can begin – if and it is a big if, we have banks that have cleaned up their own balance sheets and are positioned to lend to good bets.

    The difference between the 1930 and 2009 is the vast amount of purchasing power existing today in the U.S. independent of employment. That purchasing power will be a force that will halt the downward spiral without any more intervention from the government.

    Bernanke is mistaken when he thinks what he learned from the depression of the 1930′s can be applied directly to today. We live in a different world today.

  • Posted by Twofish

    ReformerRay: When big banks fail, the FDIC should turn the issues over to the bankruptcy courts and 7 years latter all the lawsuits will be resolved. Everybody involved loses, except the lawyers.

    That’s fine except that I can’t wait seven years for my checks to clear.

    ReformerRay: The alternative to letting big banks fail is to continually provide federal money to pay off debts that would never have been allowed to be created if we had a good system.

    The alternative is to pump money into the system to keep it from collapsing, fire the people responsible for causing problems, and then we are no longer in crisis mode, regulate the hell out of banks that are too big to fail. It’s a very, very bad thing to prevent that you will let a bank fail when it’s obvious to everyone that you won’t or can’t. So don’t pretend. Just say that X bank is too big to fail, if it runs into trouble, we are going to bail it out, therefore we are going to regulate it to make sure that it doesn’t ever need bailing out.

    ReformerRay: Keeping big banks alive with federal funds is leading us directly into the Japanese trap. Banks that exist but are unwilling to make loans.

    That’s not the big problem right now. If you look at the big banks, they are making huge amounts of loans. The problem is that before the crisis, most of the credit in the United States *didn’t* go through the banks.

    The good thing about the “shadow banking” system is that when things fell apart, lots of people lost large amounts of money. The bad part is that having lost large amounts of money, hedge funds are not inclined to start lending.

    Also, you need to pump massive amounts of money to clean up a banking mess. It is far, far cheaper to just pretend the loans are good, which is what the Japanese did. If you want to actually fix the problem, you have to make paper losses real, which means spending huge amounts of money, which the Japanese were not willing to do until it was too late. Closing a bank is very, very expensive.

    ReformerRay: The real problem is that those of us at the bottom do not want credit now. And we should not.

    Fine, if you don’t want to borrow then save money and in a good system that money will be used to build new factories and infrastructure.

    ReformerRay: Consumers must build up their balance sheet before banks.

    Consumers can’t save if there are no jobs, and there are no jobs if there is no credit, and there is no credit if banks are dead.

  • Posted by Twofish

    ReformerRay: House prices have not hit bottom. Consumers have not yet restored their balance sheets. Debt does not feel comfortable yet. So, let nature take its course.

    Tried that in 1930, failed miserably.

    ReformerRay: When house prices come into agreement with income and personal assets for consumers, then the turn around can begin – if and it is a big if, we have banks that have cleaned up their own balance sheets and are positioned to lend to good bets.

    And that just won’t happen. If you don’t have credit, the jobs disappear. Once jobs disappear then incomes and assets disappear, once incomes and assets disappear then jobs disappear. The cycle doesn’t end until you have huge unemployment, and people get fed up.

    ReformerRay: The difference between the 1930 and 2009 is the vast amount of purchasing power existing today in the U.S. independent of employment.

    No there isn’t. Most people have to work for a living. Even people that don’t have to work for a living (i.e. retirees) get their wealth from people who do. If you are a retiree or hyperrich, your income comes from stocks and bonds or social security, and without workers, all of that is worthless.

    ReformerRay: That purchasing power will be a force that will halt the downward spiral without any more intervention from the government.

    No it won’t, because once credit disappears, companies start collapsing, then stocks and bonds will be worthless. This is much too big a problem for markets to handle, and as in the 1930′s, we need a bit of socialism to save capitalism.

    ReformerRay: Bernanke is mistaken when he thinks what he learned from the depression of the 1930’s can be applied directly to today. We live in a different world today.

    Actually we don’t.

    The problem was that people forgot some of the lessons of the depression, so between 2000-2008 we had a return to the lassize-faire policies of the early-20th century, and we’ve had to relearn why we had as much government regulation as we did.

    It’s not a coindence that things happened when they did because around the 1990′s, people that actually lived through and remembered the Great Depression started dying off, which made it possible to start suggesting policies that would have been considered madness in the 1950′s or 1960′s.

  • Posted by Ying

    RR:

    Credit derivatives has suffered the greatest loss under current environment. What about currency derivatives and interest rate derivative? Do they have enough merits to exist? Will these contracts be forced to wind down too in the near future in case there is a big unexpected movements in currencies and interest rate? Where do you draw the line on regulation?

    Maybe financial capitalism needs to be destroyed completely and countries go back to industrial capitalism. Then there is an environmental constraint on how far industrial capitalism will go.

  • Posted by observer

    Twofish: 1) how you can convert the assets on the banks books into cash without invoking money fairies. [...]

    Lets get back to the issue under dispute here. Twofish claims that it is necessary to bail out derivative counter-parties and unsecured creditors of banks in order to protect depositors.

    I find this claim dishonest because it seems like a blatant attempt to disguise a bailout that mostly benefits hedge fund gamblers and large financial firms as necessary to protect widows and orphans i.e. retail depositors.

    I contend that it is not at all necessary to bailout counter-parties and bond holders just to protect depositors who are after all a completely different class of creditors.

    Obviously it is more expensive to bailout a larger class or creditors than if we only bailed out depositors. But I’d go even further and assert that it is *far* more expensive to bailout counter-parties than just the depositors.

    As evidence, I offered a list of recently failed banks taken over by FDIC and showed that in all cases assets exceeded deposit liabilities. Even if the assets are mis-valued, the typical FDIC loss figure is not more than 10% of deposit base.

    Twofish says that bank assets are illiquid. Yes they are, but so what? The FDIC has no obligation to immediately liquidate these assets. They can wait until markets recover. In any case, it is not clear what the relevance of this is to the core question of why derivative counterparties have to be bailed out, so this is an irrelevant point anyway.

    Twofish also says that FDIC will find it much harder to take over ver large banks. Once again this is true but irrelevant. Yes a mega-bank like Citi would pose challenges to the FDIC and possibly new institutional arrangements may be required. But what has this got to do with bailing out derivative counterparties??

    In summary, Twofish has provided no justification for his claim that somehow bailing out hedge funds with CDS contracts is necessary to protect depositors.

    I think it is distasteful to try and cover up a bailout of large financiers using depositors as an excuse.

    There may indeed be good reasons to bailout the financiers e.g. systemic risk, or the need to keep credit markets active, or even just the sheer complexity of unwinding contracts etc, but lets be honest about it at least and not hide behind widows and orphans.

  • Posted by observer

    To summarize on bank failures. Suppose a bank becomes insolvent, a lot of bad things will happen. Credit markets may get frozen etc etc. But one thing that will *not* happen is deposits being frozen or lost. Checks will continue to clear and ATMs will continue to operate just like they always did. This has been the case will all bank failures in the FDIC era.

    A mega-bank may pose operational challenges, but once again protecting depositors has absolutely nothing to do with bailing out bond holders and derivatives counter-parties.

  • Posted by ReformerRay

    Ying wants to know my position of derivatives.

    Derivatives are going to exist. I think trying to regulate either derivatives or hedge funds is a fools errand.

    Let them exist in the unregulated space that they want; let them do whatever they want.

    Only rig the system so that they cannot get access to funds that have been committed to banks and insurace firms in the regulated system. The regulated system is should be designed primarily to serve the interests of wealth preservation. Keep my money safe.

    Better informed people than me will have to work out the details. I know it can be done. Banks and insurance firms have always worked under restrictions. Whatever reasonable restrictions are required to make funds same will include restrictions on flow of money from the regulated system to the unregualted. Perhaps some flow can be permitted. But it must be limited so that funds in the regulated system are safe.

  • Posted by ReformerRay

    Twofish is full of arguments saying that the wall I want to construct cannot be erected. We will not know the answer to that until we try, will we?

    Does Twofish also think that the wall would be undesirable, if it could be constructed?
    I am not sure about that. I know he hates the whole idea.

    Well, I hate his idea that everything must be regulated.

    Does Twofish want to see a “regulatory scheme” set up that is likely to fail from too big a burden?

    I’ll admit to a desire to see hedge funds reduced in size and influence – and less ability of gamblers to use derivatives to bet on events that are irrelevant to the business of the party buying the protection.
    Forcing these activities to be funded by people who know they are playing in a market that is not protected or backed up by a mega bank or the governemt will greatly reduce the leverage they can get.

    I think the undesirable activities that caused our current problems will be reduced much more rapidly by cutting them loose from access to regulated funds than would be the case if attempts were made to regulate their activities. When we try to include them in regulated activities, the possibility of borrowing unlimited amounts from mega banks will remain.

  • Posted by ReformerRay

    Previous post “make funds safe” not ” make funds same”

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