Brad Setser

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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.


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.


  • 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


    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”