This page has been archived and commenting is disabled.
Guest Post: The Opposite Of Apocalypse
Submitted by JM
Fear is where the Power Is
November 2008: the situation was dire. But was it ever really an apocalypse? We were all conditioned to think that without government intervention a waking hellscape of crappiness awaited. And it continues. Over and over, we are told of being just a step away from US government default if someone dares fiscal sensibility. Or some variation of bank implosion catastrophe, or everyone going into foreclosure immediately, or something else equally horrible. These outcomes are debatable, and they deserve to be debated. Everything that happens in the future is debatable.
What is not debatable is that we continue to be threatened with imminent doom if politicos don’t get what they want. I’m not a believer in global conspiracy theories, much less a perpetual ruling class, but I am a believer that democracies are absolutely awash with propaganda, veiled threats, and fear-mongering.
Why? Fear is where the power is.
Anybody who knew what was going on in November 2008 was afraid. I know I was. Being afraid of the unknown is exhausting and defeating. The only way to defeat this fear is to make it known, to see the beast in the clarity of thought-light. Being willing to communicate and engage is the step forward. No matter how big, ugly, or evil it is, one can stand up to it, fight it, and break it.
It’s time to break the spell of fear that makes this whole planet reek like week-old gym socks. Breaking the spell means only this: to be unafraid to communicate, to be open and receptive to ideas, to weigh them on their merits. It doesn’t mean “find some guru and accept their crap ideology at face value.” No one is totally, unambiguously, right. Ideas may be challenging and unpleasant, but ones based on facts don’t wither under scrutiny. Here goes.
Can a Company be “Shorted to Death?”
I’ve heard many reasonable, intelligent people say that AIG was shorted to death by Goldman Sachs among others. On the face of it, sure looks like it. After all, Goldman Sachs took out protection on AIG exactly when it was most vulnerable. They profited from the demise of the largest insurance firm in the world.
The question is not if Goldman Sachs did it. The question is why.
The reason why they did it is because AIG was the insurer of a large chunk of the equity tranche securitizations they held. These securities were risky, and Goldman Sachs bought protection on them in the case of default. This protection was desirable not just as default protection. The price of protection goes up in times of stress, meaning profit, so it was a way to manage daily marks.
So Goldman knew there was a housing bubble that would pop and they would lose when it did because of these securities on book. They also knew that AIG insured more than just their paper, but most of the world’s paper. Before the crisis even started, AIG was having trouble posting needed collateral to cover their losses associated with the securitizations for which Goldman paid insurance. This means Goldman would effectively pay insurance premiums for nothing, because AIG was at risk of not being around when they needed to pay out.
So they bought CDS on AIG as a company. At least they would be able to recover a portion of their losses in the event that AIG went under. This is the naked shorting that has been talked about so much. It isn’t really naked at all, because it was insurance on the insurer of their book assets. This is a good business decision. It didn’t bankrupt AIG, because the swap counterparties, not AIG paid out if AIG went under. What bankrupted AIG were bad business decisions by AIG. They had to mitigate risk exposure, which they did.
So did this “shorting AIG” actually bankrupt AIG? Could the situation be repeated for other companies? No and no. AIG didn’t pay out CDS upon default, the CDS counterparty paid out. Now it is true that a blow out CDS curve can affect a company’s funding costs and this is especially bad for financial companies. But insurance policy holders aren’t to blame for the spread blow-outs. A company that makes bad business decisions that take them to bankruptcy is to blame for spread blow-outs.
And this isn’t a Goldman Sachs issue. Just about everybody with securitizations on book that knew what was going on did the same thing. In a sense, Goldman Sachs gets singled out because they weren’t a sucker holding the bag. Why should anyone weep for some suckers on Wall Street? Nobody weeps when the hammer comes down on retail.
Am I saying all the bailouts and effectively free money was the right thing to do? No. I am saying that free money and political cronyism is a separate issue. No hedge fund I know of got a bailout. Is it Goldman’s fault that Uncle Sugar and the Fed screwed the taxpayers for generations to come? I don’t know the answer to that and remain open to evidence to know either way. I pass over it in silence until I know more.
The Opposite of the Black Swan: Did Margining Mitigate the Apocalypse?
CDS were designed to manage credit risk: one leg gets a payout given a triggering event and the other leg receives a premium up to that event—sort of like an insurance premium. To do this there has to be a buyer as well as a seller. Market makers are flat credit risk. Prop desks, hedge funds, and institutional books buy protection. Net sellers are the monoclines and insurers—beat-up companies like AIG.
Credit default swaps are transacted in terms of notional amounts, but the notional amount isn’t paid at the outset… it is funded, meaning it is paid in some series of installments. Because they are paid in this way, and because the price of a credit default swap fluctuates in price based on supply and demand, the market value of the credit default swap position is monitored, mostly on a daily basis. To cover adverse swings in price, the party affected must post collateral.
So we come to times of crisis. What do you think happens to CDS in these times? That’s right, the spreads blow out and more collateral has to be posted. More collateral is very beneficial to dealing with a crisis because a chunk of the crisis is paid for as spreads widen, before the default actually happens. This means that the losses were less sudden and more manageable than they would have been otherwise. Losses accumulated on a daily basis instead of all at once. CDS helped because the problem was insolvency. CDS procedurally expedite the insolvency process.
The problem was inordinate concentration of risk, meaning that one side of the risk was taken on by too few parties, or equivalently, the parties that paid in the event of default didn’t charge enough premium (because more premium reduces risk).
Has Nothing Been Learned?
Well, this is an open question which is in some ways a legal issue that others should address. What I do know is that the industry is moving towards exchange traded derivatives, where there are a few central counterparties. This isn’t just some cosmetic hogwash. It can be clearly seen in the fact that non-OTC CDS contracts are being standardized. Standardization means that contracts are more like homogenous transaction units where the differences in circumstance are dealt with via an upfront payment by buyer or seller. The events that trigger CDS payouts are simpler and straightforward to manage than OTC, so a clearing house can settle up a contract easily. Counterparty exposures will be known, so you won’t have entities like AIGs effectively taking on risk that make no economic sense. Far before crisis happens, entities won’t buy protection from counterparties with insane exposures.
Exchange cleared CDS is huge because it means multiple layers of protection for transaction settlement. More importantly, it means that dealers which make the market are responsible for each other’s failures. The clearinghouse is a business that survives or fails on the basis of its risk management. How?
That’s how. All this still does not mean that the system is unbreakable. Things are simply better in an imperfect world. But consider this… when was the last time that the CME busted on an options meltdown, or oil price spikes? The answer is never.
OTC (meaning non-clearinghouse for this purpose) CDS will continue to exist, at least until bank regulations catch up to how the market is evolving. This is because some parties need to have trigger events that are contingent on restructuring events, not just defaults. The motive is no speculation. It is pure insurance need.
The Sun Also Rises
All the fear-mongering facilitates a symbiotic victimhood simply because it is so paralyzing. It makes it easy to believe that never before has a society had to endure the trouble seen by those unfortunates living right now—because of the abomination unleashed by those whom voters legitimately brought into power. The great depression needs its capital letters removed. Chairman Mao was a benevolent breeze of fresh air compared to Bush. Cambodian genocide victims should heave a tremendous sigh of relief that they never saw the like of Ben Bernanke’s blasphemous money printing. This socioemotional hypocrisy is an obscenity.
Take comfort in knowing that Joseph Fourier showed (Riemann proved) that everything can come in cycles, just like the sun coming up day after day on what is usually nothing new. And the sun will come up just like it always has independent of anything that happens on Wall Street.
The last thing fear spreaders want is calm acceptance of truth; they want control. It is truly debatable whether anything alive and feral like a financial market can be controlled. But this is precisely what one is supposed to believe: a pretence that everything is under control. Accept that the experts have it all worked out, simply because they say so. Give in to public servant demands, or risk that hellscape scenario again and again. And when the endgame finally vaporizes what is regardless of any action or reaction, the ruse just starts again with the hideously stupid formula: “We can get things back under control. Oh yes, we can!”
At their core, time-honored religious texts like Dao Te Ching and Ecclesiastes contain the vision of an intrinsic moral logic in the universe that makes things right. Even if the universe rolls like that (debatable), convergence is slow and unpredictable. The support for anybody having anything completely under control is pretty flimsy. Ben Bernanke could scarcely control himself on a “60 minutes” interview.
Break on through to the Other Side
So what to do? Let go of fear of the unknown and try to make it known. Let go of easy comfortable ideas that just can’t stand up to news flow. Holding on to shimmering BS is a sham unworthy of the intellect. That is to say: communicate and engage.
There’s no going back as memory ensures that ideas aren’t reversible. There never was a Golden Age when everything was clean and easy anyway, because nothing has ever been easy or clean. So what if the 1950s didn’t have derivatives. They had Jim Crow laws and H-bomb tests that literally annihilated pristine South Pacific islands instead. They had to put up with this awful crap too.
Everybody needs containers to hold their insecurities, including the author of this joint. But I know enough to know I haven’t figured it all out. And I never will. I will keep trying to figure out the nature of things, use the knowledge to make things better and adapt when it all changes in an instant. This is the spice of life.
Living things don’t stay still unless they are dead, so don’t let your thinking stall out. Break on through to the other side.
»
- 10663 reads
- Printer-friendly version
- Send to friend
- advertisements -
With no fear of reproach from a sackless "regulator," why would you stop betting? Give me a bottomless account and I'll sportsbet/trade all day. I know the house wins but why worry, my friend will give me some more sugar when my luck runs out.
Exactly, it continues and CDS are a MSM attempt to divert blame once again to the "speculators". The problem is that a "hedge" is only a hedge if the markets are fair. Since we've long forgotten about fair/orderly markets(HFT, Flash Crashes, Law Changes, Currency, PM, and other types of Manipulation/Misinformation) how can anyone pretend that our Govt and their friends or owners, Wall Street, operate for any other purpose than to transfer wealth to their friends? MBS got crowded and wall street knew it. They knew there was a bubble but until a bubble bursts it is pretty damn good at making money so why stop betting until your luck runs out? The "smart money" saw the endgame and "hedged" their bets knowing full well the conflict of interest but it didn't matter, their buddies over at the Fed and in the White House had no problem continuing the shell game. It's a pity that normal people don't even consider these ideas and let sackless bankers and politicians confuse them with BS. Is it funny that a country founded on liberty and justice, has lost all semblanes of justice and liberty, well go to the airport. There is no problem with CDS, only a problem with the market. It is time for regime change. End the Fed. The western world is now blessed with a lost decade or four of higher taxes in any form, lower public services, and a fattened "ruling" class. Obummer is a puppet. Central Bankers run the world. Congress is like a Kindergarten class and the judicial system is an insane asylum. There is currently nothing in federal politics that works for main street. But on with the sugar, if you're invited, and if not well there's always the latest version of rubbish on tv that looks great in HD. Bow to your masters for saving their system that benefits them and you well, please buy stocks or bonds that may lose any intrinsic value tomorrow. What do you do with your savings? Probably buy GM stock right, because at least the Government will force the bondholders to take a haircut...there is nothing to do but buy PM's. This is the market they've created. This is what they wanted and let's jus hope it doesnt end the way that they want because loss of portfolio value will be pale in comparison to the NWO. Disclosure-I am for global conspiracy theories where they are utterly obvious.
In other words, "roll with it".
Great post.
Let's now move on to cascading CDS margin calls,
Cause Mama, That's Where the Fun Is....
IMHO, cascades will happen on a much larger scale... between say, CME and ICE. That's where the jump to default action could bite hard.
I guess clearinghouses could daily reconcile, but I wonder if there is a perverse incentive to not do so... maybe that is a niche TriOptima can fill...
Good post.
CDS are just a financial tool. They can be used fraudulently (just like any financial tool) but they are not fraudulent in and of themselves.
They need to be regulated to ensure that their effect is to balance risk, not to create it.
If risk reserves had been be set high enough, AIG couldn't have sold so much insurance, so cheap that they blew themselves up.
If the people who had purchased insurance from AIG had been forced to absorb the loss when AIG failed (after all they should have known they were buying insurance from a weak company), they would have learned to be more prudent.
If we had just let the system function without the idiots (read the government) intervening to protect their buddies and masters, we would have had a short, severe correction and be back on the road to healing.
Iceland is doing better than Ireland. Propping up dead companies makes for a zombie economy.
Our world may be ending but THE world isn't ending. Adapt or die (figuratively) is how the world works. Crooks are always around, governments (but I repeat myself) are always around. Honest people have to learn to live with crooks and governments and survive. The world isn't fair but we got the long end of the "unfair" stick, here in the USA. Live, laugh, love as best you can. That is all the wise person has ever been able to do. If you want to make it a perfect world, you will only make the world worse. Tend you garden and accept that the world will always be less than perfect.
Good luck! (RANT OFF)
I get it JM. Your whole premise in this article is that we shouldn't blame the CDS's or other instruments for the financial problems. And, that with new systems in place, the likelihood of failure is reduced. Got it. But no one cares about the instruments. Most are not upset that AIG, as the house, took the sucker's bet without the funds in the bank. We don't care that GS hit the Blackjack tables on a broke casino. We don't blame the cards, or the felt the tables were made out off. What pisses people off is that the Federal government picked our pockets to pay the bet and we weren't even in the casino!!!
Not only did the pay out GS bets after letting lehman walk away broke, but then they bailout foreign banks, institutions, anyone with a bet on the table, with OUR MONEY.
If CDS are good, why not the nth derivative of a CDS?
Because medium of commerce (money) is primary. Derivatives of money decline rapidly in terms of real value. The financial ecosystem has strayed so far away from the "real axis" of productive human endeavors we now have a giant malignant tumor that exceed the size of the body it depends on for life. Some have the false belief that the tumor is on par with the body and it should be nurtured and strengthened. Those people are leading humanity astray.
Beyond the noise of our society, beyond the denial, a growing number of people realize this is going to be an unprecedented, historic fail. To borrow an avatar from this site, cognitive dissonance is growing.
Choose your acorns wisely, this is going to be one hell of a winter. When spring finally gets here, we'll be doing well, to support 2-3 billion people on this rock. Pray if it brings you comfort.
the only thing to fear is fear itself?
so go short fear? go short naked fear? blow goldman sacks?
Next to fear-mongering, over-simplification and ommission of key material facts are pretty high on my list of things to be vigilant about. Here's just a few that you left out:
Your omissions amount to revisionist history, whether or not that was your intention.
Glass-Steagle wasn't followed anyway for years before it was repealed. Gov failure.
Please explain how the exemption matters here. You're saying they didn't margin?
AIG sold protection on itself?
You and I don't know what Goldman knew. It was fully hedged, and then they hedged the counterparty risk on AIG.
No haircut?... blame the folks that were elected.
Nevermind
Dude:
There are bastards on Wall Street. They do bad things. There are victims that are the result. Wall street needs reform. On this I think we can both agree.
But CDS are a thing that can be used legitimately and equally abused. They aren't the problem in my opinion.
A lot of common ground, no?
"I’m not a believer in global conspiracy theories"
Stopped reading.
JM, you're just defending the indefensible. I don't know what version of 2008 you witnessed but it was completely different to mine, you sound like a goldman sachs shill to me.
You sound to me like you don't have any facts to back up whta you say, therefor you start up the name calling.
Just stupid.