115 Comments

1. Mark:

Wrichard writes:

“While civilization may not wish to voyage its waters on an warship, the question is whether it can safely risk it on the Love Boat.”

While many signed up for the free cruise, a large number got to travel first class. Indeed, they took up residence there, a la Franklin Raines and his Four Seasons condo.

Wealth ultimately comes from investment and profits. The profits go back into productive activity, or even into philanthropic foundations (which in turn goes into productive investments to keep up with inflation.)

What we have seen in recent years is the appearance of productivity, a processing of paper, based on requirements that every one out of five loans (20 percent?) be ‘reinvested’ in the community. These loans inflated the real estate market, with the predictable result. A Harper’s Magazine magazine article outlined the inevitable scenario two years ago.

Or, to put it in other terms, for every five dollars you saved or invested, Congress promised one to unqualified lenders. . . . and told the banks they had to do it. Which resulted in lots of apparent prosperity, but was really Congress telling bankers to loan out your money. The bankers could not believe their good fortune, and the analysts calculated feverishly re. how to maximize their margins on this windfall.

Re.the Love Boat, we forgot to ask how long it could run without fuel, or how it would survive a storm or iceberg.

There’s a 20% hole in my financial accounts today, and it went to pay for lots of people taking cruises on a ship of fools.

Oct 11, 2008 - 8:43 am 2. Teresita:

Wretchard you cite 9/11 and the recent market meltdown as perils, but they are not existential perils. Sure, 3000 people died on that day, but it was a sucker punch from 19 guys, a wake-up call, we’ve taken vengeance against the Taliban, we’ve even taken vengeance against a dictator who had nothing to do with it, and we’ve taken steps to prevent anything like that happening again. The current financial troubles we are having are simply market forces ramming through a correction (despite socialist efforts to prop up prices) to a historic bull run that began in 1982 and turned into a vast check-kiting scheme writ large. If market corrections like this did not happen I’d be more worried. But a lot of people took a haircut on their retirement fund, so it just seems like the end of the world.

Oct 11, 2008 - 8:46 am 3. dla:

After the stock bubble popped, we got more regulations. Now publicly traded company’s are managed like banks. Because Congress wanted to prevent another Enron. So stock options disappeared for the worker-bees.

What will Congress enact this time? Will they ban the CRA? Doubt it. Will they even acknowledge their culpability in this mess? Don’t kid yourself. Will Barney Frank be removed from office? No – he’s a Democrat. But my guess is that ultimately you and I will be impacted negatively.

So is Congress going to outlaw bubbles?

Oct 11, 2008 - 8:57 am 4. Leo Linbeck III:

The question of “convenience” is an interesting one. It’s not clear to me that less convenience is a bad thing.

If I keep a refrigerator in the TV room, it is certainly convenient for me to grab a cold one during a football game. But it is also more convenient for me to store other goodies, and that convenience increases the likelihood that I will watch more TV. If this cycle continues, I will end up fat, glassy-eyed, and ignorant. (OK, more fat, glassy-eyed, and ignorant.)

So this convenience, while optimal for watching football, is really a local suboptimum. The global optimum is quite different, and requires health, which is undermined by simultaneous access to bread and circuses.

The core of a common culture is a shared set of goals. This is true of all social organizations, whether they are corporations or nation-states. Management consultants speak of mission, vision, and core values. Politicians speak of life, liberty, and the pursuit of happiness. Without this consensus around shared goals, subsidiarity degenerates into civil war.

The biggest danger of the US experiment has always been faction. Washington understood this, Lincoln fought this, and the “culture war” is the current language to describe it. It is a real danger, although it is one that is easily dismissed by those who don’t realize its fundamental importance.

Life, liberty, and the pursuit of happiness are our shared values. These are the attributes of the true Love Boat. And it is not a pleasure craft. It is a hard target.

L3

Oct 11, 2008 - 9:02 am 5. Stephen:

“The great benefit of the admittedly inconvenient, pre-global and more localized world is that it was compartmented into nations. Parts of it could be sealed off and rest of it still function.”

Speaking of compartmentalization. The thing that has been driving me crazy is the idea of the credit default swap. As is understand it, this instrument is essentially credit default insurance purchased by the buyer of bonds to provide extra protection against credit risk. It isn’t actually called insurance because that might make it subject to insurance regulations.

What makes me want to scream is the idea than an institutional investor can pass on making a rigorous evaluation of credit risk because the purchase of the default swap takes the place of critical analysis at the cost of a slight decrease in net yield after the price of the derivative contract is factored in. Does this sound like moral hazard to anybody? How many of us have heard from a broker on the phone that a bond has a AAA rating or some such, and that therefore it is a suitable addition to one’s portfolio?

Investors got too comfortable with rating agencies and big investors got to comfortable with credit risk hedges. All of the business and academic defenders of derivatives talk about the benefit to society of the ability to hedge risk. Is this really a benefit or is it a mortal danger when investors turn off their bullshit detectors and get comfy with credit risk when it is hedged through counterparties with credit risk issues of their own.

I think compartmentalization is a good, simple concept and I think it is clear that derivative contracts have been a primary means of defeating compartmentalization.

Oct 11, 2008 - 9:34 am 6. Pascal:

Let me point to parallel operations by many of the same players. Let us defend our freedoms from (what my opposite on the last few threads has aptly labeled) the gamed political system.

Bipartisanship is the facade, an appearance of comity, whereby the representatives get along with each other far better than with dissidents within their own parties. Whereby I have stung with far more venom from my “representative” in requesting reforms than he ever displays when “fighting” the Left. Thus, like many of the disgusted around the nation, I see the GOP leadership both taking a dive and fragging my champions.

So in some ways what you have just proposed supports Mika’s suggestion for a multiparty instead of our two party system. As Konyok and others pointed out to Mika, the problem is the members in the institutions who’ve learned how to game it, not necessarily the institutions themselves. For certainly, the end product of all those parliamentary systems has not made those nations stronger than ours. There splinter parties may extort a government’s dissolution at any moment, while here they have to wait 2 or 4 years.

Back to the topic. All for one and one for all is what our MSM/Ministry of Information/MinInfo has been pressuring for with its hammering the GOP for its lack of bipartisanship. Meanwhile the old snakes at the head of the GOP spews venom at their own partisans while displaying statesman like comity when faced with seeming insanity by members of the other party.

I cannot be the only person here to have witnessed this. So why don’t more of you force the issue out into the open? It’s time to force at least one party back into forming a true opposition against the other.

Oct 11, 2008 - 10:02 am 7. Wadeusaf:

Compartmentalization thinking inside ones own box.

Oct 11, 2008 - 10:07 am 8. Tamquam Leo Rugiens:

One thing about a crisis is that it focuses the mind wonderfully. Some very fine minds are focused on our current crisis and occasionally come up with ideas that make a modicum of sense. One such idea, simply called “Plan B”, This seems like a good idea to me.

h/t Tyler Cowen

Oct 11, 2008 - 10:09 am 9. NahnCee:

My basic bottom line is I do not, under any circumstances ever, want “the world” telling America what to do. That includes the world bank, the United Nations, and whatever international courts are out there milling around waiting for their defendents to die of old age.

Bush is meeting with 7 Treasury people from around the world today. I’m going to be really really really annoyed when he comes out of that meeting burbling about giving Russia a couple of trillion dollars to bail them out so they won’t be so desperate and angry any more.

We just cannot afford to be both the money-creater to the world and the policeman to the world both. Again, I think we need to pull out of Iraq and Afghanistan post-haste, and nuke Iran and Pakistan before we go since that’s the easiest and cheapest way of dealing with those two trouble-making countries.

Oct 11, 2008 - 10:25 am 10. slade:

Meanwhile the old snakes at the head of the GOP spews venom at their own partisans while displaying statesman like comity when faced with seeming insanity by members of the other party. – Pascal

Bipartisan comity sustained F&F.

The more difficult question is who/what sustained the derivatives market.

Oct 11, 2008 - 10:29 am 11. Pascal:

Exactly slade. Thanks for picking up on it. I wrote on 3 October of the dangers of the bailout while the poison that started the crisis remained within the system. I won’t bother linking.

[P.S. I failed to edit properly. I should have written spew instead of spews.]

Oct 11, 2008 - 10:44 am 12. Stephen:

“The more difficult question is who/what sustained the derivatives market.”

I doesn’t look difficult to me but then I’ve been reading Frank Partnoy’s book F.I.A.S.C.O.

He makes a convincing case that it is rapacious derivatives salesmen on one side and on the other side two different types of customers:

1. Institutional investors looking to “misbehave” and make bets that are prohibited by the rules of their own institutions, in search of either speculative profits or unusually high yields.

2. Institutional investors looking to purchase a magical spell to ward off credit risk, in the form of hedges.

Put eager parties on both sides of a potential transaction and you have a deal. Repeat until judgment day.

Oct 11, 2008 - 10:44 am 13. Pascal:

Can you expand on The more difficult question is who/what sustained the derivatives market.? I’m not even sure what that is even now.

Oct 11, 2008 - 10:47 am 14. Sima Qian:

Reminds me of my own country really — Singapore. Should we still have the draft? Why maintain such huge foreign reserves? Why not dispense some as welfare? Why have a standing army? Why maintain ‘hard points’ in the circuitry even though we are a completely globalized economy?

The answer, I should think, is that we want to be a combination of cruise ship and aircraft carrier. This means some redundancy in the system. Rather than free-ride on the United States (which everyone does to some degree), we have a standing army. Rather than leave economic defence to the vagaries of international markets or whatever the IMF says to do, we have some form of bulwark against which to ride out the tempest, etc. ‘Integration’ may not be so bad if you have a secondary line of defence. I don’t think the two are mutually exclusive: your metaphor only goes so far.

Oct 11, 2008 - 11:00 am 15. slade:

That’s exactly the point, Stephen. The derivatives market cannot be easily framed in ideological terms, which implies, with history as our guide, that it will be ignored – left to the financial wizards, like Michael Milken, who created these “vehicles” to now … do what exactly?

Achieve a political policy goal?
Stabilize the markets?
Free up credit?
Keep Russia and Europe afloat?

So far the only “policy” direction to emerge is the need to eliminate F&F and the rest of the GSE’s. This won’t “fix” the risk in derivatives paper.

Pascal – I personally would define derivatives as vehicles that disguise risk. As such, they can be applied to any market, which is the danger. The basic structure was created by Michael Milken. Derivative securities were at the heart of the LTCM collapse in 1998. When real estate took the big five financial houses went into full gear. I would make the use of derivatives illegal. I do not see how transparency in this type of vehicle can be regulated in any meaningful way. It seems to me like a short-cut to fast money that should simply be removed from the system.

Oct 11, 2008 - 11:09 am 16. slade:

When real estate took off, the big five financial houses went into full gear.

Oct 11, 2008 - 11:13 am 17. Mike Sylwester:

Maybe the Republican Party attempted to put too many eggs in its own basket. Steve Sailer makes a good argument that the Bush Administration pushed banks to grant bad loans in order to increase home ownership among Hispanics. This policy plus the policy of not enforcing immigration laws was supposed to attract Hispanic voters to the Republican Party’s coalition.

http://www.vdare.com/Sailer/080928_rove.htm

The Republican Party has received divine punishment in the form of this financial disaster during the two months preceeding the 2008 Presidential election.

There is a common idea that the Republican Party is a coalition of somewhat oddly fitting components. The components have been variously defined as including the economic conservatives, religious fundamentalists, strong-military advocates, neo-cons, anti-abortionists, the gun nuts, and so forth.

Define the coalition however you wish, it has been successful at the job of winning Presidential elections for the past quarter century.

Just maybe, however, the scheme of adding all the Hispanics to the coalition by promises of open borders for all their relatives and promises of home ownership with no-money-down loans was one additional component that was way too big, complicated and problematical.

Oct 11, 2008 - 11:16 am 18. Taxpayer:

Carriers are designed as they are in part because the Navy still has an institutional memory of the effects of battle damage. Ships last a long time, and so this memory has a long time constant. And perhaps more importantly, the results of the design decisions are physically visible, and fairly readily understood by non-experts.

There are analagous redundancy and diversification vs. efficiency tradeoffs in a host of important civilian systems – power generation, communications, gasoline refining, ports, etc. What would some redundancy be worth in the event of a single EMP burst over New York, or Houston? How does one achieve a reasonable level of infrastructure or systems insurance?

Generally, I think this is one of the best arguments for leaving as much power and decisoin making as possible at the local and state level, rather than concentrating it at the Federal level. When the Feds make mistakes, they are big ones.

Oct 11, 2008 - 11:24 am 19. Pascal:

The Bush Admin is filled with old snakes Mike. Conservatives who bridled any bit of Bush’s “compassionate conservatism” were dispatched as old nags at every opportunity. Thus there are less traditional conservatives left in the party. Not a Stalinist purge, but as close as it has come in American to date.

Oct 11, 2008 - 11:25 am 20. Pascal:

Oh, and that dispatching of conservatives filtered down from on high to many state party corps where Rove would install his counterparts. An example is Parsky in California. One cannot convince a sane person that installing Parsky, the declared enemy of the GOP gubernatorial candidate the same year, was an accident.

Oct 11, 2008 - 11:33 am 21. Michael C.:

This economic collapse is the result of social engineering. The Community Reinvestment Act was set up to give cheap housing to the Democrats favored group, the black community. The deal was so good that the white community which has a lot more money got in the act and was willing and able to take a great deal more risk. Free mortgages for everybody. Once the banks figured out how to get them off their books it was a free-for-all. The law of unintended consequences, social engineering run amok. No different than the Great Society. The Bush administration warned time and time again about the coming problem (see article at Investors Business Daily). But there was no chance to stop this because too many people were making too much money. The financial system has grown so large particularly with the tremendous increase in world trade that no one is able to design a big enough aircraft carrier.

Oct 11, 2008 - 11:56 am 22. Leo Linbeck III:

Derivatives are not really that mysterious. I’ll take a crack at describing what they are, why they can be used well, and how they can be abused. This will be somewhat stream-of-consciousness, so I apologize in advance if this rambling, trivial, or incoherent.

The simplest definition of a derivative is a financial instrument with a value that depends on the value of something else. Derivatives are called such because they derive their value from something else.

The most easily-understood derivative is a call option. A call option allows the owner of that option to purchase a security at a fixed price within a defined period of time. An example would be an option to purchase AIG stock at $50 per share before 31 December 2008. If AIG stock is worth more than $50 on that date, my option has value. If not, it is worthless.

Derivatives are actually far more ubiquitous than might appear. For instance, common stock in a publicly traded company is, in reality, a derivative. Its value is based upon the enterprise value of the company – simplistically, its expected future cash flows before financing costs – less the value of the debt. In this respect, equity in a firm is like a non-expiring call option. If you own AIG stock, and it has loans of $50 per share, you have a claim on all the assets above $50. If the enterprise value of the AIG is greater than $50, your shares have value. If it’s less, your shares are worthless. Just like a call option.

But this means shareholders and lenders are not fully aligned in their interests. Shareholders want the company to take more risk than the lenders. If the company does well, the lenders can be paid off and go away, leaving the shareholders with all the spoils. That’s why we think of bankers as dull (a Whiskey beta) and stock traders as cool and sexy (a Whiskey alpha).

Here’s one way to think about debt from a shareholder’s standpoint:

When Heidi Fleiss was arrested for running a Hollywood call girl operation, her little black book was made public. In it was Charlie Sheen. Some enterprising reporter tracked down Mr. Sheen and asked him why, as a rich, famous, good-looking celebrity he felt the need to pay for sex. Charlie corrected the reporter; he didn’t pay for sex, he paid to have his pleasure partner go away after the sex.

Debt is like a call girl – at the end, you pay her a pre-negotiated amount and she goes away. Equity is more like Denise Richards – she gets a piece of everything.

Anyway, employee stock options are the next level up – a derivative of a derivative. They’re options to buy stock, which is a claim on enterprise value above the level of debt, itself sort of an option. A second-order derivative, if you will. They are supposed to align the managers’ interests and the shareholders’. But they don’t. If shares go up, the managers do great. If shares go down, the managers are no worse off (since options were “add on” compensation to them), but the shareholders are in pain. It’s an asymmetric payoff.

Remember this word, asymmetric. It is one of the keys to the whole deal.

Managers who have stock options, then, like to add debt, because it makes a big payoff much bigger (making their options worth a ton), and if there’s a bad outcome, it’s not really their problem.

Now, there are lots of risky ways to use derivatives, but they aren’t necessarily good or bad. Properly used, derivatives can be great tools for market efficiency and risk sharing. But they can be abused.

What we need to remember is that, historically, all new financial instruments have gone through periods of trial-and-error before we understood the right way to use them, prudently and for the long haul. And until that understanding was part of our law and culture, lots of people lost lots of money.

For instance, it took centuries for the use of debt to be properly regulated. A few millenia ago, we had lenders and borrowers. But it was easy for the moneylenders to take advantage of the borrowers; this is why usury was such a big deal. This potential for abuse led to usury laws in the Judeo-Christian west, and an outright prohibition on lending in the orthodox Islamic world (although there are Sharia-compliant financial instruments that mimic loan behavior – an interesting topic in its own right).

Lending is a great way to allocate resources to productive activities. But improperly used, it can create more problems than it solves. So over time, we were able to create rules and practices that resulted in a net benefit. The right amount of Design Margin, if you will.

The same sort of learning curve occurred with equities, the oldest form of derivative. Joint Stock Companies are several centuries old, going back to the early 1600s. They were used to spread the risk of exploring the new world (Virginia and the East Indies) to private persons, rather than the traditional approach of the Crown borrowing money.

Along with some early successes, however, there were many, many equity failures. Canals, railroads, and banks all had spectacular failures that wiped out equity investors in the 19th and 20th Centuries. Each failure led to increased regulation of both the financial instruments (equities) and the underlying industries.

Today, increased computing power has led to an explosion in the number of new products that have value derived from something else. Calls, puts, swaps, et. al. are now easier to analyze, and therefore more confidently traded. But we are still learning how to best use these instruments.

One early failure in the derivatives market was, ironically, one of the guys who discovered the original option pricing model, the Black-Scholes equation. Myron Scholes is a brilliant man, and worked hard to figure out mathematical models for pricing options. The story I have been told is that Scholes took his new equation, before publishing it, and used it to buy options that he calculated to be undervalued. But within a few weeks, he had lost more than $100,000, so he stopped. Later, he commented that “Just because you understand the laws of physics and geometry doesn’t make you a good pool player.”

The reason for this disconnect is that to properly price derivatives you must assess the range of possible outcomes, and determine the probabilities of each outcome. The Black-Scholes formula uses a factor called volatility to capture these probabilities. But assessing volatility is very difficult, mainly because it requires an accurate assessment of the future. And volatility can change very quickly, as we’ve seen in the past few weeks.

I’ll take a break now. Back in a bit.

L3

Oct 11, 2008 - 12:51 pm 23. Brock:

Wretchard,

The difficulty with nationalized financial markets is that they are shallower and less liquid than global financial markets. New York City is the financial capital of the world because it was the financial hub for all 50 States, not just New York. London came to rival it only when London became the financial hub of the EU, rather than just Britain. Financial markets book a return to scale unrivaled by any other industry. They are always the first industry to take advantage of new globalization technology – be it messenger pigeon, rail or telcomms.

But your concerns are well noted. I can’t help but think of Glenn Reynold’s recognition that survivalism is “back” in many areas you would not expect it – like suburban Tennessee. I expect that at some deep level many people feel insecure in the current state of the world. The Cruise-Shippers, with their lavish unemployment benefits, medicaid, environmental regulations and $4 lattes have taken over the system, and those with who are conservative by nature don’t like it. They’ve given up trying to change the system and instead just prepare to hunker down when the inevitable shit hits the fan. Using your analogy, they’ve armored their own cabin on the Love Boat and stocked up on life preservers.

As for your specific concern, this could be good or could be bad. The New York and London stock exchanges are incredibly robust and durable institutions. They have survived for centuries through all sorts of turmoil. So have Lloyds and the Merc in Chicago. The Anglosphere knows how to create financial clearing houses that are robust to shocks. If a similar exchange is created as a global clearing house of interbank lending it could be good. But if they create a Fannie Mae only 10x the size, that would be really, really bad. Financial Institutions cannot have a social agenda that takes precedence over economic efficiency.

Oct 11, 2008 - 1:11 pm 24. whiskey:

Teresita — imagine 9/11, but with “borrowed” nukes from Pakistan or Iran. Imagine 3-6 million dead, NYC, the center of US finance, business, culture, a smoking ruin. The great metropolis, a charnel house.

Now consider more threats. Of that nature.

The only way to survive, for Dallas, Salt Lake City, Atlanta, etc. is to KILL every Pakistani. And possibly every Iranian. Just to make the point.

Technology — nuclear weapons proliferation which is a fact and irreversible, equalizes things so that poor, tribal, factionalized places can kill great American cities.

And will.

Oct 11, 2008 - 1:13 pm 25. slade:

Leo -

I would quibble with your expansive definition of derivatives (I think of them as synthetic gambles in the arithmetic sense, not associated with value but the more artificial metric of price that allegedly reflects value in some proportion consistent with market reality), but obviously I’m not going to quibble with a grand master.

My only point is that the more “toxic” forms should be isolated from the portfolios of the general population. Right now 401K and IRA plans across this country just saw their value cut in half as the result of a phenomenon most of us barely understand. We do understand the laser effect of “specialized” derivatives that turns a simple bubble bust into a worldwide meltdown faster than you can fry an egg on the hood of your car in the desert.

My second point is that this is not primarily an issue of ideology or partisanship, despite the fact that the genesis is undoubtedly both. We could have survived all of the bad Democratic policy, but for the absence of effective compliance, with transparency, accountability and enforcement, as the ultimate “backstop” for the prolonged frat party that brought us to the brink of insolvency. It’s not as if the financial services sector was virginal after the rapacious failure of LTCM.

Who has the skill set to provide the technical tweaks to reset the ship’s course? I don’t expect to find it within spitting distance of Congress.

Oct 11, 2008 - 1:16 pm 26. Brock:

Leo,

You’re not wrong. Mind if I cut through the crap though?

The reason that derivatives are easy to understand is because they aren’t anything new. They’re just a contract between two parties that says one party will pay the other the economic effect of something that’s been around forever (loan, option, equity, debt, insurance, etc.) without having the thing itself. So a derivative between me and my bank might say “I’ll pay you a monthly cash flow as if I owed you $10,000 @ 5%.” Or it might say “I’ll pay you a quarterly cash flow as if you owned stock in my company and were collecting dividends.” But there’s no loan and no stock, just a contract to make payments as if there was.

Financial institutions use derivatives because if they actually made loans or sold stock they’d be subject to the regulatory regimes governing those transactions. Because there’s no loan or stock though (just a contract) there are no regulations. And hence, you get what we got last week.

Obviously, this needs to change.

Oct 11, 2008 - 1:22 pm 27. Micha Elyi:

Thanks Leo for the clear explanation of derivites and a bit of background about the history of financial instruments.

Brock, yeah let’s “cut through…” You can begin by giving real-world examples of your fanciful examples. Name names, please. Else, what you’re cutting through is your own you-know-what.

Oct 11, 2008 - 1:31 pm 28. Buck Smith:

I am unconvinced that this market meltdown is somehow much worse than anything in the last few decades. The long term trend is for recessions to be shorter and milder. I am an owner of a small company, our customers are bigger corporation and VC funded startups involved in tech, energy and transportation. We are booming right now, I expect we will see slow-downs with some customers, but most of them are making lots of money right now. My crystal ball’s track record is not great but better than Franklins Raines’ recently. So we will see.

Oct 11, 2008 - 1:42 pm 29. Leo Linbeck III:

Back now.

There are many financial products that we purchase that are, in reality, derivatives. I wrote earlier about equity being a call option. Another example is insurance.

Insurance is a put option. A put option allows the owner of the option the right to sell their asset for a predetermined value. And that’s the way insurance works.

Let’s say you take out an insurance policy on your house. Let’s say your house is insured for $200,000. And then lightning strikes your house and causes $50,000 worth of damage.

Your policy effectively allows you to sell your house to the insurance company for $200,000. The way this works is that the insurance company “pays” you $150,000 in-kind (your house) plus $50,000 in cash. You think of your insurance proceeds as $50,000, but economically you have sold your house and bought it back for a combination of cash and real estate.

In the same way, if your house is completely destroyed, the insurance company writes you a check for $200,000. You’ve sold the pile of detrius to them for a pre-agreed price.

For this to work for everyone, the insurance company has to insure more than just your house. It must insure a lot of houses, on the assumption that most houses will not be destroyed by a lightning strike. This means there is low covariance between the probabilities of the houses they’ve insured being destroyed. This is a reasonable assumption.

Credit default swaps (CDSs) work the same way. They insure the lender that they will be made whole in the event of a default on a loan. They are a put option sold by the lender to the CDS buyer.

There’s nothing wrong with this, of course. A CDS buyer could own a bunch of different CDSs, each of which insures a different group of loans. The assumption is that these loans are not correlated, so covariance is low and the marginal risk of a pool of loans is less than the standalone risk of the individual loan.

This is why there were both buyers and sellers in this market. Let’s say you’re a bank and made a loan for $1M, and there is a default risk of 1%, or $10,000. A CDS buyer may have a pool of loans that it is insuring worth $10B. If you assume that your $10B worth of loans have a small correlation with this new loan, your incremental risk might increase by only $5,000. (If anyone is interested in the math behind this, I can provide this in another post.) This means you sell a CDS for $7,500, and both you and the bank are better off.

To be sure, there were snake oil salesmen, and stupid buyers. But the fundamental problem is that buyers underestimated the covariance of the loans in their portfolio. This underestimation resulted from a lack of understanding of what happens in a financial crisis: a flight to quality.

Let’s say you have $10B worth of loans you’ve insured through CDSs. When there is a financial crisis, everyone loses confidence in risky assets and begin to sell them to buy non-risky assets (e.g. US Treasury Bills). This mass sale of all risky assets means that covariance of assets underlying my CDS pool skyrockets to 1 – all asset prices move down in lockstep.

This simple fact undoes the logic of a pool of risk. Without a very low covariance, there are no benefits to pooling, no benefits to scale. This means that, on our example above, there is no difference between the marginal risk of the $1M in our pool and its standalone default risk. And, to make matters worse, the banks original default risk might substantially increase, since a financial asset bubble bursting usually leads to a recession, which causes default rates on loans to increase. Let’s say that the standalone default risk has now increased to 2%. This means that instead of having bought what we thought was an incremental default risk of $5,000, we’ve now got an incremental default risk of $20,000. Yikes.

The result is that the capital supporting my pool of CDSs is now wiped out. This is what has happened to AIG. It had a huge CDS operation which is now bankrupt. But does this necessarily mean that the whole system will come crashing down?

Not necessarily. The bank still has the loan, and so long as the loan payments continue to be made, there’s no fundamental problem. It’s kinda like all of the municipal bonds that were insured; just because the insurance company has gone kaput doesn’t means the bonds have no value.

The key is how the underlying loans perform, and how the unwinding of the CDSs occur. This gets trickier because CDSs were traded as standalone products, so you could have $100M in notional value of CDS contracts outstanding that are derived from the performance of our $1M loan.

Ideally, someone will go through AIG’s CDS portfolio and match up all of the CDSs it bought and sold for a given loan and match up the buyers and sellers and cut AIG out of the middle. This can be very complicated because CDSs can be on packages of loans, but it can be done.

What is left over is the residual exposure of the unbalanced CDSs. There are two ways to unwind those instruments: a) go back to the bank that sold the CDS and pay them to cancel the contract, effectively transferring the risk back to the bank, or b) find another buyer for the CDS and sell the contract to them.

When all of this is said and done, there may still be some residual exposure. Given time, that exposure may require them to cough up some cash. To fund that, AIG will have to sell off its profitable traditional insurance lines.

All of which means AIG is going through, effectively, a bankruptcy process. There might be something left of the company at the end, but there might not. But done properly, it shouldn’t cost the taxpayer a nickel. Done poorly, it could, but not nearly what people fear. For the most part, loans are still performing.

So none of this means that CDSs are a bad idea. They are actually a good way to spread default risk across the system, and this can lead to increased lending and economic growth. Of course, there is still the problem with flight to quality. But that can mitigated now that we understand it. One way to that would be to both increase capital reserves and have the CDS buyers purchase re-insurance to mitigate their risk of a flight to quality. The re-insurer could be an entity that holds US Treasury instruments, or options on Treasuries. If there is a flight to risk, their Treasury portfolio value would skyrocket, and those gains could be used to pay claims made by CDS issuers. Just an idea.

The moral of this story is that a big, successful company sometimes screws up its assessment of risk, and this kind of screw up does not mean that the product that led to its demise is a bad idea, just that they didn’t account for its true risk.

After all, canals, railroads, and banks were great improvements to society. Just because the financing of those efforts led people to misprice the risk doesn’t mean we should have outlawed them. But it does mean that we will, in the future, require more Design Margin for CDSs, and the size and profitability of the market may be smaller than its cheerleaders expected.

Which means, at the end of the day, CDS salesmen will have to find something else to sell. But they will. They always do.

Sorry for the long diatribe, but I hope it’s been helpful.

L3

Oct 11, 2008 - 1:54 pm 30. RWE:

One of the main factors in the severity of the great Depression in the U.S. was that things Were Not connected.

At that time it was illegal in the U.S. for banks to have branches. This was a policy favored by small town banks so that they did not have to compete with branches from the big cities.

But when factors such as high tariffs hurt farm communities those small banks had nowhere to turn and went under. A larger bank would have been far less affected by things like the price of corn or wheat. In Canada, where there were no laws against banks having branches, almost no banks failed during the Great Depression.

Now, today, how many small town banks have failed? Well, not very many. They were not pressured to hand out loans to people who could not afford to pay them back. They weren’t lucrative targets for scam artists and race baiters.

But in both cases, the 30’s and today, government banking regulations intended to favor one group ended up being disaterous.

Oct 11, 2008 - 1:54 pm 31. steveaz:

I like Wretchard’s larger implied point about subsidiarity.

When, in my discussions with “One-World-er’s,” they rush to trash us supporters of the nation-state as “nationalists,” I always point out that their own bodies are in fact constructed from billions and billions of cells, each one, itself, bounded by a cell membrane, and most containing a nucleus that is, itself, a distinctive, bounded subsidiary of a cell.

The two things that the Transnationalist Movement works to suborn, namely territoriality and redundant, bounded administrable jurisdictions (and by extension, individual politicians’ accountability therefor) are the essential traits inherent to any complex, functioning system.

In fact, to achieve the “One-World Government” role that the human brain enjoys over its multi-cellular body, our bodies did not outlaw bounded, administrable entities, we proliferated them! If social engineers weren’t so masturbatorially immersed in human-sociological assumptions – and if they trained themselves to consider advanced biological models instead, they’d recognize this, and it’d lend more credence to their policy prescriptions.

All of which leaves me with the impression that the Transnational Movement is intent on vandalizing the development of a workable international order, not abetting it. Otherwise, they’d seek to build on the nation-state, rather than work so hard, day and night, to tear it down.

Oct 11, 2008 - 1:58 pm 32. Leo Linbeck III:

slade,

I guess my point is that all financial securities are synthetic. GE stock is synthetic; it gives you some legal rights and limits your liability, but that’s about it.

It’s not clear what toxic really means in this context. Was Enron toxic? WorldCom? Cisco (which lost $300B in market value after the dot com bubble)?

The underlying cause of this situation are what you’ve described: political structures that supplant market discipline. These rules – whether CRA, GSEs, or any of the other TLAs that populated this universe – perverted the normal competitive process for managing Design Margin.

The best approach – competition and subsidiarity – allows for lots of small failures to occur. Federal regulation eventually leads to large scale failure. What is interesting to watch is the placing of blame on the mechanisms that were abandoned by those who were responsible for their abandonment.

And you are absolutely right. This ain’t partisan. This was a bipartisan donnybrook. That’s why I believe the stage is set for a completely new approach to the problem. I don’t know what it will look like, but I completely agree that it will originate beyond the masticatory zone of the Beltway.

L3

Oct 11, 2008 - 2:12 pm 33. slade:

The King is Still in the Building

Wider use of financial innovations such as securitization and derivatives could help the world’s emerging economies develop faster by freeing up huge pools of “dead capital,” Michael Milken said on Thursday.

Milken, the financier and philanthropist widely regarded as the father of the “junk” bond market, told a conference in London: “Without access to financial technology, you can’t really have prosperity.”

Milken did not “create” the concept but he was one of the first to put it to good use.

Oct 11, 2008 - 2:23 pm 34. Leo Linbeck III:

Brock,

Crap-cutting welcome.

The players in these markets were assumed to be sophisticated. Events have proven this to be wrong in retrospect. But that is not a good argument for trading one set of stooges for another. Moe for Curly is not a trade up.

My confidence in the long term – which is still strong – is based upon my personal observation that our federalist system, while strained, has not yet slouched completely into a Euro-style nanny state. But the current state of affairs is troubling. And our leadership appears ignorant of the lessons of history, and – worse – appear to be ignorant of their ignorance. Cascading unknown unknows, if you will.

So, in the mean time, I am completely confident, based upon history, that we will see additional regulation. And I am just as confident, for the same reason, that it will make matters worse, not better in the short run. But at some point, our instinct for self-preservation will kick in. That’s when things will get interesting.

Hayek’s Fatal Conceit is still a belief of the conceited crowd in Washington. And still fatal. But the American people do not want to see this end. And that gives me hope.

L3

Oct 11, 2008 - 2:24 pm 35. cedarford:

A good post by Wretchard.

In a nutshell, complex systems can be affected by cascading failure. Compartmentalization, via “armor”, “isolation”, “circuit breakers” is how most technological systems deal with it. And they put in design margin, system redundancies, and heavy focus on emergency response/damage control training of personnel.

The imperative for Maintenance is well understood. For lack of rigorous care and attention to UPS’s airport conveyor belts, a few failing could overload others resulting in backups exceeding UPS storage capacity in transit which could then cause a complete flow stoppage and huge financial consequences. All for lack of putting 20k into bearing lube and belt replacement “to win Wall Street analyst’s approval that operating margin costs are being effectively
“squeezed” to get higher short term profits. UPS is smart, but other organizations that do not understand cascading failure and cut some of the defenses are the ones that kill people, doom themselves, or cost nations trillions in wealth.

Societies are even more difficult because we are seeing democratic ones abandoning responsibilities of prudent management of resources to dismantling their redundant and passive defenses, refusal to maintain backup financial and system capacity, refusing to do the “maintenance”. Abdicating responsibility.

Tax cuts for the wealthy in wartime while Bush doubles the national deficit. Wall Street crooks and corrupt gov’t regulators feed at the money trough while people who pay no taxes vote to force others who do pay to feed them – and the taxpayers, fighting back, say “Let them feed, but let’s just stick our kids with the bills and borrow from China.

*****************

Leo Linbeck – Life, liberty, and the pursuit of happiness are our shared values. These are the attributes of the true Love Boat. And it is not a pleasure craft. It is a hard target.

No, they are an excuse to fecklessness. To peoples refusal to sacrifice for tomorrow or their kids futures. Our true values are not “Rights” but our Anglo-Protestant roots that we would be prudent, law-abiding citizens that would work hard to better ourselves and our kids lots…and we thought we needed reasonable levels of freedom and safety in our lives to do so. Pursuit of happiness was not thought to be a 24/7/365 activity, but in spare times of leisure where families could gather and enjoy the fruits of their industry.

And events have shown our “rights and recreation-based” Love Boat to be a very soft target slowly sinking. Sinking on – (1)financial ruin from serving non-paying passengers, (2)failing systems because no crewmember wants to do the tough work, (3)Ignorance of how the systems fail because most Love Boat components are made in other lands, (4)though the listing is obvious, passengers and crew refuse to bail, blaming one another and citing their sacred Freedoms! to do anything but start bailing.

In the mid-1970s, China was a poor country with no savings. America dominated 19 of 20 areas of industrial output and technology and was the largest creditor nation.

Things sure have changed.

Teresita:
Wretchard you cite 9/11 and the recent market meltdown as perils, but they are not existential perils.

Depends on what you call existential perils. Weimar Germany failed to deal with security and economic threats that were not seen as “existential” until that era of German society was eradicated. It’s existance ended under National Socialism.

The global meltdown of democratic capitalist countries is a threat to large forces such as globalism, “free trade”, unregulated flow of capital and labor across borders to serve multinationals loyal to no nation, and American military adventurism to bring freedom! democracy! to others at bayonet point.
It is also a threat to “Constitution Venerators” to justify why the Sacred Parchment does not need a major overhaul on matters like the Presidential line item veto, the thorough corruption of the Branches of Government by moneyed special interests, lifetime unaccountable judges ordering up taxpayer and business obligations, entitlements as “Constitutional Rights”, and completely uncontrolled deficit spending that will curse future generations.

Existentially, it is also the likely extinction of Reagan dereg and voodoo economic policies.

Some would also say that the Republicans also now face an existential threat as voters reject their corruption, favoring the rich, theocratic intolerance, and fiscal and international recklessness.

It may also signal the existential end of democratic capitalism as the preferred “best” political and economic system. In favor of massively successful authoritarian capitalist systems, or the less successful but just and fiscally sustainable Euro “social welfare system”. (Note)

The Ayn Randians and Hayek worshippers may repeat their well-worn claim that Euro’s have an unsustainable spending system – but you are talking about nations that have balanced budgets and fiscal accounting and current allocation for their welfare systems.
The USA?
9 trillion in debt.
58 trillion in unfunded entitlement liability because we never funded the long range pension, health programs. (SS, Medicare).
890 billion a year trade deficit.
A hard operating budget deficit of 400-600 billion a year.

America is is worse shape fiscally than all the Euros but Albania, Moldava, Belarus, and some say now Iceland..

We need Revolutionary change in America. We need major Constitutional changes. We need a capitalist system that does not screw the worker and small investor, a system full of efective Governemnt oversight&vital regulation, circuit breakers, compartmentalization, and redundancies.

Oct 11, 2008 - 2:42 pm 36. slade:

Leo -

There are different degrees of “synthetic” – one man’s plastic is another man’s geotextile. Not being a purist, I define synthetic as any instrument not directly connected with the end-product, either a good or a service. Derivatives, in my definition are parasites on the momentum of market movement – up or down.

“Toxic” means high risk that is disguised either through wizardry or criminal intent, if there is still a difference.

A simple sector-specific bubble, precipitated by GSE’s in the service of political policy, would have been doable – for most of us. The global contraction, precipitated by the derivative instruments, is going to hurt like hell a lot of average people, especially those on the brink of retirement.

Oct 11, 2008 - 2:43 pm 37. Habu:

Great discussion on derivatives. It should be printed out in every home so they can attempt to grasp what many heretofore only see as Plato’s Allegory of the Cave.

I’m printing it out and I was a broker for 15 years. Good job.

Oct 11, 2008 - 2:48 pm 38. Herb:

@L3
All this is well and good and quite beside the point. Left to their own devices and absent government forcing them to loan money to people who couldn’t (or wouldn’t) pay it back, thus creating artificial demand for owner-occupied housing, we wouldn’t have F&F or these CDS’s or insurances against the inevitable. Risk is immutable in markets. It yields only to information. A banker in Elbert County Ga knows his borrower. The “Counterparty” (who or whatever that is) cannot. No information=unsustainably high risk. CDS’s are a pipe dream. They are even more ephemeral than the bundled mortgages the represent. I got a pickup truck load Ill sell you.Who you gonna collect from?

This whole mess is the result of defiance of the one law that underlies all of human organizational efforts: The Law of Unintended Consequences.

The LOUC when coupled with the power of Government to kill a corporation if the Corp doesnt follow the Govt’s desire becomes fatal. I see no hope until Mark to Market and the CRA are repealed. Obviously neither I nor the rest of the investing public are really expecting this to happen in the next four years.

Oct 11, 2008 - 2:57 pm 39. wretchard:

Connectedness generally makes things more survivable because they allow resources to be shifted where needed. Military history provides many examples of how connectedness is exploited: mobile reserves, good logistics, fire control direction centers for artillery.

The one problem with centralized things is that the covariance in their local effect is very high. When a centralized system fails totally, it fails everywhere. To hedge against this, armies have evolved an amount of subsididiarity. One of the great innovations of World War 1 was the return of the Platoon. They had certain organic assets, which if the Company failed, would still serve them. That didn’t mean the abolition of the Company. But it meant the Platoon could be somewhat independent of it.

As Sima Quian pointed out, the choice isn’t between an aircraft carrier or a cruise ship. It would be wrong, I think, to react to 21st century challenges by becoming Luddites (though the Greens might be sympathetic to this idea). But it might be a good idea to incorporate ideas like subsidiarity into the evolving design. I should like to point out that aircraft carriers are connected too. It’s just that they often have watertight bulkheads and doors between the connections.

It has always been interesting to me that people who design routers and networks have to solve the aircraft carrier/cruise ship tradeoff too. They have to move the packets quickly and economically but they have to ensure redundancy and security too.

Oct 11, 2008 - 2:59 pm 40. Herb:

First sentence should read:
Left to their own devices and absent government forcing them to loan money to people who couldn’t (or wouldn’t) pay it back, thus creating artificial demand for owner-occupied housing, banks wouldn’t need F&F or these CDS’s or insurances against the inevitable.

Just sloppy. Editor beaten.

Oct 11, 2008 - 2:59 pm 41. Leo Linbeck III:

cedarford,

Thx for your comments.

The pursuit of happiness is not the pursuit of comfort. This is the principal point of confusion in our society. We think more stuff will make us happier. It does, but only to a point, and then it makes us less happy. Weird, but true.

I agree that forgoing current consumption for future benefit is a critical part of the picture, as are raising children to be better off. What we didn’t count on was that we’d be so much better off that our children would view that level of affluence as an entitlement, not a privilege.

However, none of that undermines the argument for the pursuit of happiness as a core value. True happiness comes from doing and being good. Its pursuit requires work. It’s hard to be good, and requires sacrifice. There are big parts of our population that haven’t figured that out, but they will during this recession. It’s been 35 years since we had a recession like the one we’re entering. It will be a wake up call for an entire generation, maybe two. There will be a lot of pain, but it will not kill us. It will make us stronger.

And key to that strengthening will be the renewal of our commitment to what we have in common. That renewal may very well come through constitutional changes – as I’ve argued in other BC posts. And increased compartmentalization and redundancies, and more local government, can come from subsidiarity.

But if you’re looking for a system that won’t fail – that won’t “screw the worker and the small investor” – you may still be disappointed. These things happen because humans are flawed – all of us. And no system created by man can overcome this harsh reality.

All in all, however, the US has done pretty damn well, so I’m not inclined to throw the baby out with the bathwater.

I’m not a fan of Ayn Rand, and Hayek only gets me so far. But the Euro system is clearly unsustainable, if for no other reason than it being in demographic collapse. The US has a lot of debt, but it also has a huge GDP: $13T annually. Yes, entitlements need to be faced, and I believe will at some point, but the debt and deficit numbers you cite are swamped by our productive capacity.

We clearly need a consumption breather. And it’s coming, whether we want it or not. But I’m not ready to start a revolution, mainly because I’m not thrilled about their historical track record.

But that’s just me…

L3

Oct 11, 2008 - 3:16 pm 42. Leo Linbeck III:

W,

The relationship and distinction between connectedness and command-and-control is interesting.

Connectedness is critical for survivability. A node in a network goes down; the network survives because other nodes can route around the failure.

The problem is that connectedness is exploited by centralizers to increase command and control. The mortgage origination network was highly decentralized and redundant. F&F exploited their implicit government backing to dominate the mortgage bundling market; the government protected this monopoly to promote their social agenda. The network was converted into a mainframe system.

The proper role for government is to make sure no node on the network can get big enough to change its topology. This function – anti-trust – has been all but abandoned for more popular pursuits like corporate executives, lobbyists, and the Scooter Libbys of the world.

Subsidiarity is a really just a network design that keeps the nodes as small as practical. While not perfect, it has high survivability, as shown by the US and the Catholic Church.

L3

Oct 11, 2008 - 3:31 pm 43. bigroy:

Lots of words. All goes away if you do not make loans to voters that have no money.

Oct 11, 2008 - 3:34 pm 44. Leo Linbeck III:

Herb,

Fair enough. But CDSs were not just issued against mortgage packages, they were used for a variety of debt instruments. There are still many cases where they have helped overall risk. (I should note that I own no CDSs, have never had anything to do with them, don’t work in a financial services business, or have in any way shape or form involvement with CDSs.)

My fundamental point is that CDSs are not the source of the problem. The residential asset price bubble is the problem, and F&F were the proximate cause. The jury is still out whether CDSs help or hurt the situation. And outlawing them and other derivatives may, by the LOUC, cause more harm than good.

L3

Oct 11, 2008 - 3:43 pm 45. slade:

Conciliance in Design

E.O. Wilson, in his recent book Conciliance—The Unity of Knowledge stated, “a balanced perspective cannot be acquired by studying disciplines in pieces, but through the pursuit of the conciliance among them.” Our future will depend on bringing our knowledge together in a form that can be easily understood and used.

Oct 11, 2008 - 4:13 pm 46. slade:

The jury is still out whether CDSs help or hurt the situation. – L3

The mortgage-backed securities were leveraged at 30:1 (higher overseas) when repackaged as derivatives, compared to 12:1 regulatory cap for other finance vehicles. Higher leverage magnified the exposure and transformed 5% of the domestic mortgage industry into a global $500T to $600T liability that must be funded in a recession.

“Everything should be made as simple as possible, but not one bit simpler.” – Einstein

Oct 11, 2008 - 4:28 pm 47. Stephen:

“My fundamental point is that CDSs are not the source of the problem.”

I think the CDS and instruments like them are the source of the problem in that they result in a consolidation and centralization of the risk assessment function. When institutional money managers feel less of an imperative to use their own credit analysis, because they can lay off so much risk, the job effectively gets handed to the guarantor who puts his money where his mouth is. But if the guarantor institutions are asleep to the risk because they are being misled by their own commissioned dealmakers, then nobody is really looking at the risk the way it should be looked at.

Oct 11, 2008 - 4:30 pm 48. enscout:

Interesting analogy with the Battleships.

Our problem now is that we don’t have the USS Washington covering our back.

We have McHale’s Navy.

Oct 11, 2008 - 4:53 pm 49. Charles:

Oil’s Outlook Darkens

MF Global energy analyst Andrew Lebow said he — and likely the market — strongly expect the IEA to further revise demand estimates downward in the coming months.

“We now know that the global economy couldn’t really handle prices above $100 and OPEC will have to figure out a price the economy can handle,” Lebow said.

Oct 11, 2008 - 5:59 pm 50. Dave:

Steveaz: What do your mean mastubatorially immersed? “Masturbation is cheap, clean, convenient, free of the possibility of wrongdoing———-” (Lazarus Long)

None of what these transnationalist social engineers are up to matches the above description.

On the other hand, they do seem to have gone blind, their brains are definitely soft and I’ll bet you they do too have hair on their palms.

Oct 11, 2008 - 6:09 pm 51. Dave:

L3: Excellent presentation(s) sir.

I would like to see a return of the word “intangibles” to describe the securities markets.

My Hemi is tangible. Stock in Chrysler is intangible. Rental property is tangible,
cash flow from said property is intangible.
A greater understanding of the differences would (maybe) reduce the amount of fraud perpetuated.

Slade: What I am afraid of is throwing the baby out with the bathwater. As you know, commodity futures are not for anybody but professional speculators. Their purpose is to transfer risk from users to said speculators. However, commodity options are no different than Puts and Calls on the CBOE.
You cannot lose more money than what you put up. Decades ago, there was some fraud in these options and they were banned from the 1930s into the 1980s. Consequently, the public was deprived of vehicles that could be used either for gambling or as a hedge against
extreme loss.

Even today, puts and calls are verboten for retirement/trust accounts and I find this galling. Writing a covered, out of the money call means you get to pocket some cash and the risk is limited to your having to sell lower than you might have otherwise gotten but higher than what you paid for the stock.

At any rate, again ongrats to L3 for starting this ball rolling and to Salde and others for
some additional enlightened commentary.

Oct 11, 2008 - 6:28 pm 52. buddy larsen:

Some smart old graybeards –well in Muriel Siebert’s case, grayhair –the first order going forward should be a central clearinghouse for financial derivatives, so that they can be booked after every trading day (as are the put/call options on the CBOE). This would require registration of dealers & principals –right now, unregistered pools of money (”dark pools”) trade in unregistered derivatives in what is being called the “shadow banking system”. The shadow will break into the open markets anytime some component needs liquidity –and these breaks lately have lit up something so freaking huge that this ‘panic of 2008′ strted at the top –with the folks who had been “eliminating risk by spreading it thin and wide”.

The iceberg was (is) made up up the last decade’s giant trade –including petro –imbalances, speculating in the best risk/reward available –the housing markets, collateralized as they are by ‘real’ property.

The ‘financial terror’ attacks on the USA that have been identified as early as the summer of 2007 and active in the oil futures during the gap climbs earlier in the year, come thru the Dubai and London exchanges but none of us civilians yet are being allowed to know the originators –tho i’ll bet the FBI knows ‘em by now.

Ms. Siebert (the first lady to buy herself a seat on the NYSE) gets called on everytime there’s a crash, and this time around she says “Clearinghouse, book ‘em nightly, so regulators can know who has what when.”

Oct 11, 2008 - 6:29 pm 53. Bonzo:

Mark at 8:43 said:
Wealth ultimately comes from investment and profits. The profits go back into productive activity, or even into philanthropic foundations (which in turn goes into productive investments to keep up with inflation.)

What we have seen in recent years is the appearance of productivity, a processing of paper, based on requirements that

—–

Wealth comes from people, individuals who are free to create and make. Societies who permit people and individuals to make and create become wealthy. Places where wealth is pulled from the ground and then spent are poor and enslaved. It sounds at first, especially to those who ‘have’, dumb but it is true.

Oct 11, 2008 - 6:31 pm 54. Dave:

And speaking of not putting all eggs in one basket. At cnn.com there was a feature article on Stephen Hawking. He is of the firm opinion that the next 200 years will tell whether the human race endures or becomes extinct.

And he says that going to space is what will
enable our species to survive and make it.

He himself is going to take a sub-orbital ride
next year some time. Richard Branson will purchase his ticket. (Cost $200,000).

Which is a bit pricey. XCOR out of Mojave
has their Lynx craft about ready. It only carries one passenger for $100,000 but can
make the trip more than once a day.

XCOR is also perfecting a methane (natural gas) engine which can be refueled from
supplies in deep space.

So the boys are building the additional baskets. Gotta keep the government from hamstringing them.

PS: To find Hawking article, google, advanced search, all the words “Stephen Hawking, 200 years, Space”.

Oct 11, 2008 - 6:41 pm 55. Shivermetimbers:

Leo Linbeck III

You Wrote:

“To be sure, there were snake oil salesmen, and stupid buyers. But the fundamental problem is that buyers underestimated the covariance of the loans in their portfolio. This underestimation resulted from a lack of understanding of what happens in a financial crisis: a flight to quality.”

and later wrote:

“My fundamental point is that CDSs are not the source of the problem. The residential asset price bubble is the problem, and F&F were the proximate cause. The jury is still out whether CDSs help or hurt the situation. And outlawing them and other derivatives may, by the LOUC, cause more harm than good.”

I would like to add my 2 cents into this, if I may.

I work for a software and information services company that tries to grapple with these issues. My clients are many of the leading hedge funds, prime brokers, fund admins, institutional asset managers, custodians, etc., So, I have seen this from multiple perspectives and have reached out to many contacts I have made to discuss this issue for many years now.

There are TWO big problems we are facing. The first is making its way through the system, subprimes, where now many people have heard of Fannie Mae and Freddie Mac, where as 6 months ago, they probably haven’t.

The second problem is CDS, and this has the potential to pull everything down.

Unfortunately, a big cause of both of these problems is lack of information. Lets start with the subprime mess. Many firms have junk on their books, but how much junk? How do you value it, or measure the risk of it?

Let me explain. my mortgage gets pooled with other mortgages that have the same interest rate and maturity date. This is what we refer to as GNMA or FNMA, and is not a bad thing. But, these GNMA’s have been purchased into structured products such as CDO’s that also get purchased on up into other CDO’s – on and on again. How do you price these instruments, or measure risk? Where does the data come from?

The original issuer of my mtg knows my risk profile as it looked 6 years ago when I got my mortgage; but now? how do you know if I am a dead beat, or where I live (Upper west side? Detroit? Las Vegas?) that may be in a highly impacted area. And, when these products are rolled up into other products, it is impossible to link them.

For example, lets work downward. If I have a CDO, how do I know what is in it? It is in a prospectus in a PDF along with hundreds of other positions – including other CDO’s. No one is going to enter hundreds and thousands of these things into a computer – it just doesn’t happen. There are a few products out there, but they are just scratching at the surface.

So, firms try to price these instruments, or assign risk values to them based on models. And when you scratch at the surface of the model used, you recognize it is just a guess.

The issue comes down to how much junk do you really have on your books and no one really knows. When the giant hedge fund Citadel bought eTrade’s asset back business for .20 cents to the dollar, some one was betting it was worth more, while the other person just wanted it off their books.

This is still being flushed out of the financial system.

The second issue deals with CDS, and in my opinion, it is far worse. For example – Bear Stearns, Most folks believe that the Fed was not bailing out Bear, but was bailing out JP Morgan who had a $10 Billion CDS exposure with Bear, and $55 Billion overall. If Bear tanked, they would have taken JP with them, and in turn, JP would have brought others along with them.

An example of how this works for those not too familiar – Lets say I am a hedge fund, and I have a $10 million loan in the form of a bond to Bear. Bear agrees to pay me 7% interest per year on my loan and at the end of 10 years, pays me back my principle.

Now, I think bear is a little risky and I am worried about my principle, so I go to JP Morgan for a CDS, which is insurance. JP do not think Bear is too risky and charge me 2% (200 bps) to insure my principle. So, I think I have 5% risk free. Bear pays me 7% and I pay JP 2% for insurance.

And then Bear does the unthinkable, they tank. I look at my hedge fund buddies and say ‘no, problem’ we are insured, JP will pay us back our $10 million. In fact, they will pay all $10 billion in CDS that people had with them. That would have been a huge run on them that they could no have withstood. Thus, the fed stepped in. If JP tanked, they would have brought others down with them.

The CDS market is believed to be $40 – $50 trillion and no one really knows what the risk (counterparty risk) really is.

The chicago mercantile exchange has been trying for years to be the exchange for these CDS. They would have had complete transparency knowing the full extant of counterparties. But the banks that today act like exchanges fought tooth and nail because they made heaps of money on the spreads of products.

Again, an informational problem.

So, now there is a flight to safety because know one really knows how much junk they have on their books or what the extent of their counterparty risk is.

However, I should point out that this flight to safety is causing most of asian money to fly to the US. When things get bad, the US is still the safest, least corrupt place in the world. It amazes me that we still have much of the worlds gold here in NY at the fed.

Oct 11, 2008 - 6:53 pm 56. mark_b:

Downloaded a copy of Victory at Sea – Guadalcanal from archive.org.

http://www.archive.org/details/VAS_06_Guadalcanal

Amazing how the media did not openly hate the military. What happened?

Oct 11, 2008 - 7:10 pm 57. Derek:

Very interesting.

McArdle on bloggingheads.tv has a discussion of these things. One thing that comes up again and again is that they couldn’t go against the data. The data was confirming again and again that they were right, it was safe.

Maybe someone here more familiar with the people involved can comment, but it seems that the whole system is populated with actors who are seeing their first failure.

It illustrates that models can be fatal.

Derek

Oct 11, 2008 - 7:12 pm 58. Tony:

Wretchard – thanks for this beautiful analogy, cruise ships v aircraft carriers.

The current crisis is looking more and more like the dot.com boom and crash, with the frightening difference that during the dot.com boom we all knew we were selling vaporware. With the social engineering of Fannie and Freddie, we were selling real houses in the real world – on the same ‘burn rate’ thinking of the dot.commers.

When the dot.com guys invented new companies and Bill Gross and the rest dumped in ‘incubator fund’ monies on the hope that just one or two of the crazy new companies would be the next AOL, mostly MBA’s and suddenly “brilliant” investors momentarily doubled, tripled and multiplied their monies on paper.

Somehow, in this latest craze, the biggest names in finance like Merrill Lynch, Bear Stearns, Fannie and Freddie … turned out to be the duped, drunken investors.

We’ll get through this, it’s just annoying that the world is not a cruise ship Transformer that can morph into a battleship in the blink of an eye. Though morph it will. Hang in there.

Oct 11, 2008 - 7:36 pm 59. buddy larsen:

derek –as shivermtmbrs sez –nobody can evaluate an instrument that may have 5000 or 8000 individual mortgages inside, spread out over the whole country in local markets with different –and rapidly changing daily –characteristics. So the rating agencies (now better known as the ‘over-rating agencies’) –such as Moodys and Standard & Poors, use statistics –actuarials –according to the tables an instrument may BE safe –but the other risk, the risk no one rates because it has little to do with numbers –is the so-called “market risk” or “headline risk” –that affects the price of the security on the market. If it has to go on the market in a flood with of others –well, meltdown of price. This is where ‘mark-to-market’ is literally killing the banking systen, totally unnecessarily –and thus CRAZILY –since a phone call can change mark-to-market. Almost makes ya think there’s some gigantic conspiracy.

Look –look into it –this FASB rule –which is just a rule, not part of mother nature –can be suspended for six months and take a HUGE amount of the emergency and panic pressure off the system. WHY WON’T they DO it?

Oct 11, 2008 - 8:03 pm 60. Leo Linbeck III:

Shivermetimbers,

Great post. A couple of additional comments:

1. I absolutely agree that a major contributor to the current mess is a lack of information. In the absence of information, counterparties demand liquidity – I don’t know if your CDSs are worth $1B, so I require that you post collateral to reassure me. There may or may not be an underlying asset problem – you may or may not have to pay out on the CDS – but I need to know that there is cash there since, well, I don’t know. This transforms the problem from a asset value problem to a liquidity problem. If Bear had been able to post a $5B letter of credit, their problem would not have escalated.

This substitutability of assets and information is also at the heart of just-in-time inventory systems. If I have a big computer system that tells me exactly what my sales are, and I can decrease the amount of inventory I carry. This represents a sort of “inventory leverage” which is often expressed as days of inventory. But as well all know, when there are shocks to the system, these JIT processes break down for lack of sufficient inventory. It is the same way with cash in financial services businesses.

2. The reason I’m not sure that CDSs are going to be such a big problem is that their notional value exaggerates the total exposure.

Let’s take the Bear Stearns-JP Morgan example you cite. When Bear tanked, JPM had $10B of CDS exposure. But Bear only has that full exposure if it has no net assets (assets – secured debt). But the bonds underlying the CDSs do have some value. And Bear had bought some CDSs too, thus reducing its aggregate exposure, much like insurance companies do with reinsurers. So the total losses it will suffer is very unlikely to be $10B.

Problem is – just as you said – no one knows. So everyone required that Bear post collateral, and this “run on the bank” forced them to be thrown into the arms of JPM. But since JPM didn’t know what the exposure was either, it required the government to step in and provide the liquidity necessary to reassure the counterparties.

The general point is this: we shouldn’t view the $50 trillion of CDSs as the total amount at risk. It’s not. The total amount that can be lost in CDSs is the total amount lost in the underlying loans, plus transaction costs. It’s as if I bought an insurance policy on my $200,000 house, and the insurance company pooled that risk with 4 other firms, and all 5 primary insurers bought reinsurance. By the same accounting, there would be $2M of aggregate insurance risk since my $200,000 house has 10 insurance companies.

But if I have a $50,000 insurable loss on my house, the total loss is $50,000, not $2M. How the $50,000 is divvied up between the parties is certainly important, but there is never $2M of money at risk. It’s simply not possible, even if all of the insurance companies go bankrupt.

Finally, the reason we don’t know if CDSs helped or hurt is that we don’t yet know where the losses will go. If the CDS counterparty has a stronger balance sheet than the originating bank, they will help. If the opposite is true, they’ll hurt. And a collapse can’t happen as long as there is enough total equity to absorb the losses, and sufficient liquidity for the loss to find its way to the appropriate counterparty.

FWIW.

L3

Oct 11, 2008 - 8:05 pm 61. Doug:

The Minority Mortgage Meltdown

Anyway, if you’d asked about how Californians could pay off their monster mortgages, you’d probably just hear that the firm’s rocket scientists had taken everything into consideration in their immensely complicated calculations. They’ve got decades of data on California mortgages! What could possibly go wrong?

Unfortunately, one little thing had changed over the decades that the Wall Street quant jocks didn’t include in their numbers: the Californians themselves.

The current average resident of California just doesn’t have the same human capital as in the old days.
In the 2007 National Assessment of Educational Progress test, California’s 8th graders came in 49th out of the 50 states in reading.
A United Way study recently found that 53 percent of the adult residents of Los Angeles are functionally illiterate in English.

If you stopped and thought about it, you might wonder how they would earn enough to pay back those massive mortgages. But stopping and thinking about the shortcomings of minorities is the road to legal ruin in modern corporate America.

Oct 11, 2008 - 8:07 pm 62. fred:

During the 1930’s FDR jacked way up the personal, corporate, and capital gains taxes. And the severe recession turned into a very long Depression. No one was investing. Smoot-Hawley and other nations’ retaliatory protectionism really screwed the pooch.

So, given Obama’s proposals to double the capital gains tax, and to significantly increase corporate and personal income taxes, combined with promises to restore the Welfare State that Reaganomics allegedly dismantled, how is he going to be more successful than FDR was?

I want to hear it from the Obama supporters. I want them to set me straight on how history and logic will be different this time.

Oct 11, 2008 - 8:07 pm 63. Leo Linbeck III:

buddy,

Suspending mark-to-market for a few months is probably a good idea. It will give people time to do the processing that Shivermetimbers refers to, and that would be a good thing. We have the equivalent of a denial-of-service attack on the financial system – too much stuff to process in too little time, so the system shuts down until the queue is cleared.

But I’m less excited about permanently getting away from mark-to-market. There are strong incentives for a management team to avoid writing down an asset, and without some form of outside discipline, problems can be hidden for a long time.

The best approach is probably a blend: something like mark-to-average, based on a rolling average of market value.

L3

Oct 11, 2008 - 8:18 pm 64. Tony:

Fred, now that you mention, I intrigued by the same data points:

Unemployment rates:
1930: 8.7%
1931: 15.9%
1932: 23.6%
1933: 24.9%
1934: 21.7%
1935: 20.1.%
1936:16.9%
1937:14.3%
1938:19%
1939:17.2%
1940:14.6%

How’d that happen?

How FDR’s New Deal Harmed Millions of Poor People – http://www.cato.org/pub_display.php?pub_id=3357
“New Deal programs were financed by tripling federal taxes from $1.6 billion in 1933 to $5.3 billion in 1940. Excise taxes, personal income taxes, inheritance taxes, corporate income taxes, holding company taxes and so-called “excess profits” taxes all went up.
The most important source of New Deal revenue were excise taxes levied on alcoholic beverages, cigarettes, matches, candy, chewing gum, margarine, fruit juice, soft drinks, cars, tires (including tires on wheelchairs), telephone calls, movie tickets, playing cards, electricity, radios — these and many other everyday things were subject to New Deal excise taxes, which meant that the New Deal was substantially financed by the middle class and poor people. Yes, to hear FDR’s “Fireside Chats,” one had to pay FDR excise taxes for a radio and electricity! A Treasury Department report acknowledged that excise taxes “often fell disproportionately on the less affluent.”
Until 1937, New Deal revenue from excise taxes exceeded the combined revenue from both personal income taxes and corporate income taxes. It wasn’t until 1942, in the midst of World War II, that income taxes exceeded excise taxes for the first time under FDR. Consumers had less money to spend, and employers had less money for growth and jobs.
New Deal taxes were major job destroyers during the 1930s, prolonging unemployment that averaged 17%. Higher business taxes meant that employers had less money for growth and jobs. Social Security excise taxes on payrolls made it more expensive for employers to hire people, which discouraged hiring.”

Oct 11, 2008 - 8:23 pm 65. Leo Linbeck III:

Stephen,

You and I agree that centralization of the credit analysis function is a big problem. But I think this centralization created the CDS market, not the other way around. Bond buyers have been lazy for longer than the CDS market has existed.

If there’s a unifying theme to all of my remarks, it is that centralized processes are not robust over the long run. This is true whether the process is mortgage packaging (Fannie and Freddie), credit analysis (S&P and Moody’s), lawmaking (the Federal Government), or energy trading (Enron).

Our politicians should focus on keeping the nodes small. Unfortunately, small nodes make for small contributions. And therein lies the taproot of the problem.

L3

Oct 11, 2008 - 8:25 pm 66. buddy larsen:

L3, that underlying value to which you refer began to get priced yesterday, when the LEH CDS were auctioned (i think to 5 or was it 7 buyers) –transactions averaged eight and a half cents (+/-) on the dollar. Where is the 91.5 cents now, i wonder?

Oct 11, 2008 - 8:26 pm 67. buddy larsen:

L3, right, it’s bad to give up the mark-to-mkt rigor, but remember the immediate problem is the credit freeze (Libor, ted spreads+anecdotals tsunami) resulting from lenders trying to maintain required capital, in the face of the technical, abstracted, ‘paper’ drain of ‘mark-to-market’ daily discounting the capital.

Oct 11, 2008 - 8:50 pm 68. Leo Linbeck III:

buddy,

Was that 0.085 of the notional value? In other words, is that $85,000 to buy a CDS that insures against the default of $1M of loans? If so, that would mean that the market viewed those loans as having an expected default rate of probably around 5%, depending on what the periodic payment is. Sounds about right.

In that case, the other 91.5 cents is in the underlying loans that won’t default. But maybe I don’t understand what was sold. That’s certainly possible, since I’m not an expert.

L3

Oct 11, 2008 - 8:52 pm 69. Leo Linbeck III:

buddy,

We’re in violent agreement on the way mark-to-market is locking up the system right now. A temporary suspension is a good idea, as long as it sunsets.

L3

Oct 11, 2008 - 8:55 pm 70. Leo Linbeck III:

Tony,

Very interesting numbers. And, taken in combination with Intrade’s latest, depressing (no pun intended).

L3

Oct 11, 2008 - 8:58 pm 71. Leo Linbeck III:

slade,

No disagreement on the imprudence of highly leveraged financial firms. But there is simply no way that there is a $500-600T liability that must be funded. It can’t be that high so long as we provide sufficient liquidity. Lack of liquidity was the fundamental error in 1929, and so far it appears we’ve learned that monetary lesson.

Of the fiscal lessons, I’m not so confident.

L3

Oct 11, 2008 - 9:01 pm 72. buddy larsen:

L3, not to obsess, but one more thing –the dramatic credit emergency described by our politic leaders, ”act now or we’re doomed”, is just totally disconnected from the fact that the executive could pick up the phone and suspend the rule that is in itself the problem most proximate and exigent. it just don’t add up, L3.

Hey, Tony –take a look:
http://www.amityshlaes.com/

Oct 11, 2008 - 9:06 pm 73. buddy larsen:

L3, your 8:52 –i can see you’re an optimist –but i think the 8+ cents is the value of the debt dollar on LEH’s asset side. IOW, not so good. Unsure as to when the auction completed but it was late yesterday and if any mkts were still open it would not have been for more than a very short while. IOW we see the results for the first time when Asia/Pacific opens tomorrow —

http://news.google.com/news?sourceid=navclient&ie=UTF-8&q=lehman+bros+auction+cds

Oct 11, 2008 - 9:17 pm 74. ledger:

“Yet if September 11 and the current financial crisis aren’t aberrations at all but simply the first two of the storms generated by a complex, globalized century then some convenience must be foregone for safety…” – Wretchard

I agree.

One convenience that must be forgone is the reliance on the Liberal MSM to make sure our Presidential Candidates are properly vetted. For example, vetting Obama would be a good start – but would probably inconvenience him and the MSM – yet it must be done.

Next, we should be careful of who we entrust our money. This would include those politicians who have little knowledge of accounting and finance yet control huge financial organizations such as Fannie Mae and Freddie Mac. The financial health of these organization plays a huge role in our entire banking system.

A thorough examination of their Financial and Fiduciary skills may cause some inconvenience. If they are not skilled enough or show Criminal Traits they should be ejected from the job.

Lastly, we may have to thoroughly examine “community organization” such as ACORN causing them some inconvenience to ensure that there in not massive voter Fraud. Those who have committed massive fraud should be inconvenienced with some Prison Time.

Oct 11, 2008 - 9:31 pm 75. Doug:

As of August 2008, California alone, with 12 percent of the national population, accounted for 29 percent of all foreclosures. Add in the two California wannabes, Nevada and Arizona, and states with just 15 percent of the population are responsible for 36 percent of the foreclosures. Add in Florida, and four states with 21 percent of the population are home to half the foreclosures.

This is not to say that Hispanics account for most of the defaults in those four states. Plenty of white speculators bought homes figuring they could rent them out to all the Latino laborers who had flocked across the border to build exurban homes. And other whites wanted to move to the exurbs to get their children out of public school systems overwhelmed by the children of illegal immigrants. (Notice the circularity of the economic logic of this decade—which Dennis Dale aptly calls “The Blunder Years”?)

Oct 11, 2008 - 9:42 pm 76. Dave:

Buddy, you may not have seen it but in a previous post I said that this crisis is more like a 19th Century panic than a 20th century
depression. So far that is.

The airplane analogy is that we have encountered a stall and all the alleged
experts know how to do is jerk back on the stick. And wonder why they are in a spiral.

Raise margin requirements in both stock and bond markets and tell member banks to raise reserves to 20 to 25% and this one will be over by June or earlier. (Okay, doing away with mark to market would help too.) Keep on with what they have been doing and we will have another case of clueless Hoover handing things over to clueless Roosevelt.

OODA????? They are ignoring the first three letters. Consequently the last letter is irrational.

Oct 11, 2008 - 9:48 pm 77. buddy larsen:

dave, PIO –Pilot-Induced Oscillation –pilot inputs not synched with aerodynamic reaction –reacting to something that will already be different by the time the input affects attitude –

Oct 11, 2008 - 10:06 pm 78. buddy larsen:

Open the pod bay door, Hal.

Sorry, Dave, I can’t do that.

Oct 11, 2008 - 10:11 pm 79. buddy larsen:

re dave’s ‘19th century Panic’ –take a look at the snips re Panic of 1873; –workers vs bankers.

Oct 11, 2008 - 10:17 pm 80. NahnCee:

Now, who was it that was telling us how good the illegal aliens are for our economy when we Californians were bitching about how much they cost to our infrastructure of roads, health care and education?

I can go out in the world now and claim that 50% of the foreclosures are because of Messicans and that that one group of people have brought down the whole entire financial structure of the world … because Doug said so!

Kewl.

Oct 11, 2008 - 10:38 pm 81. ledger:

I will make this a quick post.

I agree with Buddy that the lack of transparency is the biggest problem with derivatives – but that is usually by design.

I notice when new derivatives are concocted the ability to properly value them is almost impossible. It’s a game where a product is sold and it is usually over-priced and only for “professional” investors (which means anyone stupid enough to buy them).

The total market value of these CDS is no where near 500 trillion. That number is akin to M2 money supply number which reflects the base amount times the turn-over.

The mark-to-market rule is not sound when the prices move violently and maybe manipulated. But, it does work when quotes are solid.

I notice that the sellers of these derivative products are “invisible” to the public. I would suspect that they are European or Asian.

L3’s description of these derivatives leaves the impression that they are as simple as “house insurance” – which they are not.

Further, if you have ever “negotiated” with an insurance adjuster you will find him hard to deal with and you usually receive less money from the insurance company than you paid them in total.

Further insurance products such as Health insurance and Deposit insurance depend on the US Government being the lender of last resort. For Health insurance it is Medicare and for deposit insurance it is the FDIC. I don’t know if this is a good thing.

Eraj Shirvani, the head of the International Swaps and Derivatives Association, is deeply involved in the “unwinding” of said swaps has made about 10,000 in political donations – but I can’t find out to whom.

[Financial Times]

The initial auction results were settled at 9.75 cents in the dollar, meaning banks and other investors who had agreed to make these payments in the event of Lehman’s default will have to pay out 90.25 cents on the dollar.

As well as Lehman’s default, the steady collapse of banks will require pay-outs on other credit derivatives, such as Washington Mutual and three Icelandic banks.
Eraj Shirvani, chairman of International Swaps and Derivatives Association (ISDA), the industry body that manages the auctions, said these concerns were misplaced. “Sellers of protection mark their positions to market every single day. So those firms have already marked down and provided collateral against their positions. As a result, there should be little or no unanticipated additional cost involved in the settlement of Lehman CDS,” said Mr Shirvani, who is co-head of European credit at Credit Suisse.Net exposures were usually around two per cent of the gross amount, which vastly reduced the potential cashflows. Assuming $360bn of gross exposure, this would translate into $7.2bn if these estimates are correct. “Despite immoderate claims relating to the magnitude of the Lehman settlement, these are insignificant when put into the context of $5 trillion in payments on foreign exchange transactions that occur each and every day,” he said. The settlement of the Lehman CDS highlights the plunge in value of the debt of the investment bank, which filed for bankruptcy nearly four weeks ago. With around $130bn of outstanding bonds, holders of this debt have made severe losses. The bonds were trading at around 80 cents on the dollar just days before Lehman collapsed. The value of Lehman Brothers’ near-$130bn of outstanding bonds plunged to a new low of 8.5 cents on the dollar after initial prices set on credit derivatives linked to Lehman Brothers came in lower than anticipated.

See: Bad news on Lehman CDS
http://www.ft.com/cms/s/0/25137702-972d-11dd-8cc4-000077b07658.html

[Bio]

Mr Shirvani has been a member of the ISDA Board since 2004.He is a Managing Director and Head of the European Credit business, including sales, trading and syndicate.He is also Head of European and Asia Pacific Credit Sales and Trading.Mr Shirvani is a member of Credit Suisse’s Global Derivatives Committee.He is also a board member of The Clearing Corporation and the Depository Trust & Clearing Corporation’s DerivServ Board.Mr. Shirvani received his B.A. in International Relations and French from the University of Pennsylvania and his M.B.A. from Columbia University.

Oct 11, 2008 - 11:36 pm 82. 3Case:

A. global “banking policeman”…Rolls right off the tongue kinda like Oil for Food.

B. As to “The more difficult question is who/what sustained the derivatives market.“, my first 2 candidates are:

1. Alan Greenspan (IMHO “the First Vote”); and
2. Congress.

I cannot tell you the number of ignorant, while otherwise intelligent) people who have never heard the old PoliSci adage “The President proposes. Congress disposes.” It seems to have got lost after I ventured forth from the West Bank of the Charles.

C. “It’s time to force at least one party back into forming a true opposition against the other.”

There has not been a second party in my lifetime; servient is a better descriptor. There have been short periods of relief from the diktat of the dominant party (’80-’86; ‘95-’99). Since the (political) assassination of Newt Gingrich the dominant order has been ascendant. The party nominally identified as the opposition has been little more than a rump party; more Stockholm syndromatic than effective in any manner it’s putative base might desire. It has been thus for 75 years as best I can tell.

Oct 11, 2008 - 11:38 pm 83. Alexis:

It’s official. According to Fidel Castro, the reason that millions of Americans won’t vote for Barack Obama is “profound racism”. The link is in the URL.

This means that those who claim that anybody who votes against Barack Obama must ipso facto be a racist is effectively parroting the official line of the Cuban Communist Party.

For the record, I regard all people who will vote for Obama on the basis of race and all people who will vote against Obama on the basis of race as racist. Race is a bad reason to vote for or against anyone. There are excellent reasons to vote against Barack Obama and getting endorsed by Fidel Castro is one of those excellent reasons.

Oct 12, 2008 - 12:24 am 84. buddy larsen:

@Doug; “A United Way study recently found that 53 percent of the adult residents of Los Angeles are functionally illiterate in English”

Hot doggity –47% of our second largest city speaks English!

Oct 12, 2008 - 12:30 am 85. Doug:

Might as well use these few days of free speech we have to print such stuff before the Messiah Proclaims it Verboten!
—
The Long Road to Slack Lending Standards

Ignoring the import of such data, federal officials went on a campaign to encourage banks to lower their lending standards in order to make more minority loans. One result of this campaign is a remarkable document produced by the Federal Reserve Bank of Boston in 1998 titled “Closing the Gap: A Guide to Equal Opportunity Lending”.

Quoting from a study which declared that “underwriting guidelines…may be unintentionally racially biased,” the Boston Fed then called for what amounted to undermining many of the lending criteria that banks had used for decades. It told banks they should consider junking the industry’s traditional debt-to-income ratio, which lenders used to determine whether an applicant’s income was sufficient to cover housing costs plus loan payments. It instructed banks that an applicant’s “lack of credit history should not be seen as a negative factor” in obtaining a mortgage, even though a mortgage is the biggest financial obligation most individuals will undertake in life. In cases where applicants had bad credit (as opposed to no credit), the Boston Fed told banks to “consider extenuating circumstances” that might still make the borrower creditworthy. When applicants didn’t have enough savings to make a down payment, the Boston Fed urged banks to allow loans from nonprofits or government assistance agencies to count toward a down payment, even though banks had traditionally disallowed such sources because applicants who have little of their own savings invested in a home are more likely to walk away from a loan when they have trouble paying.

Of course, the new federal standards couldn’t just apply to minorities. If they could pay back loans under these terms, then so could the majority of loan applicants. Quickly, in other words, these became the new standards in the industry. In 1999, the New York Times reported that Fannie Mae and Freddie Mac were easing credit requirements for mortgages it purchased from lenders, and as the housing market boomed, banks embraced these new standards with a vengeance. Between 2004 and 2007, Fannie Mae and Freddie Mac became the biggest purchasers of subprime mortgages from all kinds of applicants, white and minority, and most of these loans were based on the lending standards promoted by the government.

At city journal Steve Malanga was saying you’ve got professional panhandlers in Austin, just like the Big City, Buddy!
Have you observed that?

Oct 12, 2008 - 1:26 am 86. Doug:

The Mortgage Mess Began on Main Street

Oct 12, 2008 - 1:26 am 87. ledger:

[George Washington's blog spot]

The Times of London writes today:

“About 350 banks and investors are thought to have insured an estimated $400 billion of Lehman’s debt through complex derivatives, known as credit default swaps. These include Pacific Investment Management, the manager of the world’s largest bond fund, Citadel, the US hedge fund, and American International Group, the insurer that the US Government recently bailed out with two loans totaling about $123 billion.”

In addition, JP Morgan gave the following chart of European banks’ counterparty risk on Lehman a couple of weeks ago:

Counterparty risk *

Bank__________________Q2 2008 in mil euro

Société Générale 473,329
Credit Agricole 383,995
BNP Paribas NA
Natixis NA
Barclays 460,423
Deutsche Bank 1,138,090
Credit Suisse 277,362
UBS 652,972

* European banks – outstanding trading positions with Lehman

Source: JPMorgan estimates, Company data

PricewaterhouseCoopers has begun the process of winding down Lehman’s European units on Monday morning.

See: Who got nailed pay for Lehman’s BK
http://georgewashington2.blogspot.com/2008/10/who-got-nailed-paying-for-lehmans.html

Oct 12, 2008 - 2:20 am 88. ledger:

I can see why there is some concern by Americans about the bailout.

It appears the the UK trading desk of Lehman will profit from unwinding trades that possible they themselves made plunging Lehman into bankruptcy. Who in America wants to bailout some Euro traders that may have caused the problem in the first place?

[Financial Times]

Some of Lehman Brothers’ top executives stand to make millions of pounds for three months’ work helping the failed bank’s liquidator to unwind its trades. The Times has learnt that the bill for the work will be covered by Nomura, the Japanese bank that is buying large chunks of Lehman, in a deal hammered out by PricewaterhouseCoopers (PwC), Lehman’s [bankruptcy] administrator.

The administrator is thought to have offered some bankers a minimum of 50 per cent of their total 2007 compensation and up to 100 per cent if they managed to unwind the trades in a timely and profitable manner. Some of the employees involved each made up to $7 million in total compensation last year, about 50 per cent of which would have been paid in Lehman equity. The deals agreed by PwC were to be paid in cash for only three months’ work. Some employees were promised a percentage of the value of the trades that they were able to unwind. PwC is thought to have identified a handful of trades of particularly high value to Lehman, including derivative deals worth as much as €2 billion to the bank. That would make even a tiny percentage payment hugely profitable.
Lehman Brothers staff will make millions to unwind trades

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4894460.ece

Oct 12, 2008 - 2:47 am 89. slade:

<i?The total market value of these CDS is no where near 500 trillion. – ledger

The wikipedia entry includes a chart showing “total world derivatives contracts” hovered around $100T between 1998 through 2001 at which point, they grew to over $500T in 2007. CDS’s would be a subset of that number.

Oct 12, 2008 - 3:19 am 90. slade:

Small Incestuous World of Finance

A second turning point came when Congress passed the Commodity Futures Modernization Act of 2000. The law formally allowed investors to trade energy commodities on private electronic platforms outside the purview of regulators. Critics have called this piece of legislation the “Enron loophole,” saying Enron played a role in crafting it.

….

The most successful of the private platforms was InterContinental Exchange, or ICE, founded by Goldman Sachs, Morgan Stanley
and a few other big brokerages in 2000. ICE soon opened a trading platform in London, allowing its founders to trade vast quantities of U.S. oil overseas without being subject to regulation.

The exemptions for swap dealers and the development of overseas markets allowed big brokerages to open the door for more hedge funds, pensions and big investors to move into commodities.

In the coming years, commodity investments by funds could grow to $1 trillion, veteran hedge fund manager Michael Masters said in testimony before the Senate earlier this year. In an interview, he said this trend could raise commodity prices for everyone in the coming years and “have catastrophic economic effects on millions of already stressed U.S. consumers.”

….
In the coming months, swap dealers expect to have yet another venue for oil speculation. The CFTC has stated it would not stand in the way of trading in U.S. oil contracts overseas in Dubai. Goldman Sachs and Vitol are among the major investors in this new exchange.

Oct 12, 2008 - 3:37 am 91. wretchard:

A second turning point came when Congress passed the Commodity Futures Modernization Act of 2000. The law formally allowed investors to trade energy commodities on private electronic platforms outside the purview of regulators. Critics have called this piece of legislation the “Enron loophole,” saying Enron played a role in crafting it.

If you look back at my earliest posts on this subject, I’ve argued that setting aside money for a “bailout” was never enough for as long as there was no change to the way business was conducted. I used the metaphor of World War I to illustrate the point. Throwing more men at the machine guns wasn’t a solution to the stalemate on the Western Front. Changing the way things were done was the only way forward.

At least part of the package needed to regain confidence has to include a cleaning out of this snake pit. It’s a big snake pit but it doesn’t hurt to start somewhere. I have this horrible feeling that whatever happens in this election, the voters are going to reward some of the people who have ripped them off, ruined their lives and compromised their futures. It’s the smirks on TV, the self-righteous cocktail laughter that is somehow the most galling thing of all. One can almost hear some politicos say, “it’s your fault for not stopping us”. They’d be right in a way, but only in a way that makes one want to puke.

Oct 12, 2008 - 3:51 am 92. Nortius Maximus:

“The great benefit of the admittedly inconvenient, pre-global and more localized world is that it was compartmented into nations.”

Forgive me if this point has already been made upstream, Richard, but this also appears to suggest that downsizing and compartmenting huge-cap corporations might be wise. How can this be made to happen in a prudent yet timely fashion?

I’m not being anti-capitalist here, just aiming for pragmatism about the non-doctrinaire application of the “no ballrooms on battleships” principle. Corporations that are big enough to act like governments seem to violate that principle.

Oct 12, 2008 - 4:08 am 93. wretchard:

this also appears to suggest that downsizing and compartmenting huge-cap corporations might be wise. How can this be made to happen in a prudent yet timely fashion? … Corporations that are big enough to act like governments seem to violate that principle.

I’ll have to consider the problem to offer anything more than random observations. But I will say this is an information problem, not just a regulatory one. In fact the existence of modern information infrastructures allow the formation of virtual enterprises which do not correspond to any legal corporate structure. Just talk to a lawyer and he will unfold a dazzling array of shell companies, interlocking directorships, payouts with the requisite degrees of separation and what have you to show how you can run rings around the stolid bureaucrats of the IRS and just about anyone else. Even if we were to outlaw corporations beyond a certain size they would exist. In fact huge criminal enterprises exist with no known formal existence, or an existence under other color.

Our organs of information gathering and dissemination are wholly inadequate to meet the challenges of a globalized world. They are corrupt and inefficient. We are fed pap by rating agencies, accounting firms, oversight agencies, intelligence agencies and the MSM itself. Life is being replaced by fiction. We sometimes glimpse reality only when it bites us in the ass. Like 9/11. Like the meldown. To some extent democracy and the shareholders are struggling with the rulers and managers to keep tabs on them. And in this struggle information is the key.

Oct 12, 2008 - 4:23 am 94. slade:

Ms. Siebert (the first lady to buy herself a seat on the NYSE) gets called on everytime there’s a crash, and this time around she says “Clearinghouse, book ‘em nightly, so regulators can know who has what when.” – Buddy

I *think* that makes sense – to eliminate the unregistered “shadow” players.

Just to clarify an earlier statement.

This bunch makes the old Mafioso look like amateurs.

Oct 12, 2008 - 4:28 am 95. slade:

Consequently, the public was deprived of vehicles that could be used either for gambling or as a hedge against extreme loss. – Dave

Fine by me. As I have repeatedly acknowledged, I practice finance from a lawn chair. I am forced into this position because my “betters” disrespected my trust. I now have to understand why my retirement portfolio has been cut in half and how the explanation should impact my future investment decisions.

I repeat. A simple industry bubble would have been tolerable. Main Street investors understand the concepts of asset allocation and diversification. When diversified conservative portfolios get whacked this hard, that’s not a simple industry bubble. Pick your word of choice, but bubble it’s not.

Oct 12, 2008 - 5:09 am 96. Leo Linbeck III:

buddy,

Sorry to bug out – had to get some shut-eye.

I’m optimistic, that’s true. But I’m also trying to be realistic. Sometimes doing both is a challenge, I admit…

I checked out some of the links you sent. Thanks for sending them. It appears that the “insurers” will have to pay out on their “insurance.” But this doesn’t add to the total economic loss.

If there were no CDSs, the loss to Lehman bondholders would be about $120M. That loss is presumably due to bad subprime mortgages, etc. But the existence of CDSs doesn’t change that loss, just the distribution of who pays for it.

Let’s say there were $1B worth of CDSs outstanding on Lehman. When it comes time to settle, that $1B flows from the sellers of the CDSs to the buyers. Ignoring transaction costs and liquidity constraints, there are no additional economic losses. Some guys win, some guys lose. The total loss associated with Lehman debt is still $120M, which is really associated with the underlying paper.

But it’s possible that rather than concentrating that loss in a few bondholders, CDSs spread that loss across more, better capitalized entities. However, I admit it could go the other way. All the more reason to push for better information.

One thing that makes sense to me is a central clearinghouse, kinda like what DNS does for the internet.

L3

Oct 12, 2008 - 6:16 am 97. Leo Linbeck III:

ledger,

Thx for your posts. Interesting stuff all.

If I left the impression that CDSs are simple, my bad. They’re pretty sophisticated instruments. However, when you strip them down to their essence, they are just insurance, which is a put option. And in many ways, they are simpler than house insurance; a house has thousands of components, most CDSs are tied to one loan by one company and a handful of triggering events.

Of course, most of us don’t buy $100M worth of house insurance either…

And your comment on the inefficient pricing of new derivatives is spot on. But that’s why they only make sense when used as a hedge; if your company is making a profit on some operation and the derivative can remove exposure to some underlying risk factor, paying the higher price might still make sense (think Southwest Airlines and their forward contracts for buying jet fuel).

Trading derivatives for pure speculation is a fool’s game. And a fool and his money…

L3

Oct 12, 2008 - 6:31 am 98. Iconoclast:

Wretchard’s point echoes in calls for diversity. Outside its Orwellian political context, as in biology, diversity is the antithesis of the unstable monoculture. Global government is an unstable monoculture, but no one seems to be calling for diversity where distribution of power is concerned.

Oct 12, 2008 - 7:17 am 99. 3Case:

One can almost hear some politicos say, “it’s your fault for not stopping us”.

The original movie “Rollerball” flashed into mind when I read that…the party scene with the tree-torching pistol.

I am not old. I have seen this scenario play out 4-5 times already. My Grandfather and Father started telling me about this when I was 11 (early ’60s). My Father gave me a book to read (referenced in an earlier post). During 1974, after several of my peers expressed fear over the meltdown then, I had the good fortune to listen one evening to the investment banker who took IBM public on the subject of these cycles; “This is opportunity, boys.” We all like the highs of a bull market at a full run, but we must never forget that the rats are always working on the walls of the granary and they do get in.

The question I have long been pondering, and which Limbaugh was riffing on this last week, what is the reason that the politicians and the bureaucrats are immunized from this? They will suffer no losses. Their pensions and benefits will still be paid. A just system would put the pols and the bureaucrats at risk, and at sufferance, with the people. Perhaps this is the reason that the privatization of Social Security is fought so stoutly; not because it would be putting the people’s benefits to risk, but that a logical next step would be to privatize the plans of the government employees, which would put them to the risk of the vicissitudes of the markets, where they, of all people IMO, ought to be. It would make them attentive to the interests of the people. Another thought, it seems to me that there is a value to the privileges and uber-security that come with government employment…yet there is no discount to the people for providing that security. In fact, in the one party state in which I live (CT) studies regularly show that government employees receive pay beyond 100% of the compensation of those equally employed in the private sector and that is before the disparity in the values of the respective benefits packages are factored.

Oct 12, 2008 - 11:33 am 100. Shivermetimbers:

Ledger,

You wrote:

“Eraj Shirvani, chairman of International Swaps and Derivatives Association (ISDA), the industry body that manages the auctions, said these concerns were misplaced. “Sellers of protection mark their positions to market every single day. So those firms have already marked down and provided collateral against their positions. As a result, there should be little or no unanticipated additional cost involved in the settlement of Lehman CDS,”

I am not really sure I know what this means. I know what is being said, but, if his position is that these products are being marked to market each day, my point would be big deal. Mark to market on these derivative instruments – how???

As I said in an earlier post, I work with many of the folks who try to solve these issues from an operational and system perspective. Do you know the product you mention – DTCC’s DerivServ can only handle basic plain vanilla contracts, and struggles to to even that – I know the folks who run that platform.

The problem with contracts on these derivative products, especially credit derivatives, is that they can include almost any term two parties can think of and negotiate. If you look at the profile of many of the heads of risk in these departments, they will typically have background in finance, but also law degrees.

How can you operate efficiently this market that is highly unstandardized? Yet it had grown considerably – I don’t know where the $500 trillion number came, but I have heard it at $40 – $50 Trillion. Still a frightening number.

Oct 12, 2008 - 3:22 pm 101. slade:

I don’t know where the $500 trillion number came, but I have heard it at $40 – $50 Trillion. – Shivermetimbers

The wikipedia entry for “derivatives” includes a graph without citation.

Repeated here:

Wall Street didn’t listen to Buffett. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007.

Oct 12, 2008 - 3:42 pm 102. Shivermetimbers:

Slade – there are a lot of derivative products; credit derivatives are just some.

What I meant to say in my last post was that the CDS market grew too large without the proper infrastructure to support it.

Oct 12, 2008 - 3:49 pm 103. Leo Linbeck III:

Shivermetimbers,

This Wikipedia graphic shows the amount of derivatives outstanding as of 2Q2008:

http://en.wikipedia.org/wiki/Image:Credit_default_swaps_vs_total_nominals_plus_debt.png

It shows about $182T of total derivatives. The vast majority of these were interest rate swaps, which are exceedingly simple instruments: a fixed interest rate for a variable interest rate. I’ve seen one of these interest rate swaps, and they’re about one page in length.

The total amount of CDSs outstanding was about $15.5T. About 30% of these – maybe $4.6T – were on subprime mortgages.

The $500T number might be a global number, but it still sounds high.

Still, your fundamental point is very important: processing a backlog of non-standard paper is a laborious and risky undertaking. It will take time and capital to clear the backlog.

A couple of interesting quotes from the report from the Office of the Comptroller of the Currency (http://www.occ.treas.gov/ftp/release/2008-115a.pdf) from which the Wikipedia data was drawn:

As is often the case with a new and rapidly growing market, operational issues became a supervisory concern in the credit derivatives market in recent years. The OCC is working with other financial supervisors and major market participants to address infrastructure issues in credit derivatives.

I think this means the OCC understands and is working on the problem you highlight. And:

the notional amount of derivatives contracts does not provide a useful measure of either market or credit risks

This may be wishful thinking, but the OCC appears to believe that the true risk embedded in these instruments is far below the notional value. I suppose we will find out whether they’re right in the fullness of time…

L3

Oct 12, 2008 - 4:00 pm 104. slade:

I understand that Shiver. I just wanted folks to clarify their statements. The derivatives market growth is the issue – for such high risk investments to dominate should be of concern to investors.

Oct 12, 2008 - 4:02 pm 105. Leo Linbeck III:

Shivermetimbers,

This Wikipedia graphic shows the amount of derivatives outstanding as of 2Q2008:

http://en.wikipedia.org/wiki/Image:Credit_default_swaps_vs_total_nominals_plus_debt.png

It shows about $182T of total derivatives. The vast majority of these were interest rate swaps, which are exceedingly simple instruments: a fixed interest rate for a variable interest rate. I’ve seen one of these interest rate swaps, and they’re about one page in length.

The total amount of CDSs outstanding was about $15.5T. About 30% of these – maybe $4.6T – were on subprime mortgages.

The $500T number might be a global number, but it still sounds high.

Still, your fundamental point is very important: processing a backlog of non-standard paper is a laborious and risky undertaking. It will take time and capital to clear the backlog.

A couple of interesting quotes from the report from the Office of the Comptroller of the Currency (http://www.occ.treas.gov/ftp/release/2008-115a.pdf) from which the Wikipedia data was drawn:

As is often the case with a new and rapidly growing market, operational issues became a supervisory concern in the credit derivatives market in recent years. The OCC is working with other financial supervisors and major market participants to address infrastructure issues in credit derivatives.

I think this means the OCC understands and is working on the problem you highlight. And:

the notional amount of derivatives contracts does not provide a useful measure of either market or credit risks

This may be wishful thinking, but the OCC appears to believe that the true risk embedded in these instruments is far below the notional value.

I suppose we will find out whether they’re right in the fullness of time…

L3

Oct 12, 2008 - 4:04 pm 106. slade:

Thanks to the Gramm-Leach-Bliley Act (2000) the derivatives market, including CDO’s, CMO’s, and CDS’s, are largely unregulated; the bill designed by Phill Gramm and signed by Bill Clinton at the approval of Bob Rubin, another in-the-news Goldman Sachs alumnus.

Oct 12, 2008 - 4:15 pm 107. slade:

Stormy Weather in the Credit Default Swap Market

The size of the market has soared well above the value of the underlying debt that they are supposed to insure (reaching about USD 62 trillion at the end of 2007). This has become clear since 2005, when Delphi, the auto parts maker, went bankrupt: the CDS on Delphi’s debt in the market exceeded the value of its bonds tenfold.

Oct 13, 2008 - 6:45 am 108. Leo Linbeck III:

slade,

Re: Delphi
Just because CDSs exceeded the value of its bonds tenfold doesn’t mean losses increased tenfold. Total losses were limited to the losses on the bonds. The CDSs just spread that risk around.

There are only two ways CDSs are used: hedging and speculation. If the losses were hedged, the losses moved from the lenders to the buyers of the CDSs. No increase in loss, just a transfer of losses from one party to another. If the losses were speculative, they were fully offset by speculative gains. No increase in loss, just a transfer of wealth from one group of rich people to another group of rich people. Doesn’t keep me up at night.

So, I still fail to see the problem. In fact, CDSs might be a net positive (losses shared by many instead of a few). But maybe I’m missing something…

L3

Oct 13, 2008 - 11:49 pm 109. slade:

Leo – my understanding – such as it is – described by Ben Stein:

[start quote]

Here’s one big part of the answer. First, the alert reader will notice that Ben Stein said many times that the amount of money at risk in the subprime meltdown was just not enough to sink an economy of this size. And I was right…to a point. The amount of subprime that defaulted was at most – after recovery in liquidation – about $250 billion. A huge sum but not enough to torpedo the US economy.

The crisis occurred (to greatly oversimplify) because the financial system allowed entities to place bets on whether or not those mortgages would ever be paid. You didn’t have to own a mortgage to make the bets. These bets, called Credit Default Swaps, are complex. But in a nutshell, they allow someone to profit immensely – staggeringly – if large numbers of subprime mortgages are not paid off and go into default.

The profit can be wildly out of proportion to the real amount of defaults, because speculators can push down the price of instruments tied to the subprime mortgages far beyond what the real rates of loss have been. As I said, the profits here can be beyond imagining. (In fact, they can be so large that one might well wonder if the whole subprime fiasco was not set up just to allow speculators to profit wildly on its collapse…)

These Credit Default Swaps have been written (as insurance is written) as private contracts. There is nil government regulation of them. Who writes these policies? Banks. Investment banks. Insurance companies. They now owe the buyers of these Credit Default Swaps on junk mortgage debt trillions of dollars. It is this liability that is the bottomless pit of liability for the financial institutions of America.

Because these giant financial companies never dreamed that the subprime mortgage securities could fall as far as they did, they did not enter a potential liability for these CDS policies anywhere near their true liability – which again, is virtually bottomless. They do not have a countervailing asset to pay off the liability.

[end quote]

Oct 14, 2008 - 3:26 am 110. buddy larsen:

L3 and Slade have been an informative pleasure to read on this thread –others too, but those two outdid themselves –i say ‘thanks’ –

Oct 14, 2008 - 8:30 am 111. Dave:

Amen Buddy.

Oct 14, 2008 - 9:13 am 112. slade:

What a difference a month makes. It’s true what they say about what you don’t know.

For Congress & Wall Street

Oct 14, 2008 - 11:35 am 113. Leo Linbeck III:

buddy,

Thx for the props. As an on-and-off, long-time lurker of BC, I have enjoyed and appreciated your work. Makes the compliment all the more meaningful.

L3

Oct 14, 2008 - 7:54 pm 114. Fletcher Christian:

I would like to take issue with the notion that an aircraft carrier is difficult to sink. In fact it is very easy; I am told that when US carrier battle groups are involved in manoeuvres, that the rules have to be tweaked in order that the carrier survives. Any half-decent submarine captain has a pretty good chance of killing the carrier, if the rules aren’t biased.

The US Navy ignores this, simply because nuclear carriers are impressive, and because they employ large numbers of sailors; which in turn increases the size of the Navy and hence makes plenty of room for well-paid, high-ranking officers and also lots of profits for shipbuilders. Stealth arsenal ships would do the same or better, with much less expense on men and machinery – which is precisely why the idea has been repeatedly shelved.

There is an analogy with the financial and corporate system here. Large units ought to be more efficient because of economies of scale, but just about never are. Why? Because large organisations make for bureaucracy, empire-building and various forms of cheating and embezzlement. Of course, there is a minimum effective size for a power plant or steel mill – but how big does a bank have to be?

Of course anyone would rather be the CEO of Bank of America than the manager of some local branch – but who benefits society in general more?

Oct 16, 2008 - 7:23 am 115. Bob Murphy:

@Fletcher
I did not comment about Wretchard’s view of aircraft carrier survivability because I thought his theme was worthy.
A battleship or cruiser would have been far better examples, the former because it has much thicker armor than a carrier.
The very nature of a carrier’s task makes it vulnerable to an attack as became obvious in the Pacific in WWII.
A carrier’s immense hangar decks where the aircraft are stored cannot effectively be compartmented, the elevators that carry the planes up to the flight deck are another weak point for fire or explosion.
And, of course, carriers carry immense amounts of aviation fuel and munitions.
Their function is to be a floating airport not a gun and missile platform like battlehships and cruisers.
I better stop here or Old Salt will be on my case. (Yep I know there are no more active battleships but they were an outstanding example of a hard design, meant to absorb immense punishment and survive)

Oct 16, 2008 - 8:51 pm

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