Nostradoofus

This post was inspired by a recent NPR program.

Several years ago, Warren Buffett famously referred to financial derivatives as “financial weapons of mass destruction.” Unfortunately, he, and nearly everyone else, didn’t elaborate. For nearly everyone, “derivatives” remained just a word, vaguely associated with big money and big danger.

This post attempts to explain why one particular type of derivative, “credit default swaps,” caused the financial system to implode.

The layman’s confusion is caused in part by opaque naming. (”Credit default swap?” What the heck does that mean?) But it’s really pretty simple. “Credit default swaps” are bond insurance policies. The buyer of such a policy pays a premium to the insurer, for protection against the default of a bond. If the bond doesn’t default, the insurer just keeps the premium. If the bond does default, the insurer must pay the buyer the face value of the bond.

If it’s a bond insurance policy, why don’t they just call it “bond insurance” instead of CDS? There is a reason, and it stinks. More on that in a moment.

Among other uses, CDS were widely employed to improve the credit rating of mortgage-backed securities. For example, a dicey pile of Countrywide mortgages would be securitized, and might have a fairly risky default rating. To reduce risk, the end buyer might simultaneously buy both the securitized mortgages AND a credit default swap (again, bond insurance) to insure against the risk that the mortgage securities might fail to pay off as agreed.

The obvious problem here was that the mortgages were much dicier than expected, too many of them defaulted, and too many insurers (sellers of credit default swaps) were forced to pay insurance claims.

So far, this is a case of bad risk management, but not bad enough to take down the whole financial system. To see where the dynamite was hidden, let’s return to this mysterious reluctance to call these financial contracts “insurance,” even though that’s clearly what they are.

Insurance is a regulated industry. Insurers are required to maintain capital reserves (e.g. cash and investments), to ensure they can actually pay out claims on the policies they sell. This regulation stabilizes the financial system, but irritates the more aggressive financial types, who could enjoy vastly higher return on capital if they didn’t bother to maintain reserves to actually pay claims.

Their ultimate dream of avarice: an insurance company that has no capital to pay claims. Divide by zero: infinite return on capital. Just write policies, collect premiums, and if a claim rolls in, just declare bankruptcy and start over. Easy money.

In the 1990s, when the idea of securitization was expanding rapidly, prospective sellers of bond insurance, fueled by this utopian vision of infinite return on capital, decided not to call their product “insurance.” Instead, they called it a “credit default swap,” and argued it was not really insurance, but a “forward contract” between two private parties. This clever definition meant that, from a regulatory perspective, these products weren’t insurance, and weren’t listed securities, placing them outside the purview of all regulatory agencies.

This unregulated environment was made explicit in law with Web-Bubble-era legislation led by Phil Gramm (John McCain’s chief economic strategist until a few weeks ago).

Freed from the irritant of capital requirements, a credit default swap (CDS) free-for-all ensued. Increasingly, they were used not by bond holders, but by speculators. For example, you could buy a CDS contract to insure against the default of a bond you didn’t actually own.

To see how strange this speculation is, consider an analogy. Suppose you think your neighbor will default on his mortgage. Imagine if you could buy an insurance policy on your NEIGHBOR’S mortgage. If he defaults, you collect the entire value of his mortgage. Everyone on your street could do it, and would each collect the entire value of the mortgage if your neighbor defaults.

This is exactly what was going on in credit default swaps. Today, for every dollar of mortgage backed securities, there are believed to be about 12 dollars of CDS contracts. This is a form of leverage, in that, if a dollar of MBS defaults, then 12 dollars must be paid out by someone.

Now we start to see how the entire system could fail (but it gets worse — see below). The maximum exposure to MBS is not the total MBS market of $5 trillion, but 12 times that, the entire CDS market, or $60 trillion. This is more than 4 times the entire annual output of the United States.

How could the CDS market be so huge? One reason is that they could be structured, typically by hedge funds, into a seemingly riskless bet, known as “netting.” This trick takes advantage of the simple fact that insurance premiums are higher when a claim is more likely. (For example, it costs more to insure a 16-year-old driving a red Ferrari than to insure a 40-year-old bookkeeper driving a Honda Accord.) Hedge funds took advantage of this fact as follows.

Say you run a hedge fund. You buy a CDS on a bond when the risk of default seems low. The price of such a CDS is low, because the perceived default risk is low. Then, as the mortgage collapse unfolds, you also SELL a CDS on the same bond. In the latter transaction, you, the hedge fund, are acting as the insurer. (Why not? CDS are totally unregulated, so anyone can write a policy.)

Because the mortgage collapse is under way, the underlying bond seems more likely to default than it did before. So you can charge a much higher premium for the insurance you are selling than you paid earlier for the insurance you bought. Your profit is the premium received in the second transaction minus the premium paid in the first transaction.

Superficially, you are taking no risk, because if the bond actually defaults, you collect on the insurance policy you bought, and use that money to pay out on the insurance policy you sold. That nets out to zero (hence the term “netting”), but you still have your profit described in the previous paragraph.

What’s the problem here? Something called counterparty risk. In an actual default, you make your insurance claim and try to collect on the policy you bought (the first transaction above). What if they don’t pay you? For example, what if you bought that policy from Lehman Brothers, and they went broke before you could collect? Now the person to whom you SOLD insurance (the second transaction) comes to collect from you. You can’t pay, because Lehman stiffed you, so you are suddenly insolvent, aka broke.

So many people were netting, and the CDS speculation market had become so large over the years, that everyone was dependent upon the counterparty risk (ability to pay a claim) of everyone else. Everyone had booked profits on netting transactions, but in an actual MBS default, if any link in the chain failed to pay, everyone would go broke. Circle of interdependency. Cascading defaults.

The first link to fail was Lehman. The federal government appears not to have understood until very recently (just the past few weeks) that CDS were mainly used to speculate, not to insure one’s own bonds. As a result, the feds didn’t realize that letting Lehman fail would break the chain of interdependencies on CDS claims, causing everyone else to collapse.

So AIG went down. In addition to their regular insurance business, AIG was dabbling in CDS. Well, more than dabbling: they sold $400 billion of CDS, and in the wake of Lehman, enough of these went south to take down the company.

Belatedly, everyone understands that the CDS market should be regulated either as insurance, or as listed securities, or both.

In the meantime, we face the problem of a money supply collapse. For every dollar of MBS default, 12 dollars vanishes from the money supply. This is why the Fed is massively loosening monetary policy.

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American “exceptionalism,” a euphemism for “we’re better than everyone else,” ends with the Baby Boom. You see a clean break at birth dates around 1960.

Most educated people born before 1960 think about US policy (economic and otherwise) from a basic assumption of unlimited economic, financial and military resources. Most born after 1960 assume we have limited resources, and must prioritize and allocate accordingly.

You see this break vividly among political candidates. The Boomers (Hillary Clinton, John McCain, and especially George W Bush) unconsciously assume limitless American power and wealth. By contrast, the Gen Xers (Obama), who reached adolescence after Vietnam and during the oil shocks, assume limited resources.

Limited resources require prioritization, compromise, and cleverness. These skills are best learned early, so Gen Xers have a built-in advantage. But no matter who wins the election, America and its constituents will imminently and painfully relearn rusty skills.

(Updated 10/9/08 – minor corrections)

This post attempts to explain why it may be necessary to bail out the U.S. financial system. I’m writing it because the federal government is not publicly connecting the dots, not explaining what is at stake, nor are the best blogs and news sources on the subject.

The following is NOT a defense of the Paulson plan, which may be the wrong solution. It is NOT a defense of Wall Street fat cats whose practices brought us here. It does NOT argue we need a bailout in just a few days or weeks. This is just a specific explanation of the problem, and why it is fairly urgent.

When politicians talk about a “failure of the financial system,” they are specifically referring to a panic among banks, which become unwilling to take basic day-to-day lending risks that act as the grease to keep all commerce working.

This dramatically affects your daily life, but it may be hard to see exactly how. So let’s use an example.

Say you use your credit card to buy lunch. When you swipe it, you are not actually paying, not right away. Instead, you borrow the cost of the meal from your credit card issuer. The restaurant trusts your card issuer to pay for your meal within 3 days; your card issuer trusts you to pay for your meal when your credit card bill comes at the end of the month.

But where does your credit card issuer get the money it loans to you? In almost every case, they borrow it. Credit card issuers extend billions of tiny short-term loans to their cardholders for things like restaurant meals. To pay the merchants, issuers borrow the money they need by issuing short-term bonds called commercial paper, typically with a term of only 30 to 90 days. Credit card issuers sell those bonds to investors.

Who are the investors that buy commercial paper from credit card issuers? One of the biggest buyers is banks. Banks receive cash from customer deposits, and look for places to lend it: generally writing mortgages and buying bonds. Most often, it is specifically money market deposits that are invested in commercial paper.

Lehman Brothers routinely borrowed a lot of money via commercial paper. This paper was purchased by banks and money markets, because Lehman was a trusted borrower. When Lehman unexpectedly failed, it defaulted on all its commercial paper, causing money market depositors to lose money. This shocked depositors into withdrawing massive amounts from their money markets, which greatly reduced the funds available for such funds to buy commercial paper.

Meanwhile, many banks today hold mortgages that are in default, or mortgage securities that are declining in real value. This makes bankers afraid to make risky loans, lest they lose more money.

The nightmare scenario, which we have flirted with a couple of times in the past year, is that banks and money market funds stop buying all commercial paper.

What happens to your credit card if the issuer cannot sell that 30-day commercial paper to fund its loan to you for the restaurant meal? It’s pretty simple: the credit card issuer fails, the restaurant doesn’t get paid, and restaurants across the country stop accepting credit cards. Cardholders who routinely “run balances” on their cards every month have no cash to fall back on, so they default on everything simultaneously.

Now, in my opinion, there are actually benefits to being a cash-only society, but here is the problem: the abruptness of such a transition would certainly cause a depression.

Still don’t believe it? Then consider a much bigger issue: payroll.

Thousands of US public companies fund daily operations with commercial paper, those same 30- to 90-day loans. For example, they may fund payroll with commercial paper during the month, while they await payment for their factory’s output. No commercial paper market, no payroll.

Commercial paper is not the only way they could do this. They could keep a much bigger bank balance, and pay short-term obligations from cash reserves until they are paid. As with the credit card situation above, this cash-based solution is inherently more stable: pay employees out of savings, and then refuel cash at the end of the month after receiving payment from customers. Works great, in theory.

But industrial firms all buy from each other. If all of them simultaneously needed to stop spending for a couple of months to pile up cash, then there would be no buyers for anything. All commerce would stop. Thus, as with the credit card example, it is the overly abrupt TRANSITION from credit-based to cash-based operations that would cause all payrolls and much other commerce to fail simultaneously, triggering economic collapse and depression.

The more people pull money out of their money market and bank accounts (this is accelerating), and the more mortgages and mortgage-backed securities that default (also accelerating), the less banks and money funds are willing or able to buy commercial paper, and the greater the risk that everyone’s payroll and credit cards seize up more or less simultaneously.

This is the reason everyone is so frightened. This is why Paulson, who takes risks for a living, looks like he hasn’t slept in a week.

Not to say I trust Paulson, but one part of his bailout proposal potentially makes sense.

Many MBS are illiquid because default rates are totally unknown. The fastest way to restore their liquidity would be to reduce default risk in a transparent way, e.g. write down the principal. This would require voting majority of a given MBS issue.

But ownership of these issues is spread widely. So a fast path to majority would be a Treasury reverse auction on a given issue. Once in control of a given issue, they could write it down so far that anyone would consider it investment grade, which would create instant liquidity.

Such writedowns would reduce the burden on homeowners in those pools, and restore liquidity at the same time.

Would the Treasury actually make money? Hard to say. Kinda doubt it. But if we are truly in a panic, you can construct a scenario: buy an issue at 10 cents on the dollar, write the principal down by half, and resell at 20 cents on the dollar.

UPDATE (9/26/08): A reader points out that purchasing MBS doesn’t entitle the majority owner to modify the individual mortgages, according to this and this. However, those sources also acknowledge that the mortgage servicer can make such modifications, subject to a majority or supermajority vote by MBS owners. So the situation is more complex, but substantively the same, as what I wrote above.

Longstanding US policy is to economically ostracize nations we don’t like. Hence the decades-long embargoes of Iran, Cuba, North Korea.

There is no experimental evidence that this works. No nation has changed policy as a result. In fact, the lack of economic ties to these nations means they have nothing to lose economically in a confrontation with America.

Thus, logically, the opposite policy would work better: kill them with carefully chosen kindness.

For example, Iran lacks refining capacity, so they are an oil exporter, but a gasoline importer. An interesting Mideast stabilization policy might be to build refining capacity in Iraq, and encourage gasoline sales into Iran. Increasing Iran’s dependence on a hostile neighbor creates strong incentives on both sides to stabilize both countries.

I happen to be a Republican. But before arguing about political platforms, one might consider four basic qualifications for national office: to be smart, self-made, emotionally measured, and without known health problems.

Not so long ago, in a presidential election, both candidates consistently met these requirements. Whether you liked the platform of Bill Clinton or George HW Bush, you could rest assured they were both smart, self-made, emotionally measured, and without known health problems.

This was true, with a few exceptions, of candidates for at least the past century, but it changed with George W Bush. Here, for the first time, a presidential candidate was not smart or self-made, and had a known, serious health problem in the form of past alcohol and drug dependency. Is it unrelated that his presidency is considered by most in both parties to have been a disaster?

As a Republican, I actually don’t have a problem with most of McCain’s stated policies. The problem is that he is not smart (5th from the bottom of his class), not self-made (entered the Naval Academy on family connections, married into money, entered politics on monied family connections), not emotionally measured (famous temper — physically attacked another senator in 2006, at age 71), and not in good health (four-time cancer survivor, and won’t release his medical records).

This is simply a bad bet, no matter what your political leanings.

America currently blames others for its own failings in at least four important areas.

Trade imbalances: obviously we should foster exports, encourage production, discourage consumption. Currently we complain incessantly about China’s unfair advantages in trade, yet ignore the obvious: our federal policies of encouraging consumer demand — which may have made sense 60 years ago, when America had a ton of savings and produced everything domestically — now simply drive the durable goods deficit. How many people here bother to learn a foreign language and attempt to export something? Far fewer, as a percentage of population, than in China. We fail because we’re not trying very hard.

Drugs: obviously we should cut demand, not supply. Currently we spend billions destroying poppies and coca in Afghanistan and Colombia. This is pointless, because cutting supply simply increases price, thus increasing incentives for impoverished people to produce more. If instead you cut domestic demand, the price falls, reducing incentives and cutting supply.

Crime: violent inner cities are “us,” not “them.” Walling off suburbs into gated communities, and building vast numbers of prisons, denies the fact that our fate is shared. It is a form of blaming the victim: we already know from New York’s success in the 1990s that crime control is mainly a function of police presence. (Duh.) Public safety is just a matter of accepting our shared fate and acting upon it.

Energy: the Middle East is utterly irrelevant to our national interest, except for its oil. Controlling the availability of that oil requires projection of military power, which makes enemies. We risk domestic terrorist cataclysm mainly because we need oil. Yet North America has sufficient natural gas reserves to power the continent for decades. Has it occurred to anyone how insanely risky it is to have our entire economy (including distribution of food) depend upon reliable shipments of an imported fluid? We’re simply using the wrong fuel. Changing to natural gas only looks expensive when you ignore the Black Swan of an oil supply interruption, which is almost certain to occur at some point.
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Stiglitz claimed recently that “neoliberalism has failed.” More accurately, neoliberalism has long suffered from confusion about its origin.

Neoliberalism depends on, and exists because of, beneficial regulation. When it fails, it fails for lack of regulatory authority.

More generally, “free” markets are a structured game whose playing field is defined by government. Even property ownership is a regulatory construct, a form of monopoly sanctioned by government. This sanction has been stable for so long that Americans forget it can exist only within a regulatory structure.

For a dramatic illustration, consider the difference in the fortunes of California and Baja California. The latter fails for lack of a regulatory structure (mainly property rights, environmental law and public safety).

Neoliberalism comes under fire today mainly because of global trading imbalances. That makes sense, because when the global trading system fails, it fails for lack of regulatory authority to normalize across national borders: labor laws, exchange rates, etc.

Despite all that, for the time being, America would be better served to focus on fixing its own manifold internal problems, rather than complain about China’s trade advantages (whether fair or unfair). For example, the U.S. government’s fiscal deficit is a big problem, within our own power to fix, and not China’s fault. The promotion of consumption over production — which is now as much cultural as governmental — is also within our power to fix, and not China’s fault.

This might all be considered a special case of America’s current problem with scapegoating.
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Programmers know this, but I’m not talking about code.

In any field, it seems, optimization creates inflexibility. This is because optimization (maximization of performance) generally requires assumptions about the continuity of conditions.

In computer programming, you gain great speed benefits by writing graphics software in assembly language, rather than a compiled language such as C. But assembly is purpose-designed for a single microprocessor family. Change families, and all your work must be thrown away. So this optimization require one big assumption about future use of your software.

In investing, you can gain higher returns with leverage. But the greater the leverage, the more central your assumption of price stability or continuity, the greater your reliance on avoiding one really bad day, and its associated margin call.

In advertising, you can maximize conversion rates by having each CPC ad click through to a specific landing page designed for that ad. But the amount of work required to make a campaign-wide change increases by an order of magnitude.

Maximizing international trade optimizes economic output but greatly increases exposure to common-factor economic collapse, such as a discontinuity in the oil supply.

Thus optimization increases performance (narrowly measured), but also exposure to Black Swans.
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Restaurant chain TGI Friday’s now advertises “right-sized” (i.e. small) entrees for $5.99.

But this happy development is a causative flyspeck alongside the implications of the exploding price of corn syrup, exacerbated by the midwest floods. If the price of a Big Gulp doubles, America may save more money on health care than it spends on food.

Not so helpful to the truly poor, of course.

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