The End of the World as We Know It
I will begin this preamble to the subject systemic risk with two quotes from Warren Buffett (by quoting him I do not mean to imply his support in these efforts of mine):
- Of excess leverage in the system, Mr. Buffett has said, “No one knows who’s been swimming naked until the tide goes out.”
- Mr. Buffett calls derivatives, “financial weapons of mass destruction.”
I would like to explore the meaning of this in the context of unsettled trades in our nation’s settlement system.
Mark Twain said, “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.”
Consider this scenario:
- I loan you an umbrella.
- You use that umbrella as collateral to borrow 5 more from someone else.
- You take the 6 umbrellas and loan them out to your 6 brothers.
- Each of your six brothers now has one umbrella. Each uses that umbrella as collateral with which to borrow 5 more. Each brother now has 6 umbrellas, and loans them out to 6 of his friends.
- Each of those (6 brothers) X (6 friends each) = 36 friends now has one umbrella. Each uses that umbrella as collateral with which to borrow 5 more.
- There are now 6 X 6 X 6 = 216 umbrellas in all.
It starts to rain.
- I go to you and say, “I need back that umbrella I loaned you.”
- You say, “But that was collateral for the 5 I borrowed! If I have to return your umbrella, I’ll also have to return the other 5 I borrowed using your umbrella as collateral.”
- So you go to your six brothers and say, “I need those six umbrellas back!”
- Each brother says, “But I used that umbrella as collateral for 5 more!” So they go out to get each of their six umbrellas back by going to their 36 friends and saying, “We need our umbrellas back!”
And so on and so forth. It is easy to see how this situation, where balancing upon one umbrella were 216 borrowed and reborrowed umbrellas, could unravel in a chain reaction of “unborrowing” and returning of umbrellas.
Remove “umbrellas” in the above example and replace it with “dollars,” and you get a good image of excess leverage in our financial markets, and one of systemic failure as well.
How could the government stop this collapse? In the umbrella example, the government would take truckloads of umbrellas and inject them into the umbrella market (perhaps by loaning them out at low rates) so as to slow down and even stall that chain reaction. In the example of our financial system, the government would do it by taking truckloads of dollars and injecting them into the capital market.
This is exactly what the government has been doing for over a year. The broadest measure of the money supply is called, “M3.” The government reported the rate of change in M3 since 1959. After reporting M3 for 47 years, in March 2006 the government stopped disclosing M3. From other numbers that are disclosed by the Federal Reserve, however, it is possible to back into M3. An economist named John Williams does just that on the Shadow Government Statistics website. According to Mr. Williams’ calculations, the rate of expansion in M3 has reached 16.7% - higher than at any time since they started reporting it (the last time it reached 16%, Nixon reacted by instituting wage and price controls).
That is problematic because (very roughly speaking) the growth in money supply will equal inflation plus growth in US productivity (along with other factors like velocity and number of transactions: that is why I say “roughly). According to the Fed, productivity is growing at just under 3%. If money supply growth stays gunned at 16%, underlying inflation will heat up over 10%, at which point the dollar will crack some more, at which point interest rates will be hiked into the high teens in order to tempt foreigners to continue loaning us money to subsidize our fiscal and current account deficits, at which point we will be thrust into an inflationary recession that makes the early 1970’s look like a Sunday picnic.
That is to say, massive amounts of liquidity are being injected into the US financial markets to keep it from imploding. This will lead to inflation (”Inflation is always and everywhere a monetary phenomenon,” wrote Milton Friedman and Anna Schwartz) then a recession.
Or not, if, as some believe, M3 is too volatile to worry about.
The “rain cloud” which was the proximate cause of this situation was the home mortgage crisis that began to be exposed in the summer of 2007. People bought homes with borrowed money for which they signed IOU’s (“mortgages”). Those IOUs were aggregated and resold, chopped up, packaged and resold again to firms which borrowed even more on top of them. Unfortunately, since everyone in the chain made money from fees charged for that aggregation, chopping and packaging, they had incentives not to notice that many of the folks underneath it all were signing IOU’s they would not be able to repay. Once they stopped paying their mortgages (i.e., once those “umbrellas” started to be recalled), the system started to collapse on itself. A coordinated effort by the largest central banks in the world injected money into the financial markets to stop a runaway implosion such as that described in the umbrellas example above.
There are numerous articles out there explaining the mortgage crisis in far greater detail than the above. I present this explanation for three reasons only.
- The first is to provide the lay reader with the mental imagery by which to conceive of a systemic collapse.
- The second is so that I could point out that the mortgage crisis was the rain cloud that triggered the current crisis, but it may not be the only rain cloud. Lots of storms have more than one rain cloud.
- Third, the rain cloud is not the same thing as the underlying situation. It is merely the trigger which has caused an unhealthy underlying situation to manifest. It is important to understand not just the trigger but also that underlying situation: tremendous amounts of systemic leverage are, in the end, a giant confidence game (in the most literal sense), and if that confidence is disrupted the system can implode. What disrupts that confidence may be nothing more than a sudden, broad realization that more leverage has accumulated than has been generally understood, perhaps by accumulating in such a way that no one recognized it for what it is. I will argue in future posts that this is precisely what unsettled trades in our stock settlement system create.
Again, that third point is key: recognize that the mortgage crisis, while real, is a trigger but not the underlying situation. The dancer is different than the dance.
I would like to switch metaphors now, to discuss derivatives.
I ask you to imagine a special casino. On the ground floor, it looks like a normal casino. There are 100 people standing around playing craps, roulette, and blackjack. They each brought $10,000 so there is $1 million of betting on the first floor.
On the second floor, however, there is another casino. In that casino, people are watching television screens showing people gambling on the first floor. In the second floor casino, people bet each other on who they think is going to win and lose on the first floor. All the really big players are in that second floor casino, and they are betting hundreds of millions of dollars of action on various people in that first floor casino. Their outcomes are “derivative” of the outcomes on the first floor. A roll of the dice on the first floor that loses someone $100 may create tens of thousands of dollars of losses on the second floor (and if there is a third floor where people are placing even bigger bets on the outcomes on the second floor….)
I will argue that unsettled trades in the financial system bear the characteristics of such derivatives. However, they present a special kind of derivative. If you and I walk into the first floor casino and bet on whether the next roll of the dice is a 7 or not, no amount of betting on our part can affect the underlying event. Similarly, the underlying event will not be affect by any amount of betting by the people above us on the second floor (or by betting on them by people on the third floor).
Unsettled stock trades, however, can affect the underlying events upon which they are a bet. In fact, unsettled trades resulting from “the option market maker exception” are often the by-product of deliberate efforts to affect those underlying events. When an underlying event that someone deliberately affects is a stock price movement, it used to be called, “manipulation” (and was also called “illegal” until Wall Street captured the SEC, at which time it became known as, “a hedge fund business model”).
Because unsettled trades have this property of affecting the underlying events upon which they are a bet, they are derivative contracts with an especially nasty twist.
I tell you, that guy Buffett will go places.
PS Again, because I wish neither to imply support for or endorsement of my views, I am going to give one additional quote, without comment. In May, 2007 Messieurs Buffett and Munger were asked to comment on the issues I am raising here in Deep Capture. Mr. Munger’s response was as follows (page 6): “Those delays in delivering sometimes reflect tremendous slop in the clearance process. It is not good for a civilization to have huge slop. Sort of like how it isn’t good to have a lot of slop in nuclear power plants.”
Posted in 7) Unsettled Trades & Systemic Risk |
February 15th, 2008 at 7:33 am
As I watched the hearings yesterday, again I saw the DC practice of treating the syptom, not the disease. Each Senator, spare Senator Bennet, failed to demand answers how excess greed and leverage (convieniently under no regulation or oversight), got us to this point. More improtantly, none, spare Bennet, mentioned that it is STILL GOING ON. They got their 15 minutes on camera, again, spare Senator Bennet (hmmm), and played politics.
NO matter what side of the street you are on, except Wall Street of course, where is the outrage? $60 billion in bonuses, followed by $140 billion in write offs? Am I the only one having a hard time reconcilling this?
IMO, we are nowhere near the bottom of the barrel with subprime, and FTD’s appear to show that if you lift the barrel………..
Watching short sellers attack the insurers, and pick the bones of the carcas, would be funny if it were not so sad.
A friend of mine recently told me that we are all like a country dog in the city. If we stand still the pack will screw us, if we run, they will bite us in the azz.
February 15th, 2008 at 8:08 am
Get back to work, jackass. Your opinions aren’t worth squat.
February 15th, 2008 at 8:51 am
Ish,
Another reasoned response from the naysayers, I see.
I understand. You guys must be feeling a little sore these days.
Patrick
February 15th, 2008 at 10:29 am
If anyone has direct access to Warren Buffet, ask him one simple question. How would he like to be remembered? How great of a legacy would it be that he spent his fortune on cleaning up the American Market? It would be a lot better to do something truly constructive with his money instead of going around playing like the Easter Bunny leaving little nest eggs of cash at the front doors of charities. It sure would be nice to see someone who has an interest in doing the RIGHT THING with his fortune instead of waiting to pose for photo ops with the poster sized checks so that everyone can oooh and aahhh over how great and what a wonderful philanthropist they are.
Im sure he knows about this scandal ,but maybe he doesnt know how bad it has gotten over at the OTCBB and pink sheets.
Anybody have Buffet’s cell number?
Maybe Buffet knows D-Day is coming and he’s preparing to go shopping ..
February 15th, 2008 at 11:14 am
Great presentation Patrick.
It is the guy who exits the trenches who will go places. Buffet should be quoting you instead of the other way around.
Wise businessman, mean human being. Too busy pulling his own single seat oxcart an playing bridge with buddies trillionaires. Watch him closing in the carcasses of the demise. He’s a shame.
February 15th, 2008 at 8:19 pm
Why should Warren Buffet spend every last dime to bail out the morons that created this mess. First it would not work just like the FED efforts will not work. Second why don’t the jerks who created this mess give up their 60 billion in bonuses to repair their investment banks?
Patrick you are a fantastic person. It is soo great to se someone with balls and character to stand up to the jackels and tell them to go get screwed. Don’t give up many out here in investor land think of you as a someone who should be emulated.
February 15th, 2008 at 9:42 pm
Gentlemen,
At the risk of sounding presumptuous, Mr. Buffett is a friend of mine and one of my great teachers in life (and he says the same about Charlie Munger). I would appreciate that no more such comments be made (in fact, I would delete those that exist were it not my policy not to delete comments). I think Mr. Buffett has his reasons. Plus, I am sure he would be help if I ever asked, but I want to whup these folks without him. It’s a point-of-pride thing.
Besides, Mr. Munger’s quote is perfect.
Patrick
February 15th, 2008 at 10:12 pm
Buffett won’t, doesn’t want to, can’t because he has shareholders, shouldn’t, and has expressed why he can’t get uber-involved with politics.
Can you imagine what things would be like without the exemplar that is Buffett? Wall Street would be more of a cesspool.
Until one of you has contributed 1/1000th as much to society as he has, you might want to direct your attention to yourself.
February 18th, 2008 at 10:15 am
Dr. Byrne, you are my hero. I have been involved in this fight for four years. Many times I have thought of giving up. Every time I do, you appear. On tv, radio, a blog, somewhere. Almost out of nowhere. Every time, you reaffirm my commitment. You have so much to lose by taking on this issue, yet you persevere. If you can, I can and will persevere. Our country, our values, our entire system is at stake here. So I will follow you into battle, knowing we are on the side of right. And since it is Presidents Day, may I ask you to consider 2012? Now let’s all get after these criminals and make them BYRNE, BABY, BYRNE.
You rock Patrick
February 19th, 2008 at 6:03 am
In May of 2007 when I asked Warren and Charlie this Question about faliure to Delivers in our system Warren Answered it fair but Charlies answer was exactly the truth.
What did the media have to say about my question at the Berkshire Hathaway meeting?
There is one hedge fund manager and finacial blogger who went “Hog Wild” over it and had the following comments to say about Me and my question. Keep in mind before you read Jeff Matthews commentary that he was speaking of a blue collar Nebraska father of three who was asking about stealing and was dressed bussiness casual.
The following commentary is from Jeff Matthews and I often wonder if he felt a need to “make this up” to protect his friends and discredit others from ever speaking up about the crime of the century!
Below Jeff Matthews speaks………
“but now, at the Berkshire-Hathaway shareholder’s meeting, my own 28 year’s worth of experience is being put to the test by a serious, slightly breathless, man—the kind of guy you wouldn’t want to make eye contact with at Starbucks—who is asking a question as if:
1) He is about to expose the biggest scandal since Teapot Dome, and;
2) Government agents acting in cahoots with hedge funds and Byrne’s “Sith Lord” intend to cut off his microphone before he can spill the beans.
So there you have it………… With 25,000 people in the Qwest center Jeff Matthews looked acroos the arena and could tell I was the type of person that you wouldn’t want to make eye contact with at Starbucks!
March 5th, 2008 at 3:10 pm
Wall street is full of crooks. That is the way it has always been and the way it always will be. It is a system designed to take money away from the people/middle class, and put it into the pockets of the ultra-wealthy. The only way to win, is to NOT play the game.
March 6th, 2008 at 6:59 pm
Since there doesn’t appear to be a way to reach you directly, I’m posting in several places hoping to catch your attention.
The presentation is excellent, but you will get exponentially more attention for this topic if your video were on Google and/or YouTube.
I know I can personally generate at least 10,000 views and I would not be surprised if it were to go “viral.”
The intersection of Wall Street and “conspiracy” is of interest to a lot of people.
Interestingly, the most “viral” video I’ve been personally involved with (182,160 views in three months with just two very minimal promotions) was on a Wall Street topic.
The public is interested in this stuff and you’ve made your case quite clearly.
I’d like to help. Just put the video on one of those services, send me the address and we’ll throw viewers at it.
Best wishes.
March 11th, 2008 at 6:44 am
The natural world could cause financial collapse. One reason expectations of multiplying financial returns can fail systemically is continually diminishing physical returns in exploiting the earth. These take some effort to explain and to observe. The global economic efficiency of using energy to produce wealth is a good stand-in for a comprehensive measure adding that all up though. http://www.synapse9.com/issues/World-eff_grow.pdf We can also see diminishing returns (slowing rates of exploitation increase) in virtually all physical and intellectual resources, disappointment in their accelerating combined returns then seems quite inevitable. That would leave continual economic growth reliant on products and services that have no resource or energy content, and take no effort to make. The supply of those may be infinite, but the prices would be unstable….
March 13th, 2008 at 11:06 pm
Buffett may be the rich man but he is hidding the bad side dof himself. During 911 why was buffett and major stock market ceo’s at offutt afb waiting for bush to arrive. It was buffetts insurance companies that had interests in eerything that happened on 911 in ny. His company insured the twin towers even though he had a investigation of having it town down due to abesteos and corrosive acts to the frame of the building.
It seems bad very bad that america is being sold down the drain because someone owns a media outlet and uses it for their own actions.
March 23rd, 2008 at 7:48 am
buffet is just another clever predator. just like bill gates is a criminal monopolist, nothing more. private ownership of business is the only square deal. for example. Michelin tire company is and has been privately owned.
March 31st, 2008 at 1:37 pm
Excellent post Patrick! I just would like to add that somebody is benefiting from all this in a really unfair way, and that is because the FED gives an unjust monopoly/oligopoly of money creation to banks and the government. It is better explained in the book:
Creature of Jekyll Island
Edward Griffin
http://philologos.org/bpr/files/Misc_Studies/ms060.htm
I thing Ayn Rand’s quote fits very well in this post:
“When you see that trading is done, not by consent, but by compulsion - when you see that in order to produce, you need to obtain permission from men who produce nothing - when you see that money is flowing to those who deal, not in goods, but in favors - when you see that men get richer by graft and by pull than by work, and your laws don’t protect you against them, but protect them against you - when you see corruption being rewarded and honesty becoming a self-sacrifice - you may know that your society is doomed.”, Ayn Rand
April 4th, 2008 at 4:37 am
Stunning, absolutely stunning! I have been following the silver bullion market lately. I have been reading Jason Homell (silverstockreport.com) & Theodore Butler/James Cook (investmentrarities.com). The silver COMEX futures are naked shorted by only 4 or 8 entities to a degree that literally cannot be covered without a HUGE price/ounce rise. Recently there is a bit of a shortage of physical silver. It seems the stores of it have been “leased” and “loaned” several times over. The silver story is such a parallel to your stock market story that I felt that I was rereading my silver pubs while reading/listening to your “Deep Capture.” But here there is much money to be made by simply buying and taking delivery on actual physical silver (1 oz, 10 oz, 100 oz most common but there are of course 1000 oz bars also). If you don’t know of this, please at least look at it a little bit, I think you will thank me later. Aloha…J
April 4th, 2008 at 4:38 am
Sorry…that would be Jason Hommel….J
April 28th, 2008 at 9:17 am
Jay,
I would add that the metal stocks are actually sitting on an huge pile of shorts. This is crazy. They naked shorts that are leveraging naked future contracts. And they are successfull so far. Look at CDE: 61,893,265 shorts positions reported on April 15th. The volume of shorts has INCREASED during the recent Silver spot drop. The cartel short more to avoid a short covering. The players are probably the 4 houses that own 65% of Silver short positions on the COMEX.
This is litteraly like a mafia gang. 4 guys are manipulating the entire Silver market and their producers.
May 4th, 2008 at 3:26 am
Great article on leverage, but I have to disagree on M3. M3 has never measured funds in the “shadow banking system” (hedge funds, CDOs, SIVs etc etc etc) that has been so prevalent in the past few years. There have been vast sums of money created (via leverage) in shadow banking recently. Now there are equally vast sums of money being destroyed through losses - but of course M3 does not measure those either. So while the Fed continues to pump cash into the system, it is a drop in the ocean compared to the money that is being destroyed elsewhere. That is why deflation, not inflation, is the nightmare in our near future, and the govt/Fed are 100x more scared of deflation than inflation. Look at the Japan experience, or even 1929 - when a credit bubble bursts, deflation - not inflation - is the inevitable outcome.
May 7th, 2008 at 11:02 am
Patrick — what happens when a retail investor is the recipient of a dividend paying lot of phantom stock that was created by a naked short?
Would seem like somebody would need to cover and/or pay up, no?
May 20th, 2008 at 8:23 pm
So tell me nu, what’s with the bubble getting blown in US energy futures? It’s all going to happen there next OY VeY!!!
June 4th, 2008 at 10:37 am
Oh dear!
THE BEAR’S LAIR
Exploding innovations
By Martin Hutchinson
Eleven of the world’s largest investment banks have announced the creation of a clearing house, to open in September, for the US$62.3 trillion credit derivatives market. Since it has been patently obvious for several years that such an innovation was essential for the stability of the market, the news is welcome, if a little belated. However $62.3 trillion is real money, so the question arises: how did something so dangerous grow so big before efforts were made to control its risks?
Credit default swaps (CDS) and other credit derivatives were invented in the late 1980s, shortly after the interest rate and currency swap markets became substantial. Under a CDS, one
bank promises to pay another bank money if a particular debt obligation of a third party borrower defaults. The precise definition of “default”, the mechanism for calculating the amount of money payable and the extent to which the deal relates to general debts of the third party or to one particular obligation all vary between CDS, as do the maturity and amount. There is thus no easy mechanism whereby a liquid securities market could be created in CDS, since the differing terms of each transaction tend to make them un-substitutable.
The $62.3 trillion figure for the total principal amount of credit derivatives outstanding is to some extent a “scare” number. Nevertheless, the soothing explanations from market participants that suggest they are simply a mechanism to transfer credit risk to more capable hands come up against an awkward fact: the volume of credit derivatives outstanding is now a substantial multiple of the total volume of loans and bonds to which they relate, and that multiple shows every sign of increasing rather than diminishing. In this as in other derivatives markets, it is obvious that something more than mere “hedging” and risk transfer is occurring.
Comparisons with other markets are telling. The total volume of home mortgages outstanding in 2007 was about $12 trillion, while the total of life insurance in force was $20 trillion. Thus the entire insured population of the United States could be wiped out, and its entire housing stock fall down (a not unlikely contingency for the McMansion portion thereof) and still the losses to mortgage lenders and the insurance industry would be only about half the overall losses from a credit derivatives meltdown.
Proponents of credit derivatives will indignantly point out that the aggregate exposure in the credit derivatives market adds to zero, so that for every contract there is a winner and a loser. Either the debt pays when due, in which case the seller of credit protection gains, or it defaults, in which case the buyer gains. However that is also true of life insurance; either the assured party lives through the term of the insurance, in which case the insurance company wins, or he dies, in which case the assured party wins, or rather his heirs do.
In the insurance case, mass slaughter would wipe out the insurance industry, because the gainers would be individuals not insurance companies. However, that is also true for credit derivatives; the gains and losses are not confined to the “banking system” however that amorphous entity is defined, but are spread among insurance companies, hedge funds, investment institutions and well connected riff-raff. Even financial institutions may fail, as did Bear Stearns, for whom the network of credit derivatives obligations was so threatening that the Fed was compelled to step in and arrange a bailout. If the financial institutions don’t initially fail, their counterparties may fail in large numbers, plunging the system into disaster.
Little protection
At first sight, the contingent nature of credit derivative exposure appears to offer protection, but in practice it offers little. Although losses on credit derivatives only occur when an underlying loan defaults, and the modest hiccups of normal years can thus easily be absorbed, in a credit crunch such losses will be bunched. In such a situation the credit system is already under strain. If several underlying companies fail, financial institutions will be placed in a precarious position at a time when funding is hard to come by. Then a cascade effect would take place, with each default making other defaults more likely.
Thus, in a severe credit crisis, the potential losses on credit derivatives may indeed approach the same fraction of total exposure that the $1 trillion to $1.5 trillion of potential home mortgage losses bears to the $12 billion of home mortgages outstanding. The ultimate loss would then be not 10% of $12 trillion, but 10% of $62.3 trillion or $6.23 trillion, several times the capital base of the entire US banking system, more than the current total of Federal government debt outstanding and about 40% of a year’s US gross domestic product. That would make a credit derivatives crash far larger in monetary terms and somewhat larger in terms of the economy than the Japanese banking problems of the 1990s, which caused 13 years of recession in that country.
The new clearing house will help this situation, but only if most currently outstanding credit derivatives are transferred to it. The credit derivatives market is not something that might become a problem going forward; it is already a gigantic problem that needs to be addressed in terms of the business already done. In any case, the clearing house is not a panacea; in a truly deep credit disruption it would go under along with most market participants. If a company with $10 billion of debts fails, there may well be credit derivatives outstanding relating to its debt of $100 billion. Thus while a clearing house will solve the problem of the bankruptcy of an individual participant such as a hedge fund, it is only too likely to be overwhelmed by a systemic problem.
In the Bear Stearns case, the existence of a credit derivatives clearing house would have allowed Bear Stearns to be pushed into bankruptcy, and its counterparties would have been able to continue dealing with the clearing house instead of being subject to severe uncertainty. If credit conditions among Bear Stearns’ clientele remained satisfactory, that would have been the end of the matter; the clearing house would have borne any modest losses involved, less what it could recover from the corpse of Bear Stearns. However if after a clearing house-assisted Bear Stearns bankruptcy a substantial portion of credits underlying Bear Stearns’ credit derivatives fell into default, the clearing house would very probably follow Bear Stearns into collapse, precipitating an implosion of the entire $62.3 trillion market.
It is clear what has led to the tottering and bloated nature of the credit derivatives market: the perverse incentives of Wall Street. Senior traders are rewarded with “drop dead money” - amounts that enable them to leave the business at any time, financially secure for life, with only the distant threat of long-term imprisonment to deter them. Since the financial services industry also works excessive hours, allowing little time for reflection and intellectual stimulation, a high proportion of its inmates become possessed with a monomaniacal urge to accumulate the cherished “drop dead money”.
The obvious way to do this is to find some product area in which profits can be accumulated with great rapidity in the short term albeit with the risk of enormous losses in the long term. Complex and poorly understood products, for which the accounting can be rigged to maximize current profits and push losses into the future, are particularly attractive. Credit derivatives, for which the appropriate accrual of reserves against loss is little if at all understood, have provided an ideally attractive field of endeavor for such machinations.
Once the credit derivatives problem is defined in this way, there is an obvious historical analogy: the life insurance market. Like credit derivatives, life insurance provides cash flow in the form of premiums in its early years, while losses in the form of deaths occur only later, often decades later. Like credit derivatives, the proper reserving for such losses was initially poorly understood, so life insurance companies with aggressive salesmen and low premiums could record excellent profits, and raise additional capital on the basis of those profits.
The tsunami of new business and apparent surge in profitability enabled rewards to be paid to such companies’ proprietors, who were thus acting economically rationally in the same way as today’s credit derivatives traders.
Bubbles galore
The first large insurance bubble occurred over the generation leading up to the South Sea crash of 1720, after which almost all existing insurance companies went under. Similar bubbles occurred in New York and other US jurisdictions throughout the nineteenth century. Gradually it became obvious that life insurance companies should not be allowed to scam investors and policyholders in this way, and regulations were introduced, the first by the Life Assurance Act of 1774, to ensure the actuarial soundness of insurance companies and prevent their looting by proprietors.
The analogy between the credit derivatives market and pre-1720 life insurance is a close one, even if it is difficult to imagine credit derivatives traders taking to periwigs and snuff and decamping to Antwerp rather than Brazil when things go wrong. It also suggests a solution to the problem: the Fed can make itself useful by regulating the market tightly, in particular by requiring the establishment of large reserves against each credit derivatives transaction, to be held in escrow and not paid out until the credit concerned has been repaid. Naturally, this will cramp the future growth of the credit derivatives market, but on balance that can only be a blessing.
Preventing future such casinos from growing to a size that endangers the entire financial system is more difficult. Part of the solution will come from much tighter money, reducing the immense pools of leveraged speculative capital that have disfigured the global economy in the last decade. Part of it could probably be achieved by tighter regulation of Wall Street’s compensation schemes. While government regulation of earnings is in principle unattractive, it would certainly make sense for both overall caps and limitations on short term profit-related payouts to be introduced for institutions that were deemed “too big to fail” and thus ultimately risks on the taxpayer.
Such restrictions would have the salutary effect of driving the best talent away from very large institutions and towards medium-sized ones, whether hedge funds or “merchant banks”. That in turn would ensue that new innovations remained of moderate size while their long-term viability remained untested, since counterparties would not risk gigantic potential liabilities against houses of only moderate size. If the new houses could be constructed as partnerships, so managers had primarily their own money at risk, so much the better.
Even in the financial services industry, innovation is welcome. Nevertheless, the perverse incentives of today’s Wall Street and the implicit state guarantee of the largest houses have together combine to produce in the credit derivatives market a nexus of liabilities that serves little comprehensible economic purpose and would wreck the global economy if it collapsed. Free markets are economically optimal, but partially free markets, with endless creation of fiat money and implicit government guarantees of the big boys, can produce perverse and dangerous results.
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found at http://www.greatconservatives.com.
(Republished with permission from PrudentBear.com. Copyright 2005-07 David W Tice & Associates.)
June 4th, 2008 at 1:47 pm
Alarming stuff@