Ingolf on CDSs as “zero sum” games.

ArrowRight Apologies to Cieran, Arun and ISL for using a term (zero sum) which I guess is a kind of financial markets shorthand.

Used in this sense, it's meant literally. Each of the parties to a credit default swap in effect enters into a bet. To the extent that one wins the other will lose. Equally, if one counterparty is unable, for whatever reason, to honour its obligation the other party will, to the same extent, fail to attain its desired ends (unless of course someone — like the taxpayer — is found to stand in for the defaulting party). It is in that sense an artificial construct, being neither a real asset, money or credit.

If anything, it's more akin to a bet placed on a horse, where the punter is equivalent to the buyer of a CDS and the bookie to the seller. It can also of course be compared to an insurance contract, although the principal players were particularly eager to ensure it wasn't classified as such since this would have brought them under an entirely different (and much stricter) regulatory regime. One of their fatal flaws (as David Habakkuk notes) is that they weren't traded on a regulated exchange and thereby marked to market, margined and cleared on a daily basis.

I'd assumed it would be clear from my comment that I wasn't suggesting they aren't both very real and potentially exceptionally dangerous (Buffet wasn't wrong when he dubbed them "financial weapons of mass destruction"). Their astonishing proliferation, complexity and opaqueness, and the degree to which they have become embedded in the financial system like a long and unstable daisychain is a scandal. And, as Cieran notes, now that the taxpayer has been saddled with the obligations resulting from AIG's failure, the damage has spread well beyond the contracting parties.  Ingolf

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34 Responses to Ingolf on CDSs as “zero sum” games.

  1. Harper says:

    Yes, and then some. Taxpayers have bailed out AIG to the tune of about $140 billion, largely because of AIG’s pivotal role in the credit default swap market. This is, in effect, insurance policies against the derivatives bubble blowing out. When it blew, AIG was caught holding the bag. Imagine if you could go to Las Vegas and take out insurance against gambling losses. If you win, you keep your winnings. If you lose, an insurance company picks up your losses, as a modest fee to you. How sick is that?
    Global derivatives contracts nominal value, according to BIS date, was $675 trillion as of June 2008, but the actual figure is probably over one quadrillion dollars, since record keeping is spotty.
    This bubble has burst and it can’t be bailed out, without creating the biggest hyperinflationary crisis in history. Bankruptcy reorganization is the only recourse.

  2. JohnH says:

    The question I haven’t seen posed is the following: why shouldn’t the government refuse to honor all CDS claims against AIG where the claimant can show no actual stake in the underlying asset? If a homeowner and many others have insured against the homeowner’s house burning down, why honor the claims of any but the homeowner? It is only the homeowner who had a justifiable, financial reason for insuring the house. The others were in it merely for speculation.
    To get out of this heap of garbage, we’re going to have to separate the wheat from the chaff. Let’s toss it all these claims up into the wind and see which of the claims have substance behind them.
    Why isn’t this being discussed?

  3. curious says:

    Ukraine is in severe danger defaulting. (a lot of european banks are tied to eastern european loans)
    The default will trigger huge number of CDS pay out. (things that the european can’t afford.)
    the Ukrainian government might have to implicitly assume the liabilities of the corporate sector. Sovereign external debt is US$15bn, in addition to US$42bn owed by banks and US$44bn taken out by corporates nearly half of which is due in 2009. Global Insight estimates Ukraine’s total external debt obligations in 2009 are US$57 billion, including debt amortization, short term debt equaling US$51 billion. The bulk share of these debt obligations will be rolled-over since most of the debt is related to lending between foreign parent banks and local subsidiaries.However if parent banks rescind their lines of credit as they could do under their own financial stress, this could sharply boost the Ukraine’s vulnerabilities. The IMF estimates a financing gap of US$10bn in 2009, mainly on the corporate debt side.
    Aggressive lending by banks was financed by heavy borrowing abroad, contributing to Ukraine’s ballooning private sector external debt. As in Eastern, Europe, Western European banks are most exposed – Austrian, French, Swedish, Italian and German banks have a collective exposure of around EUR 30 billion to the Ukraine. Speculation is rift of a looming Ukraine default so much so that spreads on credit default swaps (CDS), a form of insurance against default, have risen from around 400 basis points in August 2008 to over 3,500 today. According to Bloomberg, spreads at the current level imply a 69.6% chance of default in two years and a 91.8% chance in five years. Some analysts believe that Ukraine will be able to repay the debt by borrowing from multilateral lenders. Russia which recently cut off gas supplies in a pricing and repayment dispute has offered a $5bln loan however the political cost of this loan for Ukraine might be far greater than the conditions put forth by the IMF. Despite the vulnerabilities, a sovereign default seems unlikely yet the government’s contingent liabilities are rising. And surely the Ukraine will have to pay a lot more for its financing than it has done in the past.

  4. MRW. says:

    The question I haven’t seen posed is the following: why shouldn’t the government refuse to honor all CDS claims against AIG where the claimant can show no actual stake in the underlying asset?
    Oh, it’s been asked. But that isn’t the nature of these babies. The ‘insurance’ fees collected by the CDS seller are not enough to cover the value of the underlying asset. That’s how this scheme worked with these Peter Pans of Profit.
    The CDS seller charged a small percentage of the asset value; he made his killing with the multiples of it that he sold. If you take away the multiples, the pure raw gambling, it’s probably instant bankruptcy for the CDS guy. Since the CDS trader sat inside outfits like Goldman Sachs, the parent firms are fighting this tooth and nail. Why do you think they became bank holding companies overnight?
    The fact that Greenspan and Rubin refused to allow, actually fought against, even basic reporting on these transaction makes them economic terrorists who endangered the USA. Or more plainly: crooks.

  5. Patrick Lang says:

    Now, this is really getting interesting. The “gravity well”/ “black hole” analogy seems more apt all the time. Maybe this will sublimate into a “wormhole” and we will all emerge on the other side of the membrane.
    Seriously, (sort of) my wife points out the intriguing similarity between these layercakes of multiple CDS sales and the scheme in “The Producers” through which the producers sell thousands of percentage points worth of stock in the show “Springtime for Hitler” to a horde of rich little old ladies. pl

  6. Cieran says:

    I have no problem with the term “zero-sum game”. In fact, most of my professional life is based on such games as applied to the material world, though in my field, they’re called “conservation laws”, and we deploy them on things like linear momentum instead of on the supply of money involved in a market transaction.
    But I am not at all convinced that the CDS market is in fact a zero-sum game in actual practice, because it’s not clear that money is being conserved on any meaningful scale, e.g., fees and bonuses lead to small-scale deviations from conservation, while outright fraud provides the potential for violations of this idealization on a much larger scale.
    And there is plenty of evidence emerging daily that fraud is not the exception to the rule in many markets, but the rule itself.
    A market transaction is an agreement (hopefully informed, but that’s not a requirement) between two parties, and CDS transactions meet that criterion for definition. But the taxpayer was not a party (in any direct sense) to those transactions, and such “externalities” violate the idealization of the zero-sum game, and render it meaningless in practical terms.
    This problem with elementary market theories has been known forever… but fixing this hole in economic “science” just doesn’t lead to simple idealizations, and economists (both practicing and theoretical) generally eschew more complex theories that work well, in favor of oversimplified models that don’t work, or at least, don’t work when you need them most.
    Like now.
    Exhibit A here would be Black-Scholes, which begins with simplifications that are patently ridiculous, but that leads to elegant theories that are easy to program, easy to apply, and are currently proving fatal to the body economic and perhaps even the body politic.
    The use of physics-based models in economics has now been proven by to be a painful joke. And thus the solution to our current economic woes is not to deploy even more simple-minded models (including zero-sum games, but certainly not limited to them), but instead to follow the approach that our good host suggests for understanding any aspect of the world around us, namely paying due attention to epistemological principles in an uncertain world.
    In physics (which is where the quants hailed from), this epistemological approach led to the science now known as thermodynamics. Developing an analogous set of robust economic theories will take considerable time (assuming it’s possible), but rest assured that over-idealization will not provide the path to that set of new economic understandings.
    Just $0.02 worth from a professional zero-sum gamer…

  7. JohnH says:

    MRW–So let’s see if I can take what MRW said a step further: the government should refuse to have AIG honor more than one claim against any asset. The one who could prove actual ownership of the asset would be the only one reimbursed for any losses.
    Or is the problem that AIG was only one of many “insurance” firms who covered the bets at Goldman? Given the enormity of AIG’s losses, it seems to me that AIG must also have sold multiples on the same asset.
    In any case, whoever pays to cover the bet, should get ownership of the underlying asset as a sine non qua. If the “insured” can’t deliver the asset, there should be no obligation on the part of the “insurer.”

  8. b says:

    McClatchey: Regulatory reports show 5 biggest banks face huge losses

    Citibank, Bank of America, HSBC Bank USA, Wells Fargo Bank and J.P. Morgan Chase reported that their “current” net loss risks from derivatives — insurance-like bets tied to a loan or other underlying asset — surged to $587 billion as of Dec. 31. Buried in end-of-the-year regulatory reports that McClatchy has reviewed, the figures reflect a jump of 49 percent in just 90 days.

    The above does not include AIG and there will be more to come anyway …
    If the U.S. taxpayer eats all the losses, the U.S. is bankrupt. Better to close down the banks? Not sure – the pension funds would loose lots of money.
    Again my solution: Declare All Credit Default Swaps Null And Void

    At the same time:
    * all financial exchanges and markets of the world close for a week
    * CDS are declared null and void and new CDS creation is forbidden until new regulation is in place
    * the publicly dealt financial entities have seven days to figure out and publicly restate the value of their liabilities and assets excluding all CDS
    * a onetime windfall tax will be created that socializes overt advantages some entities will have from this
    * the proceed of that tax shall be used to prop up the capital of the big losers in a program comparable to the Reconstruction Finance Corporation of 1932.

  9. If war is too important to be left to the Generals perhaps economics and finance are too important to be left to the economists and financiers. What worries me is that US is sending plainly wrong signals world wide that the system of globalization we created is going to be allowed to shatter starting with trade! Of course I could be wrong.

  10. par4 says:

    Thank Phil Gramm

  11. jedermann says:

    I am curious as to why there is such a huge volume of money placed on wagers that other people’s houses will burn down. What do these “investments” look like on the balance sheets of those who made them? These were, in effect, side bets that the worst was going to happen on transactions in which they had no primary interest themselves and that were being treated in the market as low-risk. If the system was functioning normally (and that appeared to be the case at the time) there would have been very little chance that these bets would ever pay off. How were these flyers justified to the governance mechanisms of the entities that made them? Knowing what or who these entities are and what their rationales were for making these bets in the first place might be a very interesting avenue of inquiry.

  12. wcw says:

    Let’s try again.
    Take a poker game among friends. It is a zero-sum game: players win or lose, but the game always ends net $0. Take a poker game with a beer run. It is a negative-sum game, since the game ends net negative the cost of the booze. Take a poker game with a sucker. It is a positive-sum game, since the game as a whole ends up the amount of his losses.
    The CDS market is a poker game. It will net to $0, there are no beer runs, and there is no limitless pool of potential suckers. Full stop. Throwing around ginormous notional sums is a scare tactic, generally started by oft-partisan cynics who understand these markets, then repeated by sincere folks who don’t.
    Just as in a poker game, participants do not trust one another. If you want to bet, you have to buy chips — post collateral. The problem with AIG is that participants did trust it and its AAA rating (don’t get me started on the NSROs — if you want a horse to flog, try them, not CDSs). This gave AIG a giant competitive advantage, since it didn’t burn cash playing the game and since its size allowed it to place much larger bets than anyone else. While the poker analogy is strained here, imagine how often you would try to bluff the one player you allow to borrow limitless chips. The game breaks down, at least a little. CDS markets were OTC and unregulated, so there was no party that could solve the collective action problem.
    The CDS market is not something you want to delete, it is something you want to preserve and regulate. It spreads risk from the buyer of protection to the seller, and allowing market participants to spread risk is a positive externality. It enables participants to create synthetic bonds, making liquidity in what is otherwise an innately illiquid bond market, another positive externality. Liquidity creates better price signals, another positive externality. Positive externalities, however small, are good things.
    The useful questions are not “how huge are notional derivatives totals,” but “what are the systemic risks of creating these positive externalities?” It is a regulatory problem. Put up a post asking about the risks and potential solutions to the existence of a CDS market, and I can respond there. Keep putting up posts about a $30T CDS “hole” when it is $0, or implying CDSs are anything other than zero-sum, and I’ll have to focus on swatting the usual uninformed scaremongering.

  13. zanzibar says:

    What we have is the rationale of “systemic collapse” for taxpayers to fund involuntarily Goldman Sachs, JP Morgan, Deutsche Bank and others “wins” on CDS bets that they made with AIG. This ultimate fear campaign has been used to provide over $11 trillion in taxpayer guarantees to Wall Street so far – nearly the size of our GDP. There’s some similarity to the “mushroom cloud” rationale that was used to gin up the invasion and occupation of Iraq. A false pretense used to loot working Americans for the benefit of the few – the well connected financial and political elites.
    As Cieran points out this is no longer a “zero sum” game since the taxpayer backstop makes it a game where as long as you do it in size there is no downside. All futures contracts are zero sum games – when traded on an exchange force the losing party to continually top up margin accounts. In the case of CDS the Greenspan/Rubin/Summers triumvirate knocked down Brooksley Born CFTC chair who warned about the dangers of unsupervised over the counter derivative contracts with no collateral requirements and pushed for standardized contracts traded on exchanges. Now we have created a precedent where politically powerful entities can engage freely in leveraged speculation and take home the winnings and if they lose taxpayer holds the bag. The Greenspan put has been expanded by orders of magnitude by the Paulson/Geithner/Summers/Bernanke put.
    A perverse consequence is that as CDS spreads widen it forces CDS sellers to short the equity to partially hedge their exposure further amplifying the pressure. Since there is no transparency no one knows what the netted positions are for each of the “systemically important” banks. In addition Enron-style accounting with off-balance sheet special purpose vehicles have been embraced by the large banks including our Fed. It sure would be interesting for the taxpayer to know what is in the Maiden Lane I, II & III SPVs.
    What I find interesting is that most of the discussion is around economics and its failure with debates around dogmas of free-enterprise vs regulated markets and other such distractions when the reality is that politics and cronyism is at the root. The problem is as much Washington DC as Wall Street. The Obama administration’s continued looting of working Americans may provide short term support to the asset markets but it will not restore confidence. Just like Iraq at some point the American people will realize they have been scammed by their government and political leaders and they will not be happy. Will it lead to just increased cynicism or will the anger lead to demands to hold the elites to account?

  14. Marcus says:

    This will be a huge disgrace of the Obama Administration if he doesn’t stop backing the losses of these CDS players with tax payer money.
    This brings back memories of the selling of the Iraq war using Armageddon scare tactics.
    “The whole financial system will collapse if we let AIG fail.”
    I’d rather the Ponzi financial system collapse than the government bond system collapse, which is what we are risking with these bailouts.

  15. Patrick Lang says:

    Well, it’s my poker game so you wil have to put up with THIS “uninformed scaremonger.”
    I think your description of the CDS device as “zero-sum” is valid when the only “players” are the seller and the buyer. Anyone can see that in that deal someone wins and someone loses. 0=0. That is not the case when there are other players in the game who are forced to keep paying off on the losers failed bets. AIG’s CDS liability is unclear but to the extent that TARP money (even as a fungible commodity) is used to pay off AIG’s CDS losses in excess of AIG’s non-TARP capability to pay, then this is NOT a zero-sum game.
    Cieran is right. Epistemology, like dogs, rules. If you can’t describe how you know something in words, the natural means of human communication, then there is something wrong with your concept, or your mind.
    Physics and math models for human behavior, including market models are worse than worthless. they are inherently deceptive. That is Naseem Taleb’s real message.
    I thought that nonsense about the “gravity well,” the “black hole,” and the “membrane” was funny, but no one called me on it. pl

  16. Cieran says:

    Keep putting up posts about a $30T CDS “hole” when it is $0, or implying CDSs are anything other than zero-sum, and I’ll have to focus on swatting the usual uninformed scaremongering.
    I think your last sentence has it exactly backwards…
    Try instead a focus on engaging with the unusually-well-informed discourse on this site, e.g., reading without prejudice what is actually written here. I think you might soon discover that most of us don’t need inapt analogies like “poker game and beer runs” to understand market transactions. Zero-sum games are not exactly rocket science, ok?
    Personally, I would prefer to see from you something a tad more tangible in support of your suggestions than “reasoning by analogy” and “proof by assertion”. Rest assured that the readership of this site can handle the math, if you would just be so kind as to bring it.

  17. Cieran says:

    I thought that nonsense about the “gravity well,” the “black hole,” and the “membrane” was funny, but no one called me on it.
    Nonsense? Heck, I thought it was just your way of moving your interest in astronomy from the Athenaeum over to this side of the website!

  18. John Howley says:

    The NYT did well in their editorial last week:
    The A.I.G. bailouts fail the basic test of transparency: Who ends up with the money? Major financial institutions are not innocent victims of A.I.G.’s demise. They are sophisticated investors, and they should have known the risks being taken — and who profited mightily from the relationship before it all came crashing down.
    Whoever the recipients are, they should be investigated for their roles in the crash and, to the extent possible, be made to pay for the bailouts.
    The serial A.I.G. bailouts are especially problematic for their connection to the Wall Street bank Goldman Sachs.
    [There’s more.]

  19. hjmler says:

    perhaps just a quibble, but the buyers of CDS’s do see this as a 0-sum game to the extent they can collect via various bailouts – take the money and run… and in addition, during the life of the game, many of the “assets” [e.g., CDO’s] were created and put into play by Citi, Goldman et al who collected fees at every step and likely banked these proceeds in, shall we say, indisclosed and undiscoverable locations.

  20. DaveGood says:

    As I understand it Credit Default Swaps were supposed to ” Work” as in the simplified example I give below. ( Feel free to correct me if I’m wrong).
    Let’s say Chrysler took out a loan of 2 billion with Bank of America in 2007, repayable in 2009.
    Simultaneously Bank of America, arranged “Insurance”, for a fee with Llyods of London, that if Chrysler could not repay the loan, the Lloyds would cough up the 2 Billion.
    This “insurance” is known as the Credit Default Swap or CDS… so far so good, everyone involved has “Skin in the Game” it sounds like normal prudent business practise and all the parties involved would have had a stake in ensuring that Chrysler were able to repay it’s loan.
    However, anyone can take out a Credit default Default Swap on anyone else using any financial entity willing to accept the fee.
    So literally hundreds of hedge funds etc can now, for a small fee place a CDS on Chrysler, with any financial entity ( pension funds etc) that can be persuaded to accept it that Chrysler will be unable to repay the two billion to Bank of America it’s 2 Billion by 2009.
    Now hundreds of financial organistaions stand to make immense profits if only Chrysler can be made to fail, and hundreds of billions are at stake.
    When hundreds of billions can be made by forcing good profitable companies to fail, ways will be found to make good , profitable companies fail.

  21. Mad Dogs says:

    “I thought that nonsense about the “gravity well,” the “black hole,” and the “membrane” was funny, but no one called me on it.”
    My giggling evidently disabled my ability to type. *g*
    And OT, it seems the Israel-First lobby scores again: Freeman speaks out on his exit
    The whole thing is an excellent read!
    Freeman pulls no punches as he exits, and though The Villagers won’t deign to notice (it’s not kosher, doncha know?), I applaud Freeman’s statement for speaking “truth to power” even when power refuses to listen.
    So I guess the score is now 647 kazillion to Zero.
    I wonder when, if ever again, the United States Foreign Policy interests will by decided by those who have the United States’ interests foremost at heart?
    Guess none of us are holding our breath.

  22. Marcus says:

    WCW “…or implying CDSs are anything other than zero-sum, and I’ll have to focus on swatting the usual uninformed scaremongering.”
    Too simplistic an analogy there.
    You forgot to mention that, in the CDS game, people outside the poker game are betting against the players, not the sum the players wagering (the value of the assets) but vast multiples of those assets, and that the people taking those bets made billions of dollars in trading commissions.
    This is not “zero sum”. This is Goldman Sachs et al making billions of dollars in fees and getting “too large to fail” placing bets in a financial casino, with the taxpayer being played as the bag holder.

  23. Ingolf says:

    Let me first try (please?) to put one small matter to bed.
    “Zero-sum”, as both wcw and I have tried to explain, has (in this context) a narrow, literal, specific meaning. It’s unfortunate that its use seems to have fostered confusion rather than clarity. It’s not a “model” (for which I tend to share the Colonel’s and Cieran’s disdain), nor was its use intended to whitewash the OTC derivatives market. I can’t speak for wcw, but in my case I used it with the intent of simply illustrating (that worked well, didn’t it?) that these derivatives are fundamentally different from most more conventional asset and securities markets.
    Anyway, back to the main matter.
    I don’t think there’s anything inherently wrong with a credit default swap (or, for that matter, with most other derivatives). They can, as wcw says, serve a useful function. The principal problems with the CDS market (and other OTC derivatives), as I see it, are threefold:
    1. The trading took place over-the-counter (OTC). Most dealers preferred this since it meant they usually had much more information about the state of the market than their customers and could make larger margins. I’d imagine it also meant all but the largest clients tended to be locked into their dealer for future trades.
    2. Trades were not centrally cleared and monitored. This, in my view, was the fatal error. Had this been required from the start few, if any, of the existing problems would have arisen. To begin with, contracts would have been far more standardised in order to be traded on an exchange. As it stands, because of the vast numbers of individualised contracts and bilateral deals, there’s no easy way to match out (that is, close) potentially offsetting trades. Hence hundreds of thousands (or more likely many millions) of these trades remain open even though in many cases the total of contracts held by individual participants may well to the large degree offset each other. The gigantic national numbers are, I suspect, far more a reflection of this unfortunate reality than of actual net exposure (although that’s no doubt more than large enough). Trouble is, because there’s no central clearing, nobody really knows.
    It also meant trades were not marked to market on a daily basis and so large liabilities could easily accumulate on the sly, so to speak. Finally, because it was all done bilaterally, the question of whether collateral was required, and the degree to which it was strictly monitored and maintained, was a matter for individual negotiation. More often than not, I suspect it was either not done at all or not done well. By way of contrast, on all cleared exchanges participants are forced to post margin (collateral) each day when their positions move against them by more than a certain amount. If they don’t, their positions are mandatorily closed out.
    3. There was no meaningful regulation. As David Habbabuk (and others) have noted, efforts to bring OTC derivatives under an appropriate regulatory regime were stymied.
    The net result is an immensely complex, interrelated, opaque mess which because of these very qualities now inspires fear and loathing throughout the markets. Like many on this thread, I don’t think the government should be making counterparties to these transactions whole. If someone can’t pay off their side of these bets, too bad. Caveat emptor. To the extent that counterparty failure threatens an institution that is seen as critical, then that problem can be dealt with as a separate matter.
    I do think (as with the selling of the Iraq war and the initial emergency TARP funding late last year) that interested parties are using fear as a weapon. Trouble is, everybody in charge seems so discombobulated that they cave in pretty much every time. I’m not quite sure what, if anything, is likely to change this unfortunate state of affairs.
    AIG, as wcw pointed out, was a bit of a special case. Its AAA rating (and unlike some other players in this game, like the monoline insurers, its rating was probably deserved) gave it a unique capacity to sell credit default swaps. Counterparties were happy, indeed delighted, to deal with them. To the small group at AIG who decided to embark on this new line of business, by all accounts it seemed like money for old rope. They (like, to be fair, most of the world) viewed the likelihood of having to pay out on any of these contracts as effectively nil. And so they wrote some, and liked the premiums that came in the door, and wrote some more. And so on. No doubt the (very large) incentives paid to the team in charge acted as a powerful spur. So many of the disasters of recent years can at least in part be traced to inappropriate incentive structures.
    When the risk they had blithely taken on suddenly started to feel real a few years ago, it was of course far too late. They were on the hook and there was certainly no one they could buy equivalent reinsurance from. When the losses began to mount (and the market became more aware of their exposure), their rating was downgraded and they were suddenly forced to post much more collateral. From that point on the downward spiral was inevitable. A huge and venerable firm with over a trillion in assets and more than 100,000 staff around the world was brought down by a small team of a few hundred operating out of London. A metaphor for our times, perhaps.
    Hundreds of banks, corporations, investment banks, hedge funds and others had bought CDS protection from AIG. The identity of some of the larger ones (like Goldman Sachs and Deutsche Bank) has now, as of last Friday’s WSJ article, become public knowledge. As has been mentioned by others here, there have for some time been rumours that last September the government stepped in to bail out AIG as much to protect a few favoured parties as to allay systemic risk. I obviously don’t know the truth of this matter but given how things have unfolded so far, it can hardly be ruled out.
    One thing’s for sure; despite the government owning something like 80% of AIG since late last year, they (that is, the taxpayers) have been played like a sucker ever since. Yves Smith at Naked Capitalism has (rightly) been more or less continually exercised about it all for months. The arrangement keeps getting renegotiated, a fresh tranche of some billions is hurriedly shovelled across, and then it changes again.
    Not a pretty picture.

  24. curious says:

    Timothy Geithner with charlie Ross. (including conversation about bad asset. )
    my reaction: the ‘confidence game’ emphasize will only go so far. People want to see number not generalized explanation. (eg. what is the size of bad asset, what is the result of stress test.)

  25. Ken Roberts says:

    One thing the financial system needs is some friction on transactions. Comms and paperless transactions has led to financial segment becoming too large vs tangible segment of economy.
    For instance, a Tobin tax, small fee paid on all contracts entered into, eg 0.1 pct of gross amount. Adjust amount to introduce desired friction, target is for gross financial transactions to be no more than some multiple (5x?) of tangible assets.
    How to institute? Simple. If tax has not been prepaid to a jurisdiction within X days of entering into contract, then contract is not enforceable in courts of that jurisdiction. No need to have huge new govt agency to inspect/enforce. Let the lawyers do the work, and financial firms do the paying.

  26. wcw says:

    wpl, love the scaremonger, hate the scaremongering. The net is still $0, but we taxpayers have decided to bail out a busted player. Per the 10-K, we are on the hook for a maximum of around $0.3T of AIG-branded CDS liability. That’s a lot of money, true, but it is roughly one-third what Afghanistan/Iraq have cost all-in. Let’s keep some perspective.
    Cieran, two of the first three comments here refer to gigantic notional totals as if they have meaning here. I swat what I see, and that’s what I saw. As for rocket science (my degree’s in math, so I suppose I fall short, too), I skimmed the 10-K and commented on the ‘hole’ post with some basic details of the AIG CDS liability. See above; it’s just not very big.
    Marcus, nobody is outside the game. I probably would have made GS eat the counterparty risk. I also would have nationalized any insolvent institution along the way. Even loony leftists like me find a banking sector necessary. Since we haven’t built the new society in the shell of the old yet, we have to make do with what we have.

  27. Ken Roberts says:

    About 2000 when Berkshire Hathaway decided to unwind their derivatives trading business, a total notional amount of $500 billion was extant, I believe. So to hear that AIG’s exposure is only $300 billion does not sound correct. Haven’t delved into AIG filings, have more interesting fiction to read, but just don’t think it can be only $300 billion exposure is correct.

  28. jedermann says:

    Does anyone have any answers as to why entities were placing bets that someone else’s tranactions would be defaulted on when the chances of that happening were rated very low? Was this the equivalent of blowing a few extra bucks on a 100-1 nag on the off chance that all the other horses in the race would break down? What was the rationale for placing these side bets?
    If the notional value of AIG’s liability includes the nominal value of these side bets, how can a failure to pay off at full value on bets that cost the side betters very little be said to threaten the viability of those bettors? How much can you leverage the payoff on a 100-1 wager? I would tend to agree with those who limit the real negative impact to the system of AIG’s liability to the value of assets insured by actual parties to the transaction that is the subject of the CDS. Everyone else has relatively little downside and they are making lots of noise with the right people to protect enormous upsides at taxpayer expense.

  29. Cieran says:

    Thanks for the comments. Good to see another mathematician on the site. Just a couple comments, tho, that might help get to the source of any disconnects.
    First, about idealizations… consider this statement of yours:
    The CDS market is not something you want to delete, it is something you want to preserve and regulate. It spreads risk from the buyer of protection to the seller, and allowing market participants to spread risk is a positive externality.
    The idealization is that spreading risk is a good thing. And generally, it is. That is, it’s a good thing for markets until it stops being a good thing for markets, and that’s where we are now.
    Market idealizations that work well most of the time and then fail spectacularly the rest of the time are just bad idealizations, period. If the idealizations used by (for example) aerospace engineers worked like this, then periodically, large fractions of the airplane fleet would fall out of the sky, but they don’t.
    They don’t because all real branches of engineering involve long-standing codes of ethics that begin with teaching the most elementary students not to put blind trust in their idealizations. Epistemology is the lifeblood of good engineering practice, and what we are seeing now on Wall Street is why the term “Financial Engineering” is a misnomer. It’s little more than an attempt to misappropriate the mantle of a conservative profession to a new field of human endeavor that has yet proved neither conservative nor professional.
    Market idealizations that exist currently (e.g., various theories of the stability of equilibria) might patch up some of these problems, but until they are validated under real-world conditions, they aren’t much use. I will note that Taleb’s fund is supposedly still making money, so my guess is that his theories will prove useful, but only time will tell.
    Finally, about this:
    The net is still $0, but we taxpayers have decided to bail out a busted player.
    That is simply not true, and therein lies much of the problem. The U.S. taxpayer has decided no such thing: their elected representatives have done so instead without due consultation with the public, and the electoral price to be paid may yet prove to be substantial… hence my earlier comment about torches and pitchforks.

  30. zanzibar says:

    Although I don’t agree with Jim Rogers on many issues I think he is spot on in this letter responding to a FT editorial.

  31. zanzibar says:

    The Feds Flow of Funds report was released yesterday and the total debt/GDP has increased further to around 370%. And this does not take into account the additional borrowings of the Obama administration to finance the trillion dollar deficits and the multi-trillion bailouts of banks and hedge funds like AIG, Fannie & Freddie.
    No wonder Chinese premier Wen Jiabao is concerned considering they are one of our largest creditors.
    “We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets. Frankly speaking, I do have some worries,”
    My message to Premier Wen is that he does not have to worry about being paid since Dr. Bernanke has the printing press which no doubt will be working 24/7. My advise to the Premier however would be to trade the paper for strategic resources posthaste.

  32. Ingolf says:

    Zanzibar, second your comment on Roger’s letter. The structural issue he raises is the elephant in the room that nobody seems to want to acknowledge, much less talk about.
    Cieran, I take your point about idealisations but I wonder if that’s really the issue here. A great many people understood that the CDS market, as constructed, was destined to not only fail, but to create huge problems in doing so. My take as to why was laid out in the earlier comment. By way of contrast, so far at least (famous last words) no exchange traded and cleared derivatives market has thrown up the least problem. Indeed, one could argue they’ve been “the dog that didn’t bark”.

  33. curious says:

    There goes europe. Merkel is showing off her move. She is bailing out eastern europe using her own strategy.
    So basically, Obama’s foreign policy gets a thumbs down across the board. Everybody mumbles something and says “whatever” and do their own thing.
    He better watch the steering wheel, minding his foreign policy team or the entire thing will isolate the country as global recession sinks deeper.
    Frankly, I think Biden is overated. And hillary doesn’t know jack about global diplomacy. Her neocon lite/neoliberal opening gambit was not a smart move. Both of them looks like cheap DC politics on global stage.
    Forget Nicolas Sarkozy. Ignore Gordon Brown. Angela Merkel, taking advantage of Germany’s economic heft, is now the European Union’s dominant figure. And leaders from Warsaw to Washington had best not forget it.
    Just as the German chancellor vetoed a bailout for eastern Europe on March 1, she is now leading European opposition to U.S. President Barack Obama’s call for a global pump-priming package. She’ll determine the fate of a 5 billion-euro ($6.4 billion) infrastructure proposal at an EU summit in Brussels later this week.
    “It’s Merkel who holds the key to the cashbox, and she doesn’t want to give it up,” says Jean-Dominique Giuliani, chairman of the Robert Schuman Foundation, a research center in Paris.
    Merkel’s rejection of more stimulus touched off the first trans-Atlantic clash of the Obama administration and led critics to say she risks deepening the global recession. Even as finance ministers from the Group of 20 nations were meeting in southern England March 14, seeking to paper over differences with a pledge to deliver a “sustained effort” to boost growth, Merkel was 42 miles (67 kilometers) away in London, defending her opposition to further spending.

  34. curious says:

    haa haa, recovery begin with creativity.
    A small colony of artists is cropping up in Detroit, taking advantage of the bottomed-out property prices, buying houses for as little as $100:
    So what did $1,900 buy? The run-down bungalow had already been stripped of its appliances and wiring by the city’s voracious scrappers. But for Mitch that only added to its appeal, because he now had the opportunity to renovate it with solar heating, solar electricity and low-cost, high-efficiency appliances.
    Buying that first house had a snowball effect. Almost immediately, Mitch and Gina bought two adjacent lots for even less and, with the help of friends and local youngsters, dug in a garden. Then they bought the house next door for $500, reselling it to a pair of local artists for a $50 profit. When they heard about the $100 place down the street, they called their friends Jon and Sarah.
    Admittedly, the $100 home needed some work, a hole patched, some windows replaced. But Mitch plans to connect their home to his mini-green grid and a neighborhood is slowly coming together.
    Now, three homes and a garden may not sound like much, but others have been quick to see the potential. A group of architects and city planners in Amsterdam started a project called the “Detroit Unreal Estate Agency” and, with Mitch’s help, found a property around the corner. The director of a Dutch museum, Van Abbemuseum, has called it “a new way of shaping the urban environment.” He’s particularly intrigued by the luxury of artists having little to no housing costs. Like the unemployed Chinese factory workers flowing en masse back to their villages, artists in today’s economy need somewhere to flee.

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