Posted on: November 26th, 2008 Time to Stop Feeding the Monster

In a democratic society the economy should work to support people rather than people working to support it.  Let’s not forget we invented the economy—every bit of it, from the creation of money and credit, to the way we keep score with double entry bookkeeping, to the notion of GNP and theories of monetary and fiscal policy.  When things go terribly wrong, as they have in recent months, we should be able to reinvent a functioning system not have it turn on us like some Frankenstein monster.

Our market system is exceptional.  It needs to be rescued.  But to function it requires good information and a clear connection between cause and effect.  We have lost that connection.  Nowhere is this more evident than the myth the sub-prime market was responsible for the current financial crisis.  The facts show that the market was neither large enough nor struggling enough to cause this chaos.

At the end of 2006, when large US mortgage lenders started to fall like dominoes, the entire mortgage market in the US was worth $10 trillion.  The sub-prime portion, and its close cousin the slightly better-heeled Alt A, represented 15% and 5%, respectively.  At its peak, when financial executives started to call in their insurance policies, the pool of high risks mortgages was about $2 trillion.

Let’s think about that.  The tab for the financial crisis in the US is $7.8 trillion.  For a quarter of the cost all homes underlying sub-prime mortgages could have been purchased outright.  The US could have had a housing program for its low and middle income families envied around the world, rather than what its ending up with; a corporate welfare scheme shoring up the bad decisions of a few hundred financial executives.

When the sub-prime mortgage market allegedly triggered this crisis, delinquency and default rates were lower than they had been in 2001-2002.  The problems could have, and should have, been contained and redressed well within traditional mortgage lending practices if the old rules of the game had been in play.  But they weren’t.

What’s changed?  Enter the monster.  In less than five years the rules of the game fundamentally changed due to the rise in power of derivatives markets and the underlying agreements embedded in the clauses of credit default swaps.1

A credit default swap is a contract between two parties where the buyer makes regular payments to a seller in return for protection.  Although credit default swaps are often referred to as insurance, unlike insurance which requires the insured party own the protected assets, the holder of the swap does not need to.  In fact, the buyer of protection does not have to suffer a loss to collect—all that has to happen is for a predetermined default event to occur and the buyer collects a payment.  The existence of these contracts on a wide scale, often providing multiple contracts for the same class of assets, has transformed the historical market incentive to accurately assess and underwrite risk into an incentive to disregard it.

Consider the impact credit default swap protection had on mortgage loans.  Historically the prudent course of action, even within the sub-prime sector, was to keep known risks within a certain range:  some would-be home owners were refused.  Not so when you have unlimited protection.  No income,  no job, no assets, no problem.  Prudent business practices got in the way of gobbling up market share.  The appetite of the derivatives market for new mortgages was insatiable, as it was for credit card receivables, car loans, or any other activity that could be leveraged into an ante-up for the default swap market.  The market was fattened up and then?  Well, the monster sunk its teeth in.

The majority of credit default swaps last 1-5 years with a sizable increase in volume starting in 2004.  It’s like these bets against the success of the economy were sitting on the shelf chanting “don’t forget our best-before date”.  Remember, these are like insurance contracts without the insurance checks and balances of responsibility.  Knowing your pool is insured if defaults begin to climb reduces significantly the desire to mitigate them, particularly if the negotiation process takes you past an expiry date.

This built-in disincentive to take prudent action in the face of adverse circumstances is known in insurance circles as “moral hazard”.  The greater the degree of coverage, the easier the claims process, the more likely the insured party will act in a hazardous fashion—will act irresponsibly.

An absence of consequence ruins prudent lending practice and destroys the incentive to workout a solution when borrowers face difficulty.  Renegotiating loans, behind closed doors and in good faith, has become old school.  In the past we could rely on renegotiation to contain a downturn.  Not any more.  It’s not so much that credit is unavailable, its that its going to feed the monster leaving the rest of the market to starve.

The unwillingness of lenders to renegotiate loans is now seeping into the consumer retailing sector causing large companies to head straight for bankruptcy rather than seek the useful protection of Chapter 11.  The closed door to renegotiation in the private sector is what causes companies to ask for government bailouts.

The recent $326 billion rescue package for Citigroup was in response to the company’s exposure to collateral debt obligations (CDOs).  Guess what, behind every synthetic CDO lurks a credit default swap, but its impossible to ascertain how Citigroup’s problems are in direct consequence of these obligations.  These contracts are generally held in entities not reflected on the balance sheet and the definition of credit events differ from contract to contract.  How, if and when they net out is important to know.  Based on their losses to date they’ve found themselves on the wrong side of protection way too often.  What we do know–a $25 billion problem grew thirteen times in a matter of weeks.

The powerful role credit default swaps play can not be overlooked in the recent requests for public aid from the top three auto makers.  Both US and Canadian governments are being pressured to come up with bailout packages.  What assurance is there that the money will not just go to the holders of swaps to pay off their positions?  These contracts have a tail and depending on their terms, financial institutions may be able to benefit many times over on the same pool of assets.  The nature of these agreements is that they thrive on instability and volatility.  When the tangled web of agreements are unwound its quite possible auto manufacturers will fail anyway because the rescue aid was not directed to its intended purpose.

Protection of industrial activity and jobs is critical, but if we continue to rescue entities who are lined up for slaughter to feed the economically unreasonable demands of derivatives contracts, we will not find the solutions we seek.  Until we reign in the derivatives mess we’re looking at taxpayers bailing out just about everything—except ourselves.  It’s time to stop feeding the monster.

—————————————————————————————–

1.  In December 2004 the notional value of credit default swaps in the over-the-counter (OTC) derivatives market was $6.4 trillion (2.5% of the total notional value of all OTC derivatives contracts).  By December 2007 it was $57.9 trillion (9.7% of the notional value of all OTC derivatives) while credit default swaps to OTC derivatives contracts in terms of gross market values, went from 1.4% of the total in December 2004 to 14% in December 2007.  See Table 19, statistical appendix September 2008 and September 2007 Bank for International Settlements Quarterly Reviews.

Filed under: Economic Crisis

66 Responses to “Time to Stop Feeding the Monster”

  1. Andrew Tassa Says:
    December 29th, 2009 at 11:04 pm

    This is really first rate. Can’t wait for new posts from you. Thank you so much for this.

  2. raymond Says:
    January 14th, 2010 at 11:53 am

    soma 8PP viagra 8-[[[ levitra :O viagra aeqtp

  3. wentylacja Says:
    January 15th, 2010 at 1:36 pm

    cialis 8P levitra >:-] viagra pills =DDD automobile insurance :PPP

  4. risik0o9 Says:
    January 17th, 2010 at 9:17 am

    viagra 048770 viagra dxuvji cheap levitra :PP ativan 790 auto insurance quote 85047

  5. hrvatska Says:
    January 19th, 2010 at 7:53 am

    levitra :]] buy valium ndz soma 885825 acomplia =OO

  6. jeremy Says:
    January 19th, 2010 at 5:07 pm

    viagra %OO

  7. tshering Says:
    January 22nd, 2010 at 10:13 pm

    health insurance 4464 life insurance dqro auto insurance 927357

  8. plaintextbody Says:
    January 24th, 2010 at 4:07 pm

    home insurance dfdd health insurance rfuv auto insurance quotes 8-[[ car insurance quotes 796879 cheap auto insurance %-]]]

  9. Standaard Says:
    January 25th, 2010 at 6:47 pm

    home insurance quotes 061 health insurance 8437 long term car insurance lfxvo auto insurance quotes 51959 home insurance nwytc

  10. rachaelwrites Says:
    January 31st, 2010 at 8:50 pm

    phentermine :P

  11. mytrees Says:
    February 1st, 2010 at 12:27 pm

    auto insurance 666 auto insurance efodgh cheap auto insurance 194077

  12. verdananormal Says:
    February 2nd, 2010 at 1:45 pm

    phentermine mvrx

  13. raymond Says:
    February 2nd, 2010 at 3:23 pm

    cheap auto insurance jraljq health insurance quotes chs auto insurance heb auto insurance quotes erauu

  14. underoverskrift Says:
    February 3rd, 2010 at 4:28 pm

    health insurance quotes 37794 life insurance 1663 health insurance quotes online pmdkfh life insurance upf

  15. randi Says:
    February 4th, 2010 at 8:05 am

    auto insurance qif health insurance jmbg life insurance quotes %PPP car insurance estimator :]]]

  16. BlackCorners Says:
    February 5th, 2010 at 5:07 pm

    phentermine cnraq xanax :[[[ valium iqutsd levitra 6780 accutane vynmkq

  17. subruti Says:
    February 5th, 2010 at 6:26 pm

    tramadol knnpay accutane 183644 ambien 5791 cialis uzjt propecia 983 levitra bdgi

  18. Carmen Says:
    February 7th, 2010 at 11:47 am

    tramadol omrmp buy cialis generic 8[ valium 595 accutane 5292 valium xbdqq cialis =))) ultram online gambling :P aciphex 37466

  19. kupid Says:
    February 7th, 2010 at 12:46 pm

    tramadol tqmrs aciphex aciphex phentermine discount pharmacy deqw buy phentermine %OOO buy tramadol 8PP ultram etlf online cialis iqhh viagra cialis levitra :OOO ultram mzw

  20. lorita Says:
    February 8th, 2010 at 12:45 pm

    tramadol opekd levitra cialis 8]]] aciphex 347991 accutane %((( generic valium 952800 buy tramadol online %-((

  21. austin Says:
    February 8th, 2010 at 6:09 pm

    buy tramadol online 8[ cialis levitra vs 583514 phentermine %-OOO xanax jlpz discount phentermine tcb levitra 5850 auto insurance quotes 1179

  22. admin Says:
    February 9th, 2010 at 5:46 pm

    cialis 74679 valium to buy online :PP insurance homeowner 267 valium xanax bars order cheap =[[ accutane yymi health insurance online qybm ultram buuss

  23. elina Says:
    February 9th, 2010 at 5:53 pm

    xanax ica propecia generic name 9077 accutane 084 levitra viagra vs 06050 a auto insurance 217 aciphex 5006

  24. Pharme279 Says:
    February 9th, 2010 at 9:55 pm

    Hello! kkkbgag interesting kkkbgag site!

  25. Pharmd777 Says:
    February 9th, 2010 at 9:55 pm

    Very nice site! cheap viagra

  26. Pharmg879 Says:
    February 9th, 2010 at 9:55 pm

    Very nice site! [url=http://ypxaieo.com/oooxvay/2.html]cheap cialis[/url]

  27. Pharmb425 Says:
    February 9th, 2010 at 9:55 pm

    Very nice site! cheap cialis http://ypxaieo.com/oooxvay/4.html

  28. Pharmc924 Says:
    February 9th, 2010 at 9:55 pm

    Very nice site!

  29. Pharma985 Says:
    February 9th, 2010 at 9:55 pm

    Very nice site!

  30. polfon Says:
    February 10th, 2010 at 12:28 am

    generic cialis >:-)) tramadol hcl zmvbm ultram time released pill :-DDD valium >:((

  31. fancy Says:
    February 10th, 2010 at 1:05 am

    aciphex :-]] cheap car insurance pgi short term health insurance cavgrw aciphex jwu

  32. contact Says:
    February 11th, 2010 at 1:38 pm

    online casinos 745 health insurance 8DDD texas health insurance abj health insurance quotes %[ car insurance quotes 185

  33. buy_cialis Says:
    February 12th, 2010 at 4:23 am

    Hello!
    buy cialis ,

  34. viagra Says:
    February 15th, 2010 at 1:32 pm

    Hello!
    viagra ,

  35. cialis Says:
    February 15th, 2010 at 1:32 pm

    Hello!
    cialis ,

  36. cialis Says:
    February 17th, 2010 at 1:23 am

    Hello!
    cialis ,

  37. cialis Says:
    February 18th, 2010 at 1:59 pm

    Hello!
    cialis ,

  38. viagra Says:
    February 18th, 2010 at 2:00 pm

    Hello!
    viagra ,

  39. cheap_cialis Says:
    February 19th, 2010 at 8:11 am

    Hello!
    cheap cialis ,

  40. cheap_cialis Says:
    February 19th, 2010 at 8:11 am

    Hello!
    cheap cialis ,

  41. Pharmd700 Says:
    February 20th, 2010 at 1:01 am

    Very nice site! cheap viagra

  42. Pharmf977 Says:
    February 20th, 2010 at 1:02 am

    Very nice site! [url=http://ypxaieo.com/rrqasso/2.html]cheap cialis[/url]

  43. Pharmg827 Says:
    February 20th, 2010 at 1:04 am

    Very nice site! cheap cialis http://ypxaieo.com/rrqasso/4.html

  44. Pharme392 Says:
    February 20th, 2010 at 1:04 am

    Very nice site!

  45. Pharme489 Says:
    February 21st, 2010 at 1:01 pm

    Hello! fcecfad interesting fcecfad site!

  46. Pharmc461 Says:
    February 21st, 2010 at 1:01 pm

    Very nice site! cheap viagra

  47. Pharmg386 Says:
    February 21st, 2010 at 1:01 pm

    Very nice site! [url=http://opxaiey.com/oyyraay/2.html]cheap cialis[/url]

  48. Pharmc99 Says:
    February 21st, 2010 at 1:01 pm

    Very nice site! cheap cialis http://opxaiey.com/oyyraay/4.html

  49. Pharme38 Says:
    February 21st, 2010 at 1:03 pm

    Very nice site!

  50. Billie Schubert Says:
    February 21st, 2010 at 3:25 pm

    Thank’s 4 A Good Read! I have found out Free Credit Reports is definitely a excellent place to check my credit

  51. Johnny Rosetta Says:
    February 22nd, 2010 at 6:05 am

    with

  52. cialis Says:
    February 22nd, 2010 at 7:36 am

    Hello!
    cialis ,

  53. cialis Says:
    February 22nd, 2010 at 7:37 am

    Hello!
    cialis ,

  54. jewelry auction Says:
    February 26th, 2010 at 11:15 am

    Hi, I applaud your blog for informing people, very interesting article, keep up it coming :)

  55. hamptons Says:
    March 4th, 2010 at 1:31 pm

    xanax 8[ aciphex 20 mg tog 2006 carisoprodol february mt 8DD tramadol hcl 8)

  56. damchoe Says:
    March 4th, 2010 at 4:36 pm

    valium =-DDD buy doxycycline >:-PPP propecia lxqao

  57. audrey Says:
    March 5th, 2010 at 8:16 pm

    xanax without a prescription =-PPP discount cialis pzovq phentermine nltiqp doxycycline 04452 generic propecia >:-]

  58. benimal Says:
    March 5th, 2010 at 11:51 pm

    prednisone 725763 valium =-D acomplia amp phentermine diet pills 59399 doxycycline 878420

  59. Mimi Towell Says:
    March 6th, 2010 at 7:14 am

    I read about this on another site but your story is so set right

  60. cindy Says:
    March 7th, 2010 at 1:19 pm

    valium 873 buy acomplia fgus tramadol hcl-acetaminophen 947 accutane 727

  61. loren Says:
    March 7th, 2010 at 4:17 pm

    prednisone twtf ambiencr 8-] xanax wumdf buy propecia online >:-]]]

  62. John669 Says:
    March 8th, 2010 at 12:43 pm

    Very nice site! is it yours too

  63. John669 Says:
    March 8th, 2010 at 12:43 pm

    Very nice site! [url=http://aixypeo.com/ayrava/2.html]is it yours too[/url]

  64. adult dvd rental Says:
    March 9th, 2010 at 3:51 am

    would it be possible to translate your website into spanish because i have difficulties of speaking to english, and as there are not many pictures on your website i would like to read more of what you are writting .

  65. karla Says:
    March 9th, 2010 at 11:45 am

    valium without prescription 20553 order doxycycline :-DD generic ultram 9241 order prednisone =-OOO

  66. parrnell Says:
    March 9th, 2010 at 5:48 pm

    tramadol vrduuz aciphex 20mg >:((( valium iqig buy accutane
    xqr

Leave a Reply