Sunday, October 12, 2008

Best news of last week: the unregulated free market did not collapse

It's an arcane topic and that's probably why you haven't heard much about it, but the settlement of $400 billion of credit default swaps on Lehman bonds that occurred a few hours prior to Friday's market close was a major positive event. You can read a lot of the details here, here and here, but here's my quick summary:

For the past two weeks the market had feared the results of an auction that was to be held last Friday to determine the settlement price of credit default swaps on Lehman bonds, an event that was triggered by the government's earlier takeover of Lehman. Some $400 billion in CDS contracts were at stake. No one really knew who was going to end up owing how much money to whom. Major dealers might end up on the hook for hundreds of billions if their counterparties failed. As the auction approached, those who were on the losing end of the swaps (those who had sold protection) were selling assets to raise money in case their counterparties failed and they had to make good on their swaps. In addition to precautionary sales of assets, many others did their best to avoid exposure to the banks and dealers rumored to have potentially large and losing positions. This all added up to intense fear among major market players, and that in turn probably explains why short-maturity swap spreads soared in the past two weeks.

In the end, it was almost a nonevent. In the greatest story of this crisis not yet told, the private market mechanism set up to handle the settlement of the swaps worked perfectly. Collateral requirements in place from the beginning ensured that money was available to make payments to those who had purchased protection. Major dealers had offset most of their exposure with other counterparties, and the counterparties came through (no doubt thanks to collateral requirements). The net amount of money that changed hands was only a small fraction of what many had feared.

(When you hear that outstanding swap contracts have a notional amount on the order of many tens of trillions of dollars, that doesn't equate to the actual or net exposure that is in the system. If Dealer A sells protection to Investor B, Dealer A might also buy protection from Investor C to end up with no exposure; Dealer A is simply a middleman. But the two contracts are different, and so their notional amount is counted twice. The only risk to Dealer A is that Investor B might not deliver on his promise. But collateral arrangements built into CDS contracts are there to mitigate that risk, requiring the party on the losing side of the swap to post collateral to cover his potential loss. As a rule of thumb, the net exposure of any given notional amount of CDS contracts is a very small fraction of the total notional amount; probably something on the order of 2% or so. This makes swaps a lot less scary than most people think.)

So while everyone feared that major dealers and banks might end up exhausting their capital and triggering mass cascading bankruptcies last Friday, the private sector, without the help of the government, managed to settle a huge amount of CDS transactions with no government oversight, no government bailouts, and no government agencies, and all in the space of a few hours.

The relief that ensued in the wake of the successful settlement was probably the trigger for the ferocious rally that the market staged in the closing hour on Friday.

That might be the key to marking a bottom in the market, but now attention turns to the auction for the settlement of the Washington Mutual CDS contracts, which is scheduled for October 23. I would be willing to bet that will go off without a hitch, just as the Lehman settlement did, but the market is going to be worried nonetheless so we're not completely out of the woods yet.

In any event, I feel a lot better about the carnage of last week, because I now understand the source of the fear that had virtually paralyzed the market. Those fears proved groundless, and that's a big step in a positive direction. Politicians, please take note: the private market can work wonders, if government refrains from meddling. More regulation is not the cure for this crisis.

UPDATE: The WaMu CDS auction went off without a hitch Oct. 23rd, according to the CDS clearing house DTCC. Derivatives have not contributed to the current financial crisis.

9 comments:

Tory Conservative said...

Scott,

Speaking of unregulated markets.

What do you think of this reform idea that I have, which I think might go part of the way towards making our financial system more transparent.

Financial Institutions would have to choose between being a Low Risk financial institution (LRFI) or a High Risk financial institution (HRFI).

Low Risk financial institutions would be FDIC insured. But they would be required to place 100 percent of customer deposits in short term federal treasuries or cash. Therefore, almost zero risk to the FDIC insurance fund and little confusion regarding how to respond to government regulation.

High Risk financial institutions would not be FDIC insured. But they would have the option of investing customer deposits in all sorts of investment vehicles.

The reason why I propose this reform is that bank regulators are always trying to manuever between tight regulation and loose regulation, depending on whether they see lots of investment risk in the economy and in certain assets, such as mortgage backed securities.

But government regulators are ill-equipped to make such judgements. Clearly their "risk scoring" which gave a 20 percent down type mortgage a higher risk score than AA corporate mortgage backed securities is an example of this.

Of course, this reform would have to be in addition to privatizing Fannie Mae and Freddie Mac.

Your thoughts?

Mark said...

Thanks for your explanation, and I love the way you ended it. Free markets -- free people -- can solve problems that government only makes worse.

Scott Grannis said...

Thanks marc. Tory, your idea sounds sensible. So sensible that I doubt it has a chance.

CDLIC said...

The power of politicians to coercively interfere and manipulate 'free markets' is why the current financial crisis has occurred. Most reading this blog are against such; however, society continues to believe we need politicians to stabilize society when in fact the exact opposite occurs.

Politicians are actually capitalists (as are all humans), i.e., each wanting to maintain the values on their individual value hierarchy and often at the expense of the very citizenry they profess to 'serve'.[Value Hierarchy defined as the hierarchical arrangement of one's internal, subjective values with the highest value at the top progressing downward to the lowest]. Near or at the top is the desire for maintaining political position/power, thus, ALL politicians will act to serve those values believed to achieve such. This was obvious in the $700B bailout plan as the politicians piled on pork so as to capitalize on continued support from those benefiting from the pork.

The disconnect between the citizenry and the action of politicians is individuals want to be free to prosper without being manipulated or coerced; however, for politicians, to remain in political position/power, must use coercive mechanisms, i.e., regulations, taxes, coercive laws, interference in markets, debasing of currency, licensing, etc., to achieve their individual values = keep political position and power, and most often at the expense of those at the short end of the stick.

But even worse, politicians are not at RISK for their actions, thus there is no effective feedback mechanism (as there is in the marketplace) to eliminate those politicians whose decisions damage society (and the process of voting the 'bad' ones out of office is really a joke in that the more pork a politician provides the more likely he is to remain in office). Therefore, politicians' values are not in line with those to whom he is supposed to serve other than the minority who receive pork.

So what is the solution? A society based on all individuals being at personal risk for their actions; a society based on protecting the sovereignty of the individual (defined as the condition wherein the individual is in control of his/her life and all aspects of it, and not subject to unwanted external control or compulsion by others...Sovereignty is the final say in human affairs when the sovereign say "No" it stays no), a society where free markets are the rule, not the exception; a society where freedom is the condition when all interactions are voluntary; a society where force is only used when the criminal element must be put in check and the playing field brought back into balance; a society where the rules are the same for all players.

Until the elements above are implemented we will continue to see financial markets panic and crash, citizens manipulated against their own best interest and Civilizations collapse.

And yes, there is a solution at hand to build a durable, stable Civilization without the use of coercion (and it is not Pollyanna and does not involve coercion): the solution is contained in a body of work called Civilization Engineering. Without this solution, not only will chaos continue to run in financial markets but the very existence of the species is at great risk.

I offer up the above for the truly curious, and have no financial interest in the promotion of Civilization Engineering. My only interest is to provide a bridge for like thinking individuals wanting to look outside the box for a solution to prevent the collapse of Civilizations: nothing more, nothing less.

poppakoppa said...

McCain WINS ELECTION IF he says:

Bank Credit Default Swaps must be outlawed by a Presidential Executive Order IMMEDIATELY.

Why? In San Diego alone, for example, a home worth $580,000 in today's bad housing market had a $512,000 loan default with Mortgage One, a failed producer of securitized mortgages. Wells Fargo took over as Asset Manager. With a $512,000 Notice of Trustee Sale, CDS techniques then unfairly "conscripted" this home. At the courthouse "auction", the trustee announced a NEW restricted minimum bid of only $325,000. Without knowledgable bidders, the foreclosure immediately reverted to Wells Faggo, creating AN ADDITIONAL $187,000 in bailout funds to come from U.S. Taxpayers! On just this ONE property!!

Bank foreclosure price reductions and takeovers, without due public notice of price decreases below fair market values, drop neighborhood values by an EXTRA 25-40%!

In San Diego alone, 2,000 MORE unscrupulous Trustee Sales in October will chop Home Equities there by $300Million! That is just ONE Month in ONE metro area!! YUP... Most of this new Wall Street "Excess" will be paid out of the US Treasury...

It may be OK to bail banks in a controlled fashion, but we MUST NOW STOP THE WALL STREET CARNAGE of unfair decreases in HOME PRICES. Unethical CDS practices now affect ALL homeowners and ALL TAXPAYERS!

I ask President Bush and the Congress to Freeze all foreclosures at the original Mortgage Default amount. This will save the taxpayers up to a TRILLION DOLLARS!

Brian said...

How is it that the business channels all missed giving an advance warning on such an important piece of news?

Any thoughts on where gold will go over the next six months?

Scott Grannis said...

Brian: like I said, it's a pretty arcane subject. Only bond nerds know about stuff like this.

Bob said...

Great explanation.

Is this the same situation with the other $55 Trillion of deriviatives that are supposedly out there in the ether?

The Best,

Bob Deschner

Scott Grannis said...

As far as I know this is the great untold story of all the trillions of derivatives. They are getting blamed for all sorts of bad things, but in the end the market has developed a very effective solution for settling these transactions. This bottom line is that there are most likely no derivative bombs waiting to blow up.