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.

Stocks could be cheaper now than in 1932

There's an article in today's WSJ I highly recommend, by Jason Zweig. He compares today with the conditions that prevailed just a few days before the absolute bottom of the stock market in 1932, after prices had fallen almost 90% from their 1929 highs. The summary: many stocks today are trading at levels that rival the ridiculously low valuations that the famous Benjamin Graham, the father of value investing, discovered back then. Here are some excerpts:

The nation was in the grip of what U.S. Treasury Secretary Ogden Mills called "the psychology of fear.

More than one out of every 12 companies on the New York Stock Exchange, Graham calculated, were selling for less than the value of the cash and marketable securities on their balance sheets.

Out of 9,194 stocks tracked by Standard & Poor's Compustat research service, 3,518 are now trading at less than eight times their earnings over the past year -- or at levels less than half the long-term average valuation of the stock market as a whole (according to Graham's calculation methodology).

Nearly one in 10, or 876 stocks, trade below the value of their per-share holdings of cash -- an even greater proportion than Graham found in 1932. Charles Schwab Corp., to name one example, holds $27.8 billion in cash and has a total stock-market value of $21 billion.

Those numbers testify to the wholesale destruction of the stock market's faith in the future.

This market is priced to a belief that we are in the early stages of a profound recession or perhaps even a Depression. If you believe the future is just a tad brighter than that, you should be buying stocks today with abandon.

A socialist tsunami?

Say what you will about Barack Obama, but it's a fact that he's the most liberal senator in Congress, and he has ties to the far left going back for many years. As we search for an explanation for the market's crash, it is perhaps not a coincidence that the downward plunge in stock prices has coincided with the upward surge in Obama's popularity. This comes from Investors Business Daily: "Investors' Real Fear: A Socialist Tsunami"

The Crash: "Why has the market dropped so much?" everyone asks. What is it about the specter of our first socialist president and the end of capitalism as we know it that they don't understand?

The freeze-up of the financial system — and government's seeming inability to thaw it out — are a main concern, no doubt. But more people are also starting to look across the valley, as they say, at what's in store once this crisis passes.

And right now it looks like the U.S., which built the mightiest, most prosperous economy the world has ever known, is about to turn its back on the free-enterprise system that made it all possible.

It isn't only that the most anti-capitalist politician ever nominated by a major party is favored to take the White House. It's that he'll also have a filibuster-proof Congress led by politicians who are almost as liberal.

Throw in a media establishment dedicated to the implementation of a liberal agenda, and the smothering of dissent wherever it arises, and it's no wonder panic has set in.

What is that agenda? It starts with a tax system right out of Marx: A massive redistribution of income — from each according to his ability, to each according to his need — all in the name of "neighborliness," "patriotism," "fairness" and "justice."

It continues with a call for a new world order that turns its back on free trade, has no problem with government controlling the means of production, imposes global taxes to support continents where our interests are negligible, signs on to climate treaties that will sap billions more in U.S. productivity and wealth, and institutes an authoritarian health care system that will strip Americans' freedoms and run up costs.

All the while, it ensures that nothing — absolutely nothing — will be done to secure a sufficient, terror-proof supply of our economic lifeblood — oil — a resource we'll need much more of in the years ahead.

The businesses that create jobs and generate wealth are already discounting the future based on what they know about Obama's plans to raise income, capital gains, dividend and payroll taxes, and his various other economy-crippling policies. Which helps explain why world stock markets have been so topsy-turvy.

But don't take our word for it. One hundred economists, five Nobel winners among them, have signed a letter noting just that: "The prospect of such tax-rate increases in 2010 is already a drag on the economy," they wrote, noting that the potential of higher taxes in the next year or two is reducing hiring and investment.

It was "misguided tax hikes and protectionism, enacted when the U.S. economy was weak in the early 1930s," the economists remind us, that "greatly increased the severity of the Great Depression."

We can't afford to repeat these grave errors. Yet much of the electorate is determined to vote for the candidate most likely to make them. If he wins, what we consider to be a crisis in today's economy will be a routine affair in tomorrow's.