Russ Roberts

Kling on Credit Default Swaps, Counterparty Risk, and the Political Economy of Financial Regulation

EconTalk Episode with Arnold Kling
Hosted by Russ Roberts
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Arnold Kling of EconLog talks with EconTalk host Russ Roberts about the role of credit default swaps and counterparty risks in the current financial mess. The conversation opens with the logistics of credit default swaps and counterparty risks and moves on to their role in the financial collapse. The conversation closes with a discussion of the political economy of pending financial regulation.

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0:36Intro. [Oct. 24, 2008 taping date] Turmoil in financial markets. Logistic question: credit default swaps and counterparty risks. Bear-Sterns, Lehman Brothers. Corn forward contract. I make Fritos, you are a farmer. Russ, plant some corn and I'll guarantee you a price 3 months from now. Sign a forward contract. Personal contract: counterparty risk, you may not deliver, or I might not pay. Instead of a forward contract, could trade a futures contract on an exchange. Contrast NY Stock Exchange with the Chicago Mercantile Exchange. Stock exchange has a specialist in each kind of stock, doing a lot of the trades against himself. Order book with lists of desired buys and sells. Specialist might buy at 99 and sell to guy who is willing to buy at 100, making small arbitrage. Board of Trade or Mercantile Exchange is chaos by comparison--traders shouting at each other, football players, making the market. Market makers execute the order. Works much better. More efficient, hence advanced trading takes place in Chicago. Corn sold in Chicago: on closing day you will pay the price of corn. Suppose corn goes up in price--you'll sell the corn at higher price. Sell the contract at $150,000: made a commitment to the Exchange that you will deliver cash equivalent to what the contract will be worth 3 months from now. If price goes up to $300,000 you have to deliver an extra $150,000, but you are okay with that because you have sold the corn for $300,000. Who gets the extra money? Fritos. Fritos locked in their price at $150,000. Price went up, so Fritos has to go out to buy corn for $300,000 but they will receive the extra $150,000 from their futures contract, so they end up only paying the $150,000 they were originally willing to pay. Counterparty is the exchange. If farmer defaults and doesn't pay the exchange, the exchange takes the loss. Organized exchange is said to eliminate the counterparty risk. Exchange takes a premium and imposes requirements.
10:57A lot of what we are hearing about credit default swaps is that we would be better off if they were traded on an exchange. Washington Post exposé of the battles, turf war, between different regulators over whether to require credit default swaps (CDS) and other derivatives be traded on exchanges. How can you require that? Might make it illegal to trade these privately. What is a credit default swap? Suppose you own a General Motors bond that will pay you 5%-6%. They could go out of business before you get your principle back in the future. Someone offers you an insurance policy. Bond is already somewhat less risky because in the case of a bankruptcy bond-holders are first in line for remaining assets. But some institutions need to have certain ratings, AAA, so even if risk goes up you are in trouble. So, you pay a fee for a credit default swap. In return, I make a promise that if the bond defaults, I'll make good. Guaranteed asset. Counterparty risk arises, so maybe exchange will work. I'm a pension fund or insurance company, holding GM bonds as part of my portfolio; have some legal requirements about the risk of my portfolio. Could go to AIG, others, maybe investment banks, make contract that you'll make my bond good if there is a default or if the company goes bankrupt. Insurer has to have high credit ratings itself, but could go out of business itself.
17:49Something fundamentally untenable about a credit default swap. In the corn example, there is a natural long and a natural short. In CDSs, no natural seller. On blog, someone suggested that insurance companies could do it. Insurance requires lots of capital, reserves, uncorrelated risks. AIG might have had the first two but still problem of uncorrelated risks. Potential for lots of firms to turn bad at once. Exchange can't solve that problem. Futures market has lots of small traders with small probability that any one of them will default. With CDSs, exchange can't manage its risk. What role did CDSs play in current situation? Made it appear less risky than it is. Suppose I buy a mortgage-backed security. By buying a CDS I may think I have less risk. How can you sell a CDS? The way they were sold and the way sellers thought they'd meet their obligations was: if seller of a CDS learned of bad news about GM, it sees that it will have to make good, so it shorts GM bonds or stock. So, if things get worse at GM, I'll make money on my short which will offset some of what I'll have to pay on my CDS. Individually it makes sense, but collectively it puts huge downward pressure on firms the minute they get into trouble. Systemic risk. How would that work in the mortgage market? Bear-Sterns sees foreclosure market jump up. Before Freddie Mac and Fannie Mae had explicit guarantee, say June-July of this year. Suppose you are holding their securities but you become worried that they aren't goof for them. Go out and buy CDS. People who sell them to you turn around and sell short Freddie or Fannie stock. Stock prices decline, looks like they don't have much capital. Interest rate on their debt is high, cascades on itself.
24:41Bear-Sterns, last March: At the time, such a different world. Investment bank, hedge fund operation that have bought a lot of mortgage-backed securities, some subprime. On a particular weekend, Bernanke and Paulson decide it is imperative that they be bought by another company rather than be allowed to fail. Strange for a Constitutional democracy, JPMorgan bought them as a sweetheart deal. Claim that this was necessary because if they failed, all these other financial transactions would be tied up, system would freeze up. What happened to Bear-Sterns? Engaged in some very short-term trading with each other, repo market. I sell you a Treasury bond and agree to repurchase it in a week. Thick market. Fed typically intervenes in the repo market. Important for the credit risk to be essentially zero for such short periods of time. Presumably Bear-Sterns was trying to trade everything, including mortgage-backed securities in these markets. With the slightest hint of risk, lender will either charge high interest rates, or require large "haircut": lend you $99,000 but you have to post $100,000 in collateral just in case in the next week there is a drop in value in that collateral. People started demanding larger and larger haircuts.
31:27Yesterday, Greenspan flayed himself publically and said his ideology was wrong; media interpreted it as laissez faire is a horrible idea. What he did say was he thought banks would look out for themselves and that would be sufficient to prevent this kind of financial mess. Nobody suggests that people don't make mistakes. Markets don't work perfectly. Did the participants see this coming? Did they realize it or was it a sandbag to the back of the head? How could they not know? One story: evil CEOs knew and were looting their shareholders, disguising or postponing the risk. Great, compelling story, but fictional. Richard Syron warned he was endangering the company but probably thought they were wrong and that the risks weren't that big. Probably true for most of these executives. Suits vs. geeks. Geeks, modelers probably saw it. Documents from economists about potential for a home price bubble: Dean Baker, Paul Krugman, Bob Shiller, Ed Leamer, Larry Summers. People were worried about it at Freddie Mac back in the 1980s for California. Hubris at the top overwhelmed that. Government was aware of all these things but nobody tried to impose the types of regulations that would have stopped this. Analog of the Japanese manufacturing export sector: U.S. combined quasi-government banks and private banks to support the housing sector. All the regulatory tools were there. Needed better foresight and will to use them. Greenspan forced to grovel because it was surprising. If government had let Bear-Sterns fail, what else would have toppled? Bankruptcy court would have caused the collapse of the whole financial system. Did anyone worry about that? Maybe not as much as they should have. Not a robust system. Bankruptcy need not have been an option. Letting someone else buy the company by guaranteeing assets of unknown value. $29 billion wasn't enough to save the system. Investment banks and banks managed to load up on a ton of risk. Robert Merton's calculation: value of housing in the United States had reached $20 trillion and lost a quarter of its value. $5 trillion loss. Some of it's homeowners, but not very much because homeowners didn't put very much down. Substantial amount, so you can imagine it would affect a lot of companies. Size of U.S. capital stock: $60-70 trillion. Interesting comparison: Internet bubble, we let the firms involved fail, and we recovered. Challenge with investment bank is to find an orderly way to liquidate it, without cascade. FDIC does it all the time. If they've lost money and are insolvent, we shouldn't be injecting capital into them.
43:58Political; state of macroeconomics in the wake of this. Economics has little to say about it. When the bailout was first proposed, economists said it was a bad idea. 200 illustrious economists against it; some disagreement. Little consensus about what might replace it. Economics at the macro level has been exposed. People are trying to create a narrative. How could you test any of these narratives? Munger podcast. None are testable. Only thing left is microeconomics. 1971, Kling at Swarthmore, policy right out of the latest textbooks--wage-price controls. Disaster, took 10 years to recover from them. What's going on now is not out of any textbook or any graduate course. Book on Great Depression, interview, Ben Bernanke: all you really need to do to avoid a depression is inflation-targeting. That is the consensus in macroeconomics today. Olivier Blanchard paper, ill-timed. Now everybody's talking about a Great Depression if you don't bail out the banks. Not in the textbooks. Recent macro: real business cycles and financial sector doesn't really affect the macro economy. Just another sector, like Internet stocks collapsing. No transmission mechanism. May be valid. Paulson and Bernanke, the disease they purport to cure.
52:02Great man theory of politics: just need the right people in power vs. public choice and incentives. You don't want a system that relies on picking the right person. Of all the people you'd want at the Fed, who could be better than Ben Bernanke, an authority on the Great Depression? Who will next President pick as head of the Treasury? The people who really understand mortgage securities are buried so low in organizations that nobody hears their voice. Bernanke and Paulson don't really understand mortgage securities. Original plan dissolved in a week, replaced by new made-up plan. Fascinating and frightening. Knowledge in the economy has become more dispersed. John Kenneth Galbraith, champion of price controls, worked in WWII, economy didn't grind to a halt. Nixon wage-price controls, even experts agreed they were over their heads. Medicine today: no doctor can keep track of all of medicine. Dispersion of knowledge. But in this crisis we reach to centralize power as if that will make us safer. Hayek, markets are a way of solving information problems when information is dispersed. Two aspects: One is what institutional structure or policy might be a step toward stability. That knowledge may not even be out there. Nobody knows how to put together a central plan. This is what we tried to do after the Berlin Wall fell: we'll just give them markets; but creating markets explicitly is a cake we don't have the recipe to. Know we need rule of law, honest courts, contracts, etc., but how you get from nothing to something is harder. Developing world, similar problem. In some sense we've tried central architecture with the mortgage situation and it failed. Should be humbling. Second level of knowledge: one of the levels of disperse knowledge is that there are assets that are overvalued and assets that are undervalued. Companies that didn't make these mistakes should be scooping up the remaining assets. No central planner knows what's on that list. In the short run, big aggressive players. How can you buy stock in an American firm now knowing that Paulson and Bernanke could shake it down? Rule of men, not rule of law in our financial markets. No one knows what to do with their financial portfolios right now. Sit back and wait. Government is going to be making up the rules; plus new government coming in. How do you make long-term commitments in that kind of environment?

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COMMENTS (25 to date)
Gary Rogers writes:

Another great podcast! I could listen to this multiple times and learn something each time.

One thing I would point out is that the $5 trillion of lost home value is born mostly by homeowners, not financial institutions. Although it is true that homeowners forced into foreclosure have little equity to lose, those who keep their homes suffer a loss in value, resulting in added risk to financial institutions. The losses are born by every homeowner who keeps his house and loses value through loss in equity. The sad thing is that there are plenty of losses to go around, so everyone can claim them.

Another thing I might suggest is that Henry Paulson and Ben Bernanke may not be the ones calling all the shots in this crisis. I generally do not follow conspiracies, but I cannot imagine that anyone with Henry Paulson's experience would create a panic by making the announcement he did unless there was more to the problem than he stated. He knows how sensitive markets are to this type of news and had to know that it would create a panic as it most certainly did. What is possible is that some of the large holders of our debt got together and dictated terms of the bailout. This would explain some of the strange decisions that do not make economic sense and would also shed light on the discussions in this podcast. If this is true, things might make more sense if we view the situation from the standpoint that it is no longer about what is best for U.S. citizens, but what is best for those who hold our debt.

Finally, I would add that Arnold is absolutely the best source of knowledge on what is happening in this crisis that I have found anywhere.

Johan writes:

Would not a loss of $5 trillions (especially if mostly born by the homeowners as Gary Rogers suggests) in itself cause and recession?

Steve Hemingway writes:

Very good podcast, but I felt that the discussion of exchange traded derivatives was an unwarranted digression. First, Corn futures are not cash settled. Generally 'softs' (food, grain etc.) futures are physically settled - i.e. if you buy the future, when it expires you will receive 5000 bushels (i.e. about 140 tons!) of corn. Cash settlement tends to be used for futures on indexes which are hard to deliver physically - e.g. a future on the S&P500 would require delivery of a portfolio of 500 separate ordinary shares in quantities that replicated their weighting in the current composition of the index.

One of the prime function of futures exchanges is indeed to limit the credit exposure of participants, by itself becoming the principal on one side of every trade, with all members posting appropriate collateral to protect the exchange itself from default. However with 'OTC' derivatives like CDS's it would be utterly impossible for an exchange to perform this function because the contracts, by their very nature are not standardised. Futures and options exchange offer a very limited number of 'plain vanilla' contracts with a fixed set of expiry dates and strikes (for options). This simply isn't possible for the vast majority of derivatives.

I thought the point about 'suits and geeks' was very well made. Sadly the only people who truly understand most complex derivatives are the rocket scientists who(relative to the suits) get paid a pittance and are treated like harmless drudges by the traders, salesmen and executives that employ them. Their function is to generate models for valuing this stuff, using parameters that are largely under the control of the more senior staff.

M. Fresco writes:

As a undergraduate student, I'm still puzzled:

Why does the burst of the housing bubble has such an huge impact on Economic growth?

The collapse of the housing market ensured that the collective value of all real estate in the U.S. converged closer to its real value. It's like learning that your $10,000 dollar diamond engagement ring is made from plastic.

Can you argue that we as a nation, learned that our real estate actually was made from plastic and overvalued by 25 trillion? Now realizing that we are not anywhere near as rich as we thought we were is truly causing our crisis.

From a Romer perspective; is it correct to say that even though we still have the same recipes for growth as we had in 2007, we learned that we have less capital (control over basic resources) than we thought, which in turn means that we cannot produce as much as we would have.

J Mann writes:

I apologize for the semi-digression, but speaking of cash-settled options, would someone be willing to explain what exactly it was that Porche bought when it made it's Volkswagen takeover/squeeze a few weeks ago?

I had read that Porche bought cash-settled options for VW shares, but if so, why does it now have the shares instead of cash?

Gerry writes:

Great podcast! (no surprise there...)

What I thought was interesting is that there was no discussion on the fact that Credit Default Swaps comprise a multi-trillion dollar industry that IS not regulated even though they are essentially "insurance." The fact that companies like AIG and Merrill Lynch can insure collateralized debt obligations with out a fuss ought to be alarming!! Normally, firms on Wall St. wouldn't have been so comfortable with bying these extremely risky mortgage-backed securites because they didn't know what was in these bundles...but wait!...AIG insured it...so it's ok. C'mon, that's ridiculous. Obviously firms like AIG and Merrill Lynch didn't have to have sufficiant capital reserves to insure the toxic assets it did. They didn't have to, because they were unregulated by law simply because the nature of their name (Credit Default Swaps...while insurance contracts are regulated by law) and that's what help add fuel to the fire...a lot of fuel I might add.

10 min. explanation:
http://www.youtube.com/watch?v=bHXuUx0vT0Q

That brings me to my next point:
I believe Dr. Kling has a point when he talked about the gap between the geeks and suits.
However, I don't believe the "guys in suits" were put into hat position simply because they wore a suit well and had a nice smile (if you get my drift). I do beleive that many of them KNEW that their company was "too big to fail" and I think they took advantage of that... i.e. (AIG's retreat after the bailout package...that's not the actions of someone who has just been (as Dr. Russ said) "sadbagged in the back of the head."

With regards to the 5 trillion dollar loss of the housing market, I have to respectfully disagree with Dr. Kling. Homeowners were very significant hit because most homeowners borrowed against the equity in their home. Now they're further in debt than they were when they put 0 down, because the value of their home plummeted while borrowing increased.
Main St. is not very smart...

Russ Wood writes:

Potpourri.

At around 10:57, Russ asks how it could be regulated or mandated that CDSs be traded on an exchange instead of simply between private parties. The answer is in this experiment. Log in to Ebay (or any similar site) and offer to sell one share of Coca-Cola stock (or any other public security) to the highest bidder. That seemingly innocent and simple act violates multiple laws and regulations. As Arnold guesses, the gubment simply makes certain private activity illegal.

Regarding the posts about cash versus physical settlement, I think there is no clear answer.
Contracts may be settled physically, and they likely are between Fritos and the Farmer, but most participants in the exchange are speculators who close their positions by purchasing a counter contract.

Finally, there is one aspect of this podcast, and the entire fiasco which has not been explained to my satisfaction. Arnold does a good job (starting at 17:49) explaining the systemic risk inherent in CDS positions. If I sell insurance against default by GM (a CDS) I will likely offset my own risk by shorting GM stock. According to Arnold, this creates great pressure on the GM stock that sprials it down until the company goes into or approaches bankruptcy. This also fits with the cry heard from many on Wall Street that hedge funds and short sellers were to blame. The gubment even banned short selling for a while to stop the cycle.
But my understanding is that short selling is usually only a small portion of the trading volume (short ratios, etc). How does the mere fact that new short sellers enter the market force GM, or Lehman, stock into a fatal collapse? And if it does, why didn't the gubment ban on short selling prevent further damage? Why was the ban lifted if CDS contracts still exist? I do not get the cause and effect on this one.

Thanks for a great discussion.

Ward writes:

I suspect that the answer to the question why short selling appears to cause companies to fold is that the finanical companies in question were operating with far too much leverage and there was a run on bank credit lines...not deposits, the real weak ones had deposit runs, but when the commercial paper market collapsed many companies pulled down credit lines that had been in place but unused for years so it added stress to the system. I don't think short selling should have been banned nor that it caused anything by itself, its a convenient whipping boy.

Stephen G. Smith writes:

Thoughtful podcast, as usual.

Two thoughts that came to mind...

First, Mr. Kling's comparison of our housing policy these past 25 years to that of the Japanese industrial policy of the 80's makes a lot of sense. But did that housing policy find its beginnings in the policies of the Margaret Thatcher administration in the UK in the late 70's? That is to say, weren't conservatives the first to promote the idea of getting people out of public housing projects--where there was no incentive to keep them maintained--and into homes of their own? Didn't that logically lead to the dramatic expansion of the FNM/FRE and Mr. Bush's "Ownership Society?"

Secondly, to Mr. Roberts' point about why not just let the banks fail naturally as any other business that made bad decisions would. Perhaps it is because the industry is so interdependent, that they are lined up like dominoes. One falls and the rest go with it. The banking industry -- and this includes the 'shadow banking industry' -- is the motor of credit creation. If a major part of it is liquidated through bankruptcy, then the risk is a loss of control on the downside of the money supply. If, as Mr. Kling points out, policymakers can avoid severe general price instability, then we may be able to work our way out of this mess. That is why, it seems to me, that the financial industry requires somewhat special handling.

PK writes:

The discussion of suits vs. geeks was quite interesting. Here's a link to a recent article by Michael Lewis: http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom?tid=true

Toward the end, he has lunch with Gutfreund (the former CEO of Salomon Bros that he lambasts in Liar's Poker). Lewis says, "He thought the cause of the financial crisis was “simple. Greed on both sides—greed of investors and the greed of the bankers.” I thought it was more complicated. Greed on Wall Street was a given—almost an obligation. The problem was the system of incentives that channeled the greed."

He goes on to imply that the fall of the investment banks can be traced back to Gutfreund's decision to take Salomon public, thus misaligning incentives between management and stockholders.

This is essentially the geeks vs. suits issue. When investment banks were private, ownership went farther down the chain; closer to the geeks. In that model, employees had personal risk of both downside and upside. In the model of the publicly traded bank, most employees have upside potential but limited downside risk. You would expect employees of the publicly traded bank to expose the company to an inefficiently high level of risk because their incentives are misaligned with stockholders.

That's a problem in any public company, but I think it is more likely to lead to blowups in insurance companies, investment banks, and other firms that trade hard-to-value risk. In those firms, management is motivated to maximize earnings and has a difficult time communicating the associated risks they are taking.

To add to those misaligned interests, when these companies fail, that failure can create large negative externalities. Neither management nor stockholders are likely to factor those potential costs into their business decisions because they are borne by other parties.

Isn't government regulation justifiable to address negative externalities like this? Especially externalities that could create systemic failure?

Matthew Sheldon writes:

Amazing podcast. Kling hits a home-run again...

One thing that is clear to me is that the financial industry is guilty of getting drunk in the same way a teenager gets drunk for the first time, to the point they vomit all over themselves. They should have known better, they have seen it happen to others, but the moment gets the better of them.

Kling is right to point out that if Wall Street drank the toxic brew, Government policy and social engineering brewed the poison and served it with a smile and heavy dose of peer pressure.

Both are guilty of wrongdoing, but one takes primacy. The only defense of these bailout packages was the responsibility that government should take is getting the whole Freshman class drunk, and now the taxpayer gets to clean the carpets.

If do-gooder, money-for-nothing government housing policy is the match, Mortgage Backed Securities, Credit Default Swaps and Collateralized Debt Obligations were the building, kindling and fuel-based accelerant.

These opaque financial instruments alone are not ruinous unless the commodity on which they are based is suspect.

The final conclusion in my mind is four-fold.

1. Financial institutions have little or no capacity to measure and price massive systemic risk into financial instruments

2. The confluence of big financial institutions and big government is the greatest threat to Capitalism, Free Markets and Economic Freedom

3. There is a new reason to regulate against "bigness." According to the faded anti-trust rationale, singularly large institutions are dangerous to the marketplace for anti-competitive reasons.

This episode illustrates a new reason. Now we realize that "bigness" creates potential moral hazard as an institution reaches the "Too Big To Fail" status. It can abuse the marketplace for excess profit in a new way as implicit government backing becomes clearer. Taking excessive risk can always yield excessive profit over the short run. When the eventual losses are socialized over the long-term you create massive distortions in incentives. This eventually evolves into De Facto Socialism. Joseph Schumpeter was right in ways he did not totally articulate. Socalism evolves from crony capitalism as a measure of protecting the status of the winners from the threat of both creative destruction and ruinous destruction via moral hazard.

4. Alan Greenspan lacks all measure of courage to say what is obvious to his contemporaries. This episode is not an indictment of Laissez-Faire markets. The housing, lending and securities market was anything but free of distortionary catalysts.

If Government is dangerous for it's historic ability to create unintended negative outcomes, Big Government is the ultimate threat in that it can do so on such a massive scale as to distort markets for nearly a decade while precipitating the destruction of our entire Financial System.

This episode is as strong an argument for fragmented, decentralized government policy as the re ever has been.

Fifty states pursuing diverse and sundry methods for growing home ownership can only damage their local markets independently and certainly a few will find a way to do so. But most will not, or at least correct themselves at different times. Two, three or even ten states cannot bring down our national housing market. However, one exaggerated, ill-considered Federal policy had the effect of destroying the entire global financial system.

To me, this says something about how we teach economics. We must begin teaching Systems Dynamics and the modeling of distortionary feedback cycles. Regulators must learn the art of creating natural systemic circuit breakers the same way anti-epilepsy drugs shut down certain neurotransmitters to prevent the onset of seizures.

...and a new field of economics is born. Systemic Economics is the next rule book to be written. Russ, feel like earning a Nobel Prize?

Russ, we are at that great Schumpeterian inflection point called out in part 2 of Capitalism, Socialism and Democracy. We stand at the precipice of his great warning...right now, today.

Prepare yourselves for the political left to declare the Chinese model of market-guided socialism to be the great historical winner, despite the fact that it fails to produce any cutting edge innovation in isolation of truly free markets to provide innovative models for it to duplicate.

"Creative Destruction" will be declared dead, as it is simply too painful and threatening to the effete elite to bear. It threatens their perch in the world and they use it's social disruption as a cover story to lock in their gains permanently.

Schumpeter is well on his way to being proven right, and is probably crying in Heaven or wherever he is at this moment.

I am with you in saying that if I read these words even 6 months ago I would have committed myself to a clinic for seeing demons in the daylight.

Russ, I have pinched myself and I still see demons in the daylight.

I think you do too.

Pietro Poggi-Corradini writes:

Sorry here's the correct version (Henry not Paul...):

Fannie and Freddie invested in walls
Fannie and Freddie had a great fall
All the king's Henry's and all the king's Bens
Couldn't put Fannie together again.

[Incorrect version removed.--Econlib Ed.]

Pietro Poggi-Corradini writes:

I see this as a problem of red lights and green lights. Macro traffic lights. What's the problem with them: when the light is green everyone goes, when it's red everyone stops. No need to think. No need to interact with your fellow travelers. It's quite convenient, just put on the automatic pilot...well, that's until you get gridlock!

I have an unproven conviction that grid-lock would be impossible if every intersection were a four-way stop. At each cross-road people would have to negotiate priority. If you can't cross to the other side, you wait. Somewhere on the edge of the traffic jam people are moving and that will eventually spread to the entire system.

What are these macro traffic lights? They're rules that either evolved or were dreamed up by politics that want to make life easier for everyone, uniformize the system, give the impression of control. Examples could be the Fed setting interest rates, or the Basel accords. Usually, new regulation is a traffic light. It "rationalize" markets. The players themselves demand it. Maybe the central-planning hubris has now descended down to the level of single sectors of the economy. The idea that if only we found the right architecture, i.e. street planning, then we could all go about our business without cooperating.

Hayek dreamed of a flexible kind of law. One that would adapt to a changing situation, evolve. But once, a traffic light is in place, it is really hard to remove it, because it makes us feel safe.

BTW, Arnold's analyses have been superlative.

Ajay writes:

M Fresco, ignore the valuation stuff, that's just to keep score and the numbers can over- or under-shoot. There are three real problems with the current market. The first is that resources were wasted building a lot of houses nobody wants. The second is that a lot of people lost money, ie current, past, or future income, by either investing in these boondoggles or by betting on them. The third is that a lot of home-owners are now tied into contracts, mortgages, that promise more of their future income, to be paid in monthly payments, than the houses are currently worth or are likely to be worth someday. Imagine that you promised to pay $1000 for a flat-screen TV and were told, "Sorry, they're out, here's a $500 CRT. Oh, and you still owe us $1000." The problem is that the idiots who underwrote these mortgages, in their rush to do so, also didn't make home-owners put down the traditional 15-20% down-payment. So now, the home-owners don't have the same equity they might have had in many of these houses, that might have kept them from walking away from the contract, which leads to further losses at financial institutions. Take into account that all this might not matter if another tech boom hits, and most incomes rise, and all of it might get much worse if people start panicking and doing even dumber things- Hello congress! Time to start re-arranging the deck chairs on the Titanic! My opinion is that another tech boom is about to hit and all this will be forgotten and swept away: geeks like me are working to make that happen and we will right the ship. However, nobody knows what will happen when and that's leading to a lot of uncertainty right now. I say, good, they deserve it for gambling so much but everything will work out in the end.

Matthew Sheldon writes:

Stephen G. Smith, others...

The distortions in our housing market began well before Bush's "Ownership Society".

Bush really only had one small program to grow Home Ownership, and that was called "The Dream Act". It was small in size (400,000 homes perhaps) and it provided matching equity for down payments. It actually mandated sound loan-value ratios and fixed rate mortgages. It did nothing to contribute to this.

Bush's ownership society actually had more to do with private health savings accounts and privatized social security contributions than the housing market, which was already booming at the time he announced the phrase.

He was simply taking credit for the run-up in home ownership which had it's origins in the late Clinton administration. Bush actually pressed for more stringent regulation of Fannie and Freddie.

That said, he did nothing extraordinary to head off what was an obvious bubble. As long as values were increasing and the nation felt great about the equity gains, he had a hedge against the other disasters he was creating.

If you look at the housing data, home prices begin to depart radically from inflation beginning slowing in 1996, more noticeable in 1997 and by 1999 it is clear that housing had become untethered from the economic fundamentals, especially given that this was a time when capital flows were going into over-inflated tech stocks and equities markets. Housing values were rumbling along at the height of the tech boom. The tech bubble likely kept potentially offsetting capital flows out of new homebuilding markets long enough to juice prices due to constrained supply, as well as creating a wealth effect that spurred some new buying at the margin.

Why did values take off in the late 1990s? Subprime mortgage backed securities were first authorized under the Community Reinvestment Act changes in 1995, along with a consent decree among the major private lenders to issue $1 trillion in such subprime mortgages or face painful regulatory limits on territorial expansion. Guess what? They complied. Fannie Mae used the Alt-A tool (not techically subprime, but just as risky) to juice their own business in order to keep up with Andrew Cuomo's now disastrous HUD mandates.

As private lenders began to use this tool profitably, they had no complaints. Fannie Mae did complain, as they started losing market share, so in 2002-2004 at the time that interest rates had bottomed out, they stepped on the accelerator by backing an ocean of variable rate loans under very lax standards. This is when they got the subprime mania as well.

It was this wave of variable ARM rate lock loans that began expiring in 2006 under higher interest rate conditions that brought home price appreciation to a near standstill with an uptick in foreclosures as owners tapped their equity and gave up. Given the higher prevailing rates in 2005 onwards and sky high prices that no first time buyer could reasonably afford, Fannie and now Freddie guaranteed anything stamped subprime that any lender could get a warm body to put a signature on. How do you keep a bubble from bursting? Pump more hot air into it. Home prices stagnated, but did not collapse. Yet.

Eventually in early 2007, the flood of foreclosures from expiring ARMs swamped anything lenders could do to support the market. Prices started coming down, stripping recent buyers of any hope of building equity, thus making it easy to mail the keys to whoever and head back to the apartment complex.

From there, we all know the rest.

The root cause was the unnatural acceleration in home prices, and that started in the late 1990s. It started with the onset of subprime securitization which enabled the mirage of riskless borrowing to risky borrowers. That is the match that started the fire, it just had a 10 year fuse.

The rest is all very interesting, but it is just kindling and gasoline. It is not the match.

For those who blame Greenspan, that is shortsighted. The Fed Funds rate was in the 5's and 6's in 1997-2000 and home prices still accelerated abnormally. The bubble was already forming, low rates kept it from deflating.

Greenspan was also giving the Bushes a make-good by keeping rates low in the runup to the 2004 election. Remember how Bush Senior blamed Greenspan for the jobless recovery by not cutting rates in 1992? You think he wanted to get a second Bush booted from office? No way...he kept rates lower for longer than was necessary.

This just meant he ruined John McCain instead of GWB, and GWB needed no help on that front he did that just fine by himself.

If sound lending standards had been in place along with a strong bias towards fixed rate loans instead of variable rate time bombs, this would not even be a conversation right now.

If Fannie and Freddie had enforced fixed rate loans and stringent home-equity line and down payment standards you would have had a much slower escalation of the bubble and a subtle deflation of it over a period of a decade in the form of sideways price appreciation as inflation and the fundamentals caught up with home prices.

The private lenders and securitizers follow Fannie and Freddie because they use their risk models. If Fannie and Freddie take the risk, so do they for the most part. If Fannie and Freddie say "this is crazy, or our risk models don't support variable rate loans" you can bet the private entities would have listened hard and followed suit.

Low interest rates alone cannot cause chaos as long as creditworthy buyers enter the market at a measured pace that allows homebuilding to keep pace with new demand. Home prices cannot rise so dramatically without of ocean of new buyers with a big fat pre-authorized blank check in their hand. Homebuilding failed to keep pace with the mania. You could have gotten the same long term economic stimulus from housing if you had inflated it slowly and deflated it slowly.

This was a federally inspired mania that met political goals for the Clinton administration, which Bush was all too happy to inherit and take a bit of undeserved credit for. Thanks to that he gets a bit of undeserved blame for a policy that he did nothing to drive fundamentally.

Billy writes:

I listened to the podcast last night and read this [http://money.cnn.com/2008/11/13/news/economy/dodd_hearing/index.htm?postversion=2008111310]
today.

R. Pointer writes:

Dr. Roberts,

Could you do a podcast about constitutional constraints and institutional design? I think this is the elephant in the room that no one seems to have time to point out (at least self-interested politicians don't).

My take is that we thought we had three branches of government but really we had four. And the institutional constraints were not explicit enough to restrain the Fed & Treasury from overpowering the other branches. In this I don't mean the low interest rates from 2002-2005, but rather the bailout putsch that occurred in Oct.

I would be interested to know how we could restrict the power of the Fed & Treasury while leaving it independent enough to maintain sound monetary policy. I can't think of a way for this to happen. One totally implausible method would be to not allow the government to take on debt. But that line has been long crossed.

Sincerely,
R. Pointer

Matthew Sheldon writes:

To clarify a previous post, the only real Bush Housing initiative was the following:

"American Dream Downpayment Act of 2003", not to be confused with the ill-fated immigration bill that had the word "Dream" in it.

It was signed in December 2003, and it was 40,000 homeowners a year, not 400,000.

We already had a good bubble as of 2004 when this would have had any impact.

As I said, it only helped augment a down-payments.

This bill was not a meaningful contributor. On the contrary, HUD mandates were part of the equation and Bush did not lower them from Clinton levels.

From a political context, this is excusable given that 2004 was an election year and to make that move would have been exploited badly by liberal Democrats as evidence of you-know-what.

Once these big government experiments get going, they cannot be stopped for political reasons.

Do you hear anyone talking about ending the Medicare Drug Benefit, even though it is going to vastly exceed cost projections? Talk about adding fuel to the next great American inferno...that is it.

Not a chance you can end entitlement policy until it collapses under its own weight...beware of voting for a politician making promises. They might just keep them.

It is time to end all Federal Housing Policies and let the states manage that if they really want to play with fire...they probably will. At least they will burn their house down and not all of ours.

This housing bubble was mainly a coastal phenomenon, tossing in Nevada for good measure.

Guess what? This was largely a Blue State housing bubble, and now you will get a Blue State solution.

Get ready for it!


mfresco writes:

Ajay, Thank you for taking the time to write a reply to my comment. In your last sentences you mentioned a tech boom. Would you mind elaborating on that theme?

Ajay writes:

Sure, mfresco, many technologists have long believed that all the gains from the revolutionary technologies of the PC and the internet are not anywhere close to being harvested and that another boom will take off again at some point because of this. Some thought there was a web 2.0 bubble taking off for the last couple of years, as silly web startups proliferated, but that has petered out and shown itself to be the froth that it always was. The problem is that Silicon Valley has now become a silly, marginal place, similar to other so-called industry towns like New York (finance) or Los Angeles (TV and movies). I believe that the bottleneck for another tech boom is payments and the enabling technology will be micropayments, an idea that has been long discarded by most people who know about it. Whatever the catalyst turns out to be, there is so much more we could be doing with existing technology and it is only a matter of time till we figure out how to get tech going again.

Joe Louderback writes:

Great show, extremely informative, except that I still don't know why they're called "swaps." Who is swapping what for what? One doesn't speak of ordinary insurance, which CDS's seem to be, as a swap.

vimothy writes:

They're called 'swaps' because they involve parties 'swapping' the risk of credit default. Similarly, one can think of insurance as 'swapping' risk, such that I swap the risk of crashing my car and buy a new one with an insurance company.

CDS cause systemic risk for two reasons: the first is that CDS could be thought of as insurance, if insurance was what they are actually used for. However, most CDS are speculative. Which is why there are trillions more in CDS than in the underlying bonds the CDS are derived from. This is very important. Let's say I want to insure a bond against default -- I buy a CDS at whatever percent of thet bond's value. Fine. But let's imagine that I don't own the bond, but merely have a hunch that the bond's issuer is about to default. Using a CDS I can effectively bet that the issuer will. In the words of one journalist describing the workings of the CDS market, I can take out life insurance on someone else. In fact, we all can, and more of us do, as the person gets older and older and more likely to croak... CDS are speculative.

The second reason that CDS cause systemic risk is something called netting, which is a way to arbitrage hedged CDS trades, or hedge arbitrage. Basically having your cake and eating it. Lets imagine that I have bought CDS protection against a bond default at, say, 2% of the bonds value. If the bond defaults I will get the principal from my CDS counterparty. Let's further imagine that likelihood of default increases, widening CDS spreads. I can now sell a CDS on the bond at, say, 5%, earning a 'risk-free' (ho, ho, ho) spread of 3%. Ace. However, we have now linked three companies together in a CDS chain. Should the bond default, in order to pay the the buyer of my CDS the principal, I need to receive the same amount from my counterparty on the other side. If he defaults, I could too, and indeed, the whole chain could be brought crashing down .

Furthermore, because these trades are OTC and unregulated, this is all secret. I have no idea what anybody else's exposure is. The global finance system is linked together with these chains of CDS, raising the possibility that a couple of banks going bust on the other side of the world could bring down financial institutions right here. Or vice versa.

Finally, one interesting use of CDS is synthetic collateralised debt obligations. Synthetic CDOs pool credit exposure by gathering CDS together in tranches and selling off the revenue streams from exposure to crappy loans as AAA-rated securities. There is a notorious story of one school in New York thinking it was buying bonds to invest for future projects, getting bamboozled by an investment bank salesman and ending up with synthetic CDO securities it didn't understand (or even know the name of) full of exposure to credit risk.

ben balanag writes:

After listening to the Arnold Kling podcast on "Credit Default Swaps, Counterparty Risk, and the Political Economy of Financial Regulation," I was wondering has anyone ever consider the round about way to regulate the betting in CDS contracts bought by a party that does not have skin in the game by imposing a 100% tax on the proceeds. Seems to me since US congress has the power to create tax laws, why not use that existing ability to target CDS profits kinda like a laser guided smart bomb?

This change in tax rules would not render the CDS null and void, but it would make the effective payout to a third party speculating on a default of banks, financial institutions or auto companies, zero. Figure if some of the uncertainty were removed about CDS contracts held by third parties, this would help lubricate the credit markets, and thus halt the downward spiral of the real economy.

Anyway I'm not an economist or a lawyer, but this idea has been stuck in my head since last saturday so thought I'd post the obvious question why not nullify CDS contracts if they are causing all kind of problems...

Ed writes:

Great podcast. I liked Kling's explanations. Still, if CDS are bad, what should replace them if anything?

Aaron Beemer writes:

Great Podcast!

I enjoy the topical podcasts and do not believe that the 2 week lead time makes them stale at all. I hope that in our recent economic turmoil that you continue to discuss current events with Econ Talk.

Thanks

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