|0:36||Intro. [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.|
|10:57||A 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. |
|17:49||Something 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. |
|24:41||Bear-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.|
|31:27||Yesterday, 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. |
|43:58||Political; 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.
|52:02||Great 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?|