Saturday, October 11, 2008

Its Called Risk, Have You Heard Of It?

Senator Phil Gramm famously called us a "nation of whiners" and he may be right. (Note, while I try to keep this blog about technology, the financial system seems to be so badly broken it is worthy of a comment or two.) I recently ran across a blog post on a financial site called "Our Timid Government Is Killing Us" by Michael Kao, CEO of Akanthos Capital Management. In it he complains about 4 things that the Government has not done to help resolve the financial crisis. I want to concentrate on one of there here. "Problem No. 2: Lehman's bankruptcy has severely eroded confidence between counterparties."

The problem is this. Over the last few weeks, financial institutions have become unwilling to trust one another and with good cause. The issue is Credit Default Swaps. This is a 60 Trillion dollar market (that is Trillion with a capital T) where financial institutions like banks and hedge funds (the parties) buy and sell insurance policies on bonds. The "This American Life" radio program and Podcast has very good and understandable explanation of the market and how it came to be.

There are two important things to understand about the credit default swap market. Firstly, it is completely unregulated. Senator Phil Gramm tacked a clause to keep the market unregulated to an appropriations bill in 2000 that was approved by 95 votes to 0 in the Senate. Secondly, the market is not transparent, that is the various parties to the market do not know what any other players position is. Note that these two features are the way the parties in the market wanted it. There has been great outcry about reducing financial regulations in the last few years.

Lack of transparency was not a problem until Lehman Brothers went bankrupt. They were a big player in the credit default swap market. Now all their credit default swap insurance policies are frozen by their bankruptcy. Anyone who sold a credit default swap policy and then laid off the bet by buying an equivalent credit default swap from Lehman Brothers is now on the hook to pay off the insurance policy on the bond without the compensation of being able to get Lehman Brothers to make good on their policy.

The lack of transparency means that nobody knows for sure about anyone else in the market. That is that anyone could go bankrupt tomorrow because they have bought credit default swaps from a bankrupt company like Lehman Brothers and they cannot make good on their promise of a credit default swaps that they have sold. Already AIG has needed a huge injection of government money to stay afloat, and others may be suffering as well. But no one knows what positions anyone else holds. So everyone is conserving their cash not lending it out to anyone else so that they will not lose it if the other party goes bankrupt. Thus are the credit markets constipated.

A final problem is that, because the market is unregulated, there are no capital requirements to back up a bet. I can sell a credit default swap insurance policy based on my good name. I immediately get a large sum of money which I can register as a profit. It is only later that I have to worry about a problem with the bond that I have insured defaulting (what are the chances of that?) This is how the market got to be 60 Trillion dollars in size.

The underlying issue is this. There is a large risk in trading in unregulated markets. The risk is made larger if the market is not transparent, because if one of the parties to the market goes bust nobody knows what their position is worth. These risks were not recognized in the credit default swap market and policies were sold at far too low a price to recognize these risks. If the market were regulated, like other markets are, these risks would not be there and the market could deal with usual events like a bankruptcy of a player.

Finally there is a risk to the nation in allowing an unregulated market to balloon to the size that the credit default swap market has. Bankruptcies happen all the time. the fact that the bankruptcy of a player has caused the entire financial marketplace to go into a swoon is bad for the nation. The players in the credit default swap market asked for an unregulated market and they got what they asked for. Now the risk of having an unregulated market has shown itself and as Senator Gramm tells them they should deal with it and stop whining.

I am not an apologist, I am a technologist who is interested in how things work.

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