Home > Economics - General > Cracks in the foundations

Cracks in the foundations

January 23rd, 2008

The decision of the US Federal Reserve to cut interest rates by 0.75 per cent is as clear a sign of panic on the part of the monetary authorities as we’ve seen since the 1987 stock market crash. It’s not entirely coincidental that it followed a dreadful week on Wall Street, and a couple of awful days on world stock markets while the US was closed for the long weekend.

Still, stock markets have fluctuated quite a bit in the last 20 years without producing this kind of reaction. The really alarming events have been happening in bond markets and, in retrospect, the most alarming happened just over a month ago.*

That’s when Standard and Poors cut the credit rating of ACA Financial Guaranty Corp from A (strong investment grade) to CCC (just about the worst kind of junk) in one move. This event showed the weakness of two of the most important defences against the kind of credit derivative meltdown that market bears have been worrying about for years.

First up, it’s yet more evidence that, when it comes to systemic risk, credit rating agencies like S&P are either asleep on the job or, worse, incapable of performing it. They are fine at the day-to-day job of comparing different assets of the same kind, for example, estimating which companies are more or less likely than others to default on their corporate bonds. But when it comes to assessing the risks of whole asset classes, particularly new and ‘innovative’ asset classes, they’ve proved themselves to be hopeless.

They were caught napping by the Asian financial crisis. In the dotcom boom, they failed to detect the bogus financial structures of firms like Enron and many of the big telecoms. And they have been centrally implicated in the crisis that began with the repacking of subprime loans into bundles of securities, many of which were given AAA ratings on the basis of dubious projections of default rates.

But the failure to detect problems with bond insurers like ACA is far more serious. As I said in the 2002 post I linked above,

The starting point [for a possible financial meltdown] is a crisis in derivatives markets arising when ‘counterparties’ (those owing money on the transaction) … refuse to pay up.

To protect themselves against such a risk, parties to these deals have insured themselves against the possibility of default with bond insurers like ACA. But what happens if the insurers themselves go broke? This looks very likely to happen. ACA is relatively small, and has just staved off liquidation for a month or so. But the bigger insurers like MBIA and Ambac are also in trouble – Fitch just downgraded Ambac to AA and if the other agencies follow suit, the company will be largely unable to write new policies. It’s hard to believe they can make it through the coming year without being rescued either by the big banks (themselves looking pretty sick now) or the US government.

Suddenly, there are a couple of trillions of dollars of bonds that are less secure, maybe much less secure, than their holders thought they were. If, as seems entirely possible, derivative contracts have been written with these bonds as part of the underlying assets, the amounts at stake could be much larger.

The subprime mortgage crisis, in isolation, seems likely to produce losses of a couple of hundred billion, possibly enough to generate a mild recession in the USA. But the possibility of large-scale failure in bond and credit derivative markets, now all too real, could bring an end to the long period of global economic expansion that began with the end of the last big global recession in the early 1990s.

Note:I’ve made various updates in response to helpful comments

* Just when I began my Christmas break, as it happens.

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  1. January 23rd, 2008 at 11:44 | #1

    It’s hard to believe they can make it through the coming year without being rescued either by the big banks (themselves looking pretty sick now) or the US government.

    The later would be an example of private profits versus nationalised loses. Not real fair on the taxpayers. If the financial institutions are going to be saved by the government then they should hand over a slab of equity in exchange for the bail out. The government should subsequently float the equity. That would mitigate the moral hazard to some extent and remove the bulk of the cost from taxpayers.

    Of course the financial institutions could in theory try and bail themselves out by diluting equity.

  2. Spiros
    January 23rd, 2008 at 12:25 | #2

    The big financial institutions aren’t going to hand over anything. They know that the government knows that they can’t be allowed to fail.

  3. gerard
    January 23rd, 2008 at 12:42 | #3

    If the financial institutions are going to be saved by the government then they should hand over a slab of equity in exchange for the bail out.

    Indeed they are – to the governments (Sovereign Wealth Funds) of certain Asian countries like South Korea and Singapore, and oil sheiks from the gulf! Interesting times.

  4. MH
    January 23rd, 2008 at 12:49 | #4

    Well said JQ. The central issue about which this mess turns is the lack of oversight by banking regulatory authorities everywhere. The New Deal era of FDR and the need to control and regulate the purveyors of capital has been convieniantly forgotten along with strict controls on those who hold and lend capital. The credit crisis is a solvency crisis as it is a fiduciary crisis, no fiddling with interest rates will fix this. From my perspective it will require a wholesale intervention by government into the ‘shadow banking’ system, and that will entail a significant paradigm shift in current political thinking everywhere. The question of moral hazard looms large. I suppose we will see the hazard passed to the taxpayer. Given the state of the US Governments finances, current deficit and deficit outlays into the future, the room to move for them is very limited indeed not without crashing the dollar. Bill Gross estimates that many of the much vaunted banks in the US are insolvent with liabilities exceeding assets. The next slide will commence when the overseas sovereign wealth funds realise they have been taken for a ride also. It is going to be a very long 2008.

  5. January 23rd, 2008 at 13:11 | #5

    how can you oversee something that is allowed to do business in secret?

    if the business activities of large corporations were uploaded to the web each day, would these recurrent convulsions happen?

  6. Katz
    January 23rd, 2008 at 13:15 | #6

    Indeed they are – to the governments (Sovereign Wealth Funds) of certain Asian countries like South Korea and Singapore, and oil sheiks from the gulf! Interesting times.

    Good point.

    This is an interesting table.


    It shows that the US Treasury issued an increasing supply of bonds during 2007.

    However, the two biggest purchasers (Japanese and Chinese) bought less in absolute terms.

    The Japanese are mostly privately-owned banks.

    The Chinese is the state owned Bank of China and other ChiComm govt organisations.

    The question arises why they bought fewer bonds as 2007 wore on. It is worth speculating that they were keeping their powder dry for the coming financial turkey-shoot when cheap equity could be purchased, which is much sexier than boring old govt bonds.

  7. Majorajam
    January 23rd, 2008 at 13:18 | #7

    Professor Quiggin,

    Good post. The analysis I like best demonstrated that credit insurance is not actually insurance. To truly be insurance, the probability of claims have to be independent of the price of the insurance. Which is to say, the feedback can’t be that the more cheap it is, the higher the incidence of claims. This is true with casualty and property insurance, as well as life insurance. It is manifestly not true with credit insurance. The cheaper the credit insurance, the more it is possible to extend credit to speculative entities more likely to default.

    A second test for whether something is truly insurance, is that the claims themselves cannot be contingently probable. Again, credit insurance fails this test miserably. Nearly every sector of the credit market is facing rising defaults at the moment, just as nearly every sector of the credit market faced narrowing defaults when asset prices and incomes are buoyant.

    So what you have here is a tremendously (Minsky-esque) self-reinforcing vicious cycle. And to make matters worse, as highlighted by the ACA and now AMBAC debacle, as these monolines get downgraded, they have to post more capital. In the middle of market panic. I mean, you couldn’t make this stuff up if you wanted.

    The systemic risk effects are awesome. As we’ve already seen with Merril, the monolines can cause huge damage to already faltering banks. And keep this in mind. An eye-wateringly high percentage of counter-parties to $45 trillion- with a T- in notional credit derivative exposure are represented by just the top 5 major broker dealers. To paraphrase Backdraft, they go, we go. For more info on weapons of financial mass destruction, I’m partial to this: http://www.investorsinsight.com/otb_va_print.aspx?EditionID=619

  8. Majorajam
    January 23rd, 2008 at 13:45 | #8

    One more thing- or at least I’d like to emphasize one thing. It bears reminding that all of these influences on the downside exist and existed on the upside, but simply were ignored by our Pollyanna policy makers. A great one to consider are worries over the pro-cyclical tightening of credit standards that is happening now, (inclusive of increased risk aversion, involuntary balance sheet expansion, illiquid inventory and the exiting of lending businesses), and that are rapidly accelerating the downturn in housing and credit and giving the whole thing the breakneck pace that we have seen. That of course has its mirror image- the loosening of credit standards. When everything is booming, standards get loosened, as has manifestly happened and gotten worse over 25 years of bond bull, yielding the impression that all is booming (butresses asset prices, narrows default rates, encourages speculation and more lending). In fact, this is probably the best way to detect a credit bubble in the first place- historically low default rates. Classic Minsky dynamics.

    The important thing to note is that you can’t bemoan one without acknowledging the other, but yet all of our mainstream accepted policies do just this. All of them more or less coalesce around the same dangerous idea- let booms run their course, but clean up on the downside. It’s a working definition of moral hazard and its what has found us inexorably trending toward disaster- and mammoth disaster that will make your average recession look like living the life of Riley. Take all this talk about stimulus. It’s all well and good to practice these Keynesian policies, but surely if you’re going to write stimulus packages, you also have to right ‘good times’ taxes/spending cuts? Can we imagine policy makers ever doing this? Of course not. During good times, policy makers spend or write tax cuts on stimuluses.

    I wrote about the monstrous demise we were staring at at least a year ago and probably more on this blog, maybe more. I was one of those conspiracy minded, wild-eyed, permabear prognosticators of doom, and I have felt that the oncoming slide to be terminal from 2004 (at least in terms of it being an event that everything will be dated on from now and into the future). I remember specifically saying that, on the plus side, it means much less carbon emissions. At least, poor and out of work, I will be able to say I told you so. From Pollyanna to Cassandra in three paragraphs. Not bad.

  9. January 23rd, 2008 at 15:16 | #9

    After what we have seen from the USA for the past seven years or more, why should the rest of the world even care about what happens to their economy?


  10. Alastair
    January 23rd, 2008 at 16:06 | #10

    Nice article.

    To Gandhi: That’s easy – because the US economy impacts everyone elses economy.

  11. Ian Gould
    January 23rd, 2008 at 17:39 | #11

    Terje: “The later would be an example of private profits versus nationalised loses. Not real fair on the taxpayers.”

    The governments in question could recover the cost over time via a small levy on the asset base (or premium income) of all the insurers.

    Once the initial cost had been recovered, the levy could be retained to build up a provision agaisnt further defaults.

    In theory, of course, such an insurance scheme could be managed privately but the sheer amount of money likely to be involved would make that difficult.

    You’d also run into moral hazard and adverse selection issues down the track with a voluntary scheme.

  12. Ian Gould
    January 23rd, 2008 at 17:45 | #12

    The other problem with the government demanding equity in this case is that the potential defaults could run to many times the capital base of the companies.

    So effectively you’re talking about a nationalisation, preferably temporary.

    The nearest successful model for this would be the Hong Kong Tracker Fund which bought around 20% by value of all shares on the Hong Kong stock exchange after the Asian financial crisis then sold the shares off – at a profit – over several years.

  13. Ian Gould
    January 23rd, 2008 at 17:46 | #13

    “The question arises why they bought fewer bonds as 2007 wore on. It is worth speculating that they were keeping their powder dry for the coming financial turkey-shoot when cheap equity could be purchased, which is much sexier than boring old govt bonds.”

    I think it more likely they saw the likelihood of a dollar crash increasing and decided to reduce their exposure as much as possible.

  14. observa
    January 23rd, 2008 at 19:03 | #14

    “The cheaper the credit insurance, the more it is possible to extend credit to speculative entities more likely to default.”
    That may be true but it’s piddling in effect to the enormity of the moral hazard of rolling the printing press and creating money that incresaingly must find more shaky homes. In the end all the financial intermediaries were playing with Monopoly money, but sooner or later that money commands real goods be exchanged for it. This is just a typical money supply boom and bust, when the players wake up to what the pyramid scheme requires and know it can’t be met. Now the same old calls go up for more govt controls, when it was pulling govt levers that caused it all over again.

  15. Ernestine Gross
    January 23rd, 2008 at 19:50 | #15

    Re 11: “In theory, of course, such an insurance scheme could be managed privately but the sheer amount of money likely to be involved would make that difficult.”

    I cannot agree with the ‘in theory statement’. Setting aside various forms of asymmetric information (which cannot be excluded with public ownership), complete insurance presupposes
    ‘complete markets’. Markets are not complete and this is not a consequence of regulatory ‘interference’.

    To me, a good example of the – should I use the word – ‘delusion’ is the Black and Scholes option pricig model. This formula is ‘true’ exactly when options are redundant. But options were marketed as a ‘risk management instruments’. Interesting, isn’t it?

    Sure, one can find examples (case studies) where options have been used to ‘manage price risk’. This works fine as long as the total amount of risk managed in this way is ‘negligible’.

    IMHO, the role of public (government) risk management lies not in the ‘size’ of capital but rather in the legislative power. Legislative power means that the rules of the game can be changed.

  16. January 23rd, 2008 at 21:45 | #16


    True, “the US economy impacts everyone elses economy”.

    But that’s exactly why it is in our own best interests to see this vast warmongering beast brought to its knees.

  17. melanie
    January 23rd, 2008 at 23:08 | #17

    As JQ has pointed out previously, Greenspan and now Bernanke have responded to every sign of bubble-burst with an attempt to reinflate the bubble. This could be the time they won’t succeed.

    The Bank of China announced big write downs today. Let’s hope they don’t get too big.

  18. observa
    January 23rd, 2008 at 23:38 | #18

    They probably won’t succeed because although you can throw money at a liquidity crisis (ie a run on the banks) you can’t throw it at a solvency crisis. Well not unless you’ve got very deep pockets and not even the US Fed has pockets deep enough to bail out a global solvency crisis. They’re not alone in this and yet no individual central bank has the wherewithal or the incentive to do it either. Just like the private risk insurers they are now the Reinsurers(LLoyds Names) of last resort here and yet they face the same dilemma one rung up. With the best cooperation and will in the world, how can they possibly identify and apportion their individual shares in the international losses now?

  19. Tony G
    January 24th, 2008 at 05:37 | #19

    Warren Buffett doesn’t seem to concerned about the bond market.

    “Mr Buffett has recently invested in the troubled bond insurance market. Shares in MBIA and Ambac, two of the largest bond insurers in the US, have fallen sharply in recent months on concerns that they are exposed to poor quality loans that could undermine their ability to write new business.”


    ….Although George Sorros thinks this is “The worst market crisis in 60 years”


    Buffett has more runs on the board than Soros….

    Life will continue with winners and losers.

    Economists will continue to pontificate on booms and busts.

  20. rog
    January 24th, 2008 at 06:58 | #20

    Buffett has also taken a significant stake in Swiss Re

  21. rog
    January 24th, 2008 at 07:02 | #21

    Whoops, should have read the link, here is another from Forbes

  22. jquiggin
    January 24th, 2008 at 07:18 | #22

    Tony G, your comment implies that Buffett is investing in MBIA and Ambac. Actually, he’s setting up a new firm in competition, betting the existing insurers will fail. Soros and Buffett are in agreement on this one.

  23. rog
    January 24th, 2008 at 08:14 | #23

    Buffett’s message is that the industry is viable and worthy of investment which should, in turn, help MBIA and Ambac to raise capital and maintain their rating.

  24. jquiggin
    January 24th, 2008 at 08:33 | #24

    As a general rule, rog, the entry of a deep-pocketed and well-respected competitor does not help struggling firms raise funds.

    In this case, Buffett is expressing confidence in the core business of insuring municipal bonds. Ambac and MBIA are stuck with heaps of bad debts from their forays into CDOs and similar, which will disqualify them from their former core business once they lose their AAA ratings.

    Still, if you want to whistle past the graveyard, be my guest.

  25. January 24th, 2008 at 09:06 | #25

    The best economic analysis I have read recently was by Larry Beinhart at AlterNet.

  26. Tony G
    January 24th, 2008 at 09:30 | #26

    Re 22

    Agreed Buffett and Soros both have concerns about the US living beyond its means.

    The point I was trying to get out was Buffett is not so concerned about the bond market as he is willing to assume risk there.

    If he is the only AAA rated taker in that market he can name his own price to assume that risk. (Buffett likes owning unregulated toll bridges that everyone has to cross and he is creating one by insuring municipal bonds).

  27. Majorajam
    January 24th, 2008 at 09:47 | #27

    Tony G,

    Sorry to be the bearer of bad news, but Buffet has not given a vote of confidence to the bond market. He has not bought into any of the bond insurers, (despite the fact that each have made pilgrimages to Omaha, hat in hand). You’re probably referring to his starting one recently. The plan there is to offer a premium service, i.e. well capitalized, no structured toxic waste exposure service with Berkshire’s prestine backing, and it is only for municipals that meet its criteria, and it should be noted, at the behest of insurance regulators it behooves Berkshire to stay on the right side of. For you to construe that as a vote of confidence in the mortgage, consumer credit, structured product, leveraged loan, etc. sectors of the bond market, is a more than a bit of a stretch. In any case, I suspect when his annual letter is released he’ll have plenty to say about the bond market, and none of it will remotely resemble vague indifference. He’s just not that dumb.

  28. rog
    January 24th, 2008 at 09:57 | #28

    Its not my particular view that is of importance, more those in the industry eg CreditSights who see MBIA and Ambac battered but surviving. Death notices may be premature; there are reports of an industry bailout.

  29. Tony G
    January 24th, 2008 at 10:21 | #29


    Buffett is setting up his own company insuring municipal bonds. At this point in time it is doubtful the other major players can do so..

    He will profit greatly from this.

    If you read the Buffet letters you will notice he profited from the similar savings and loan crisis.


    The subprime crisis is deja vu savings and loan crisis..


  30. Katz
    January 24th, 2008 at 10:47 | #30

    If anyone decides to bail out the existing monolines (which as Majorajam has correctly noted Buffett declined to do), then they will need extra deep pockets. (Approx 2 trillion (with a T))

    This sum is what is required to cover the shortfall in payments guaranteed by the monolines to all those pension funds and others who purchased Credit Default Swaps on the basis of the AAA ratings that they received from the rating agencies.

    Does anyone know anyone with a spare $2t?

    Buffett is positioning himself to pick up business from the wreckage of this fiasco. He is refusing to have anything to do with the CDSs that are crashing and burning at this very moment. One assumes that Buffett will be much more discriminating about what and how his business will insure.

    I cannot imagine who would invest $2t in this dog. They certainly won’t be doing it with a profit motive in mind. Rather they will be throwing themselves on the hand grenade of dodgy finance in order to preserve the system, just like the big banks did at the time of the LTCM fiasco. But this one is much, much bigger.

  31. Ian Gould
    January 24th, 2008 at 17:54 | #31

    Katz – the $2 trillion is the total potental liability if every single client goes to the wall.

    If that happens, the economy will be in such catastrophic shape that the fate of the bond insurers will hardly even matter.

  32. Katz
    January 24th, 2008 at 18:44 | #32

    True enough IG.

    Eric Dinello, who is a NY State official, has been given the job of saving the world’s financial system. All he needs to do is to convince some banks, which for fairly obvious reasons don’t want to be named, to stump up a mere $15b.


    Of course, if the monolines go to the wall, then the AAA ratings for all of those bonds, whether super-safe or dodgy, will disappear.

    That does not represent a $2t loss. However, it does mean that an indeterminate number of those bonds will have to be sold by pension funds etc., because by their articles of association they are not allowed to hang on to assets of less than gilt-edged status.

    What proportion of those $2t worth fits under that category is anyone’s guess.

  33. Ikonoclast
    January 24th, 2008 at 21:59 | #33

    I seem to recall a JQ post not so long ago (less than a month ago I think) that was sanguine about the shakeout of the American sub prime crisis and the American economics outlook in general. I hope I am not misrepresenting. I wonder if JQ is as optimistic now. The post that started this thread does not seem to indicate such optimism is warranted.

    In general, I am getting the impression that the US on the planning, administration and general governenance side (politically, economically, “corporationally”, culturally and militarily) is beginning to suffer from serious systemic problems right across the board.

    Frankly their forward planning and their responses on Iraq, New Orleans, sub-prime crisis, climate crisis etc etc is starting to look like it aint worth jack-sh** to use an Americanism.

    I know one can always be early on the call that a country is in a long and terminal decline (relative or absolute) but the US looks to be heading in a distinctly parlous direction.

  34. Socrates
    January 24th, 2008 at 23:22 | #34

    Two thoughts on this, particularly after mention of the further financial scandal in a French bank in tonights news.

    First, after having my suspicions confirmed over the years about junk bonds, then futures, hedge funds, derivatives, off balance sheet investment vehicles and now sub-prime, I think the general trend can be summed up by a simple equation:

    Financial Engineering = Fraud

    Second, regarding John Q’s lead on the dubious actions by S&P, the credit rating agencies seem to merit investigation in this. On top of a few stories about the coercive nature of fees charged by credit rating agencies last year (no fees = they downgrade you), I think the myth of integrity surrounding Moodies, S&P and their clones realy looks like just spin. Who regulates these private, profit-making “regulators” of debt markets? Nobody.


    Surely even the most devout believer in the neo-classical economic religeon must admit by now that every market at least needs a regulatory authority that is not another profit maker?

  35. Ian Gould
    January 25th, 2008 at 00:13 | #35

    So long as the ratees pay for the ratings, the whole rating business is suspect.

    How you replace it or reform it given its important in contemporary capital markets is another question.

  36. jquiggin
    January 25th, 2008 at 03:06 | #36

    #33 you can search the blog for “subprime” to get an idea of how my position has evolved. Certainly, I’m more pessimistic now than last year, but I was never exactly sanguine

  37. Majorajam
    January 25th, 2008 at 05:44 | #37

    Tony G,

    Irrespective of the aptness of your historical analogy, Buffet has not given any vote of confidence to the bond market, and with good reason. He has, as I said, set up a bond insurer, which will be a very modest operation within the municipals sector only. Bershire were urged to do this by the insurance regulators, and, again, this is small potatoes and does nothing to address current insurers liabilities that have their stock prices approaching zero. It is pretty difficult, in my view, to argue this constitutes a positive development for the bond market.

    As for that historical analogy, you’re comparing a tempest to a tempest in a teapot because they go by the same name. In reality, the S&L crisis and recession of the early 90s could not have been set in a more different environment, with a less precarious debt load, external investment position, fiancial leverage, currency fundamentals, inflation, real interest rate levels, sheer quantity of specious claims on balance sheets, hedge fund proliferation etc. etc. etc. For one data point I’m partial to, the current debt/GDP of the US economy is the highest on record, having passed the prior mark early in this decade. That prior peak was the fallout of the Great Depression, after the economy started shrinking thereby magnifying the ratio, (although even before it had, the levels were high). If you want to look for history to tell you about what’s going on in the here and now, I suggest you start there. You’ll be astounded by the parallels (including carry trades, conflicts of interest, and most especially, thin capitalizations).

  38. rog
    January 25th, 2008 at 07:52 | #38

    My thinking is that the damage by the French rogue trader will be confined to industry confidence and trust, the financial loss to Societe Generale will be others gain.

  39. rog
    January 25th, 2008 at 08:36 | #39

    To set the record straight, a Buffett spokesperson has recently indicated their (Berkshire Hathaway) willingness to participate in the bond insurance industry including providing capital and reinsurance to existing insurers. How that willingness manifests itself has yet to be seen.

  40. Ian Gould
    January 25th, 2008 at 10:42 | #40

    So, let me see if my understanding of the bond insurance business is accurate.

    1. Merchant bankers raise, say, $1 billion in capital.

    2, Merchant bankers borrow $10 billion to buy treasury bonds.

    3. Merchant bankers offer to guarantee, say, $100 billion in commercial paper based on their $11 billion asset base.

    4. Bond issuers pay them, say, 1-2 basis points per year for doing so.

  41. Will
    January 25th, 2008 at 19:54 | #41

    Can I suggest that some attempt is made to understand the nature of the monoline insurance business?

    The monolines only provide “keep whole” cover for long-term bonds and loans, mainly for US public entities, but with much smaller sub-portfolios of private infrastructure investments and, for some institutions, securitization vehicles. They do this directly or through re-insurance for other monolines.

    The majority of the underlying bonds and loans that are insured have very long maturity, 10 yrs up to even 50 yrs.

    The “keep whole” nature of the cover means that the monoline pays only the scheduled principal and interest due on the underlying bond or loan if it is not paid by the obligor. The monoline does not have to pay out the entire principal amout of the exposure at once.

    The underlying loans and bonds must have an initial stand-alone investment grade rating from two agencies as a pre-requisite to the cover being provided, so they do not cover sub-investment grade exposures. Of course the underlying exposure might migrate to sub-investment grade over its life.

    My understanding is that the monoline insurers absolutely do not provide insurance for counterparties to derivative contracts.

    Because of the keep whole nature of the cover, the monolines have a relatively small amount of annual cash exposure. Consequently they have very small capital bases relative to the principal amount of their exposures, and so are not directly comparable to other financial institutions in this respect.

    A loss of AAA rating has consequences for a monoline’s ability to write new business but, if this is lost, they can continue to operate in “run-off” mode, generating ongoing premia from existing insurance and paying out claims (noting again the “keep whole” nature of the claims)where the borrower/issuer of the underlying loan or bond is not meeting debt service.

    On a private infrastructure project the annual premium is typically in the range 15-30bp per annum.

  42. Ian Gould
    January 25th, 2008 at 21:53 | #42

    Thanks fro the explanation Will.

    I realised after I posted that the fees I was postulating had to be far too low.

    I have to confess a private company effectively guaranteeing a public entity in this way strikes me as odd – normally the public entity would have a superior credit rating one would have thought.

    It sounds like major problems in the bond insurance market would create problems for bond investors (e.g. fund managers who are are required by their trust deeds to only invest in insured bonds)but not for commercial borrowers. Although I suppose if interest rates on government bonds increase due to investors demanding a higher risk premium, that could flow on to commercial paper.

  43. Will
    January 26th, 2008 at 03:07 | #43

    The attraction for investors is that the holder of a wrapped bond needs both the monoline and the underlying oblgior to default, joint default, before it is exposed to loss.

    Assuming they are independent, the joint probability of default (PD) is ridiculously small; for example 0.03%p.a. (AAA-rated monoline) and 0.25%p.a. (BBB-rated obligor) gives joint PD in the order of 0.000075%. This is not just AAA, it is super-AAA; orders of magnitude better.

    The problem, as always in banking and finance, is the assumption of independence, and that this assumption breaks down just when you need it, in a crisis. No financial institution ever went bust, nor ever will, because of normal random variation in the value of a portfolio of truly independent assets.

    That said, there is still no way a wrapped bond should be trading anywhere near the price of the equivalent unwrapped bond, as I read they are today, as long as there is the merest hint of life in the monoline.

  44. Ikonoclast
    January 26th, 2008 at 05:37 | #44

    Let me see if I can get this right. The US under Bush has been running massive deficits. (These are mainly to fund imperial wars and tax cuts for the rich.) Now the US needs a large panic interest rate cut to stimulate the economy. Isn’t there already a massive stimulus being delivered by the gargantuan deficit budgets?

    If the US economy needs another stimulus on top of that then it is comatose on the table having the great big electric jolts applied to its heart.

  45. Majorajam
    January 26th, 2008 at 05:43 | #45

    Will, some of the monolines CDS are trading at around 1300bps. I don’t think their guarantee should provide great comfort to investors on that basis- notwithstanding the dependable research of the rating agencies- which is to say nothing of the implications of their demise for the bond market as a whole, which are legion, and the municipal market in particular, which are even more so. So, from my vantage point, it stands to reason that wraps are trading naked. I also find it hard to argue that credit insurance is significantly different than standard lending activity, given how muted interest rate vol has become. Hence why it seems dramatically obvious to me that these entities are extraordinarily thinly capitalized.

    I think your statement about the independence issue is dead on, but I would make it stronger. It’s not that crises in asset markets create interdependency amongst credits, its that interdependency amongst credits causes crises. Credit, as ever, belongs in the center of the analysis, not at the periphery. Quoth the Great Minsky, twas always thus, and always thus will be.

    Nothing illustrates that more than a cursory look at the Government Sponsored Enterprises. Take the biggest, Fannie Mae. Fannie has a book of business of mortgages, MBS and other Credit guarantees of $2.716 trillion secured against a $39.9 billion razor thin sliver of shareholder’s equity. On its $840bn balance sheet, (retained loans), it holds $106bn of private-label MBS, the majority of which are subprime and Alt-A. Not surprisingly, in light of the bailout now underway, they are as of their Q3 10-Q filing, holding $457bn of mortgage insurance.

    So best to think of it this way. On Tuesday, the market didn’t move anywhere until Ambac indicated it was exploring ‘strategic options’- in spite of an unprecedented surprise 75bps cut in Fed Funds in the premarket. On Wednesday the market was tanking another few percent until word of the bailout fund being organized, wherein the market shot up more than 5% in a few hours. Given all we know about the conquering hero GSE’s, (that are supposed to now ride to the California housing market’s rescue by buying jumbos according to the stimulus package), is it any wonder why investors are nervous?

  46. Ian Gould
    January 26th, 2008 at 06:31 | #46

    ” Now the US needs a large panic interest rate cut to stimulate the economy. Isn’t there already a massive stimulus being delivered by the gargantuan deficit budgets?

    If the US economy needs another stimulus on top of that then it is comatose on the table having the great big electric jolts applied to its heart.”

    Actually to extend the metaphor, the US hasn’t just had the electroshock its also been given repeated shots of adrenaline and now they’re about to open the chest up for some direct heart massage.

    The stimulus package will indeed blow out the deficit and is unlikely to have much effect on the economy in the short term.

    The rebate cheques and the assistance to low-income workers may ease the pain of recession for the recipients but will have little impact on the overall economy.

    The tax incentives to business to invest are positive but are a relatively small part of the package and are unlikely to affect the economy fast enough to prevent a recession.

    Anyone want to speculate on the size of next year’s US budget deficit?

    I’m expecting $300 billion+. Of course, that’s only about 2.5% of GDP which is modest compared to many other countries.

  47. Hank Roberts
    January 26th, 2008 at 08:29 | #47

    Any student of political history will note that the only reliable treatment for economic malaise in the United States for the past century has been bloodletting.

    It’s also worth noting that volunteer army bloodletting apparently doesn’t work, as it’s been going on the past five or six years. A return to a military draft that can gather up children from the privileged class has been required in the past to make the treatment effective.

  48. Will
    January 26th, 2008 at 17:23 | #48

    Majorajam, I entirely share your cynicism about the rating agencies. But my thesis as to the causes of the current crisis is somewhat broader. I think that it is due to two more fundamental misapprehensions.

    First, that there even is such a thing as an accurately measurable numerical probability of default. I challenge anyone to come up with a definition of PD that supported the distinction of 10 distinct investment grade rating classes (AAA to BBB-, with the +/- modifiers) with market-accepted PDs in the range of 0.03%p.a. to about 0.75%p.a. The purported level of precision is total, abject nonsense, whether you adopt the classical or empirical definition of probability.

    Second, that mark-to-market prices of financial assets represents anything like the “real value” of the assets. A mark-to-market price might be the price at which an asset is quoted in a market; but there is no reason to think that everyone who shows that as the value of the asset held in their books could actually realize that value for it. What if there is only one buyer at that price but ten who hold the assets on their books? And how long would that buyer be willing to pay that price for it anyway?

    Unfortunately, it is precisely these two assumptions that underlie the calculations of the level of capital held by financial institutions and structured financial vehicles. Basel II adopts it wholesale. Given that capital is expensive and competitiveness and profitability in “normal” markets is a direct function of how little capital you can get away with holding, it is hardly surprising that the capital levels are proving insufficient in the most competitive and under-regulated sectors of the markets.

    I would lay the blame here pretty fairly at the door of the academic community who provided the “intellectual” cover for both these assumptions. They are necessary to be able to build a nice coherent model or theory, but no-one told the industry that building nice models and theories is simply what academics do to get promoted.

    I think that every academic paper on finance should be required to demonstrate that the axioms – such as the existence of objective and measurable PD, volatity, etc., or the intrinsic meaningfulness of market price data – are valid. Otherwise, off to the maths department.

    A final point. While monoline CDSs trade at 1300bps, there is no reason to link this to their actual risk. The 1300bp simply represents the supply of, and demand for, the product. In this environment everyone who holds monoline exposure has been told to buy protection, full stop. Don’t think that there has been any kind of real analysis of the underlying risk, or that the price reflects it.

  49. Katz
    January 27th, 2008 at 06:29 | #49

    I would lay the blame here pretty fairly at the door of the academic community who provided the “intellectual� cover for both these assumptions. They are necessary to be able to build a nice coherent model or theory, but no-one told the industry that building nice models and theories is simply what academics do to get promoted.

    This seems a bit intemperate, Will. Academic studies of such issues exist within their own particular universe of discourse. Of course, academics attempt to model life in the real world. Anyone who acts in strict accordance with any of those models is acting quite irresponsibly. That isn’t the fault of the model-builders. That is the fault of the actors.

    Look at the issues inherent in adoption of any models of human behaviour.

    At root, any model of human behaviour must include within itself perception of the predicted effects of that very model of human behaviour. In other words, the model undermines itself as a predictive tool.

    Take an example from outside finance. During WWII possession of the Ultra Secret allowed the Allies to pattern (and to influence!) German behaviour at crucial stages of the war.

    This was an excellent capability to have. And for reasons that should be quite clear the Allies guarded their secret jealously. They knew that if the Germans found out the Germans would change their behaviour, and the ability of the Allies to predict and to influence future events would be materially weakened.

    The financial models of which you speak aren’t secret. And even when an outfit like LTCM come up with a new algorithm, their behaviour in the market is quite transparent, allowing their counterparties to adapt to their behaviour.

    Any who believe that they can pull a model off the shelf and use it to guarantee profits are fools who deserve to fail.

  50. Will
    January 27th, 2008 at 08:26 | #50

    Katz, I appreciate your point about the use of models by actors in the markets, but I do feel strongly that the finance academic community has abdicated its responsibility to address its axioms, and particularly the number one axiom that there are, in relation to future outcomes, numerical probabilities that can be measured.

    It think it is entirely reasonable to ask why we think there should be. I have worked in and studied finance for 20 years, and I have seen no evidence that there are.

    I have been involved in and observed the processes by which financial institutions and their regulators generate estimates of probability, correlation, etc. Their purported empiricism is, at best, nothing but crude projection of statistics, because the inconvenient need for stationarity is simply ignored. I think it is ignored for a very good reason, which is that they are dealing with complex systems, not casino games of chance.

    And yet the financial institutions persist because their models need numbers, and the risk management side of their businesses are now entirely model driven. Basel II is a prime example, but far from the only one.

    The fact that they are reduced to invalid empiricism or, more often, purely arbitrary assumption, to generate their probability numbers suggests strongly, to me at least, that the problem might be not in their approach but in the fundamental assumption that there actually are numerical probabilities.

    Certainly the classical definition – that the probability of A is the number of outcomes in which A occurs divided by the total number of equally likely outcomes – doesn’t help as it is circular. Numbers count something, and I cannot see what the numerical probabilities in finance are actually counting.

    Perhaps this is more philosophy than finance, but that seems to be a cop out for the academics who are the ultimate source of all the models used in the industry, and whose work provides, as I said before, the intellectual justification for their use.

    For the avoidance of doubt I am not talking about proprietary trading models here. I am talking about the now ubiqituous capital and risk management models that trace a line back through ASRF, RAROC, VAR and Merton.

    Sorry to all for taking up so much of your time, and thanks for the opportunity to provide some views.

  51. January 27th, 2008 at 08:51 | #51

    “At root, any model of human behaviour must include within itself perception of the predicted effects of that very model of human behaviour. In other words, the model undermines itself as a predictive tool.”

    I forget the name of it (maybe somebody can remind me?), but there’s even a law of economics that states something like “when an economic measure is used in policy, it ceases to be reliable”.

  52. Ernestine Gross
    January 27th, 2008 at 10:30 | #52


    I agree with your agreement with JQ regarding the uselessness of rating agencies. Are you going to write to Mr Costa, NSW State Government, telling him what you think of rating agencies or are you blaming academics for not doing it? I mention this because the only argument Mr Costa has in defence of the privatisation policy of the electricity industry is the dripple A rating!

    I may even agree with some of your statements about academic papers in ‘Finance’, if you happen to have in mind that part of the literature I am thinking about. The literature I have in mind is that which is driven by hypothetical practitioners who respond to both ‘industry demand for applied work’ and publication targets and consultancy fees. But this is not the professional economics literature where finance is but one element of interest. If ‘industry’ is not satisfied with the outcome of its demands on the education system, then I suggest you address your complaints to ‘industry’.

  53. Ernestine Gross
    January 27th, 2008 at 10:35 | #53

    PML, Milton Friedman and his students held a view similar to the one you present. I wouldn’t call it a law. However, I would be prepared to say that those who advocated ‘economic rationalism’, based on data preceding their policies on institutional change, have failed to recognise that the data on which they base their predictions is irrelevant.

  54. Ernestine Gross
    January 27th, 2008 at 12:26 | #54

    Re 50: Will,

    I wrote my post before reading your post, item 50.

    There are no axioms in the finance models you refer to. These models are characterisations of solutions to general equilibrium models on which specific ‘restrictions’ (convenient assumptions) have been imposed to allow the derivation of equations into which numbers can be put. So, they are at best special cases. This is what ‘industry’ wants because it is (looks like) applied.

    If you want to know about the axioms on which these Finance models rest, you need to study the theoretical models from which they are derived.

    General equilibrium theory does not, to the best of my knowledge, aim to satisfy the demands of managers of financial corporations but rather to investigate a particular philosophy. I should think this activity is in the proper domain of academia.

    The theoretical models from which the Finance models can be derived as special cases assume that individuals make probability assessments about future events when making their own decisions.

    There is indeed a jump to conclusions involved when applying special case solutions of theoretical models, which do not contain ‘corporate managers’ at all, to risk management by so-called ‘professional’ finance managers.

    As far as I know, most Finance programs are now taught separate from Economics. I am not convinced this is a good idea.

    You discussed the importance of the independence of financial variables in one of your earlier posts. It seems to me, the independence of financial variables depends, among other factors, on independent minds of people with independent wealth in their pockets. But independent minds are not obviously compatible with the corporate form of business.

    Your term ‘invalid empiricism’ makes sense to me.

  55. Will
    January 27th, 2008 at 17:37 | #55

    Ernestine, thanks for your thoughtful response that makes much the same excellent points about the proper use of models point as Hayek did in his 1974 Nobel prize lecture. I do think, however, that the ability to numerically specify the distribution of outcomes of complex financial systems (namely firms) is an axiom of these models.

    For convenience, I’ll take the Wiki definition: “In traditional logic, an axiom or postulate is a proposition that is not proved or demonstrated but considered to be self-evident. Therefore, its truth is taken for granted, and serves as a starting point for deducing and inferring other (theory dependent) truths.”

    Now consider, as an example of an important and public domain model, the Basel II Internal Rating Based (IRB) formula. For banking it doesn’t get more important than this. (A very convenient description see http://www.bis.org/bcbs/irbriskweight.pdf.) Now this formula calculates the amount of capital a regulated bank must hold against each of its exposures. Its major inputs, to be provided by the bank itself, are annual probability of default (PD) and loss given default (LGD). Logically, both are derived from the same distribution of future asset values of the borrowing firm (although economists might note that PD and LGD also have to be specified for sovereign loans as well).

    I think the assumption that these are measurable is axiomatic to the approach.

    What is particularly damning is that a bank is only allowed to use the IRB approach if it can demonstrate somehow that it can measure these things, but no specific guidance is provided as to how. The major criteria is the amount of data a bank can gather, explicitly pushing an empirical approach.

    Now I have seen the type of stuff that banks are doing to try to claim that they can measure PD/LGD, and that is being accepted by their regulators, and it would make you hair turn white. It is absolutely the worst kind of pseudoscience you have ever seen. As long as something, anything, can be specified to a 95% confidence level, then it is ok. Its relevance is irrelevant.

    I have tried hard to limit my comments to finance academia and not economics or academia generally (but may have forgotten occasionally) because that is where the problem lies to me. Just open any finance textbook. I think it would be great if the rest of the economics discipline took seriously what was being done in their name.

  56. January 27th, 2008 at 19:48 | #56

    “PML, Milton Friedman and his students held a view similar to the one you present. I wouldn’t call it a law.”

    I actually bumped into it on wikipedia once, under the name of “…’s law”, only I forget just whose. I’ll try searching.

  57. Ian Gould
    January 28th, 2008 at 10:17 | #57

    So when we’re dealign with thinly trading commercial instruments are mark-to-market requirements actually part of the problem?

    Is there an alternative?

  58. Ernestine Gross
    January 29th, 2008 at 07:47 | #58

    Re 55:
    Will, the link you have given doesn’t work (page cannot be found).

    I am familiar with Finance textbooks since the mid-1980s. I can’t quite agree with the generality of your statement about Finance textbooks. See for example texts by Cox and Rubinstein and in particular texts by D. Duffie. I’d be very surprised if Markowitz or Merton would treat a ‘restriction’ on the solution of a theoretical model as anything other than a hypothesis to be tested empirically. However, I have to agree that there are a few undergraduate Finance texts, even of recent vintage, which could be read by the uninitiated in a manner you describe. One I have in mind has explicit ‘industry endorsement’ comments. (Good marketing but bad scholarship as far as I am concerned.)

    Incidentally, my earlier comments were not about the proper use of models in general but merely about the specific relationship between the Finance models you indicated and post-1950s general equilibrium theory.

    You mention V. Hayek. He is known to me as an advocate of ‘laissez faire’ but not as a contributor to analytical models which examine the beliefs in ‘laissez faire’ within an axiomatic approach (eg post 1950s, starting with Arrow-Debreu-Koopman). I find it interesting that v. Hayek was resurrected, so to speak, in the political sphere at just about the time when the analytical research program showed up problems with the 19th century beliefs that may well be labeled “Cracks in the foundation�.

  59. Will
    January 29th, 2008 at 18:30 | #59

    Ernestine, thanks for your response. I will take a look at the textbooks you mention, and you are correct to pick me up for generalizing. The link to the BIS article works if you remove the full stop at the end, or else google “explanatory note irb risk weight functions”. I really recommend Hayek’s speech, which I stumbled across one day. It is at http://nobelprize.org/nobel_prizes/economics/laureates/1974/hayek-lecture.html

    With respect to Merton, his 1974 paper is specifically “On the Pricing of Corporate Debt” and pretty much offers what it promises, a function/functions for the price (yield) of debt in terms of, inter alia, “the variance (or volatility) of the firms operations”.

    Now that is still consistent with what you say about it being a theoretical model, but in the introduction he cites Black and Scholes and says of their option pricing model that they “present a complete general equilibrium theory of option pricing which is particularly attractive because the final formula is a function of ‘observable’ variables. Therefore the model is subject to direct empirical tests …”. (Download available from http://www.pims.math.ca/science/2006/06ssfme/merton.pdf)

    The issue is that the major variable in the Black/Scholes and Merton models, variance, is actually not observable, which is where my criticism of invalid empiricism comes in.

    In fact that is why we have the concept of implied volatility, where the function is assumed to be correct and the variance is then reversed out from the observed pricing. This is obviously not a new criticism, but I think that it is the acceptance and continued teaching of these models that has led to wider acceptance of the presumption that uncertainty can actually be quantified, which has now led to things like Basel II.

  60. Ernestine Gross
    January 31st, 2008 at 17:18 | #60

    Will, thank you for your replies and in particular for the Basel II reference. It looks more concise than any of the material I’ve pulled down on this topic and this is a big help for someone like me who doesn’t like reading about the procedural matters.

    V. Hayek is known to be a persuasive writer (he started in law). The lecture you referenced was given in 1974. I developed an aversion to this kind of literature during my undergraduate days. But I can see why the title is relevant to your interests.

    As for Merton’s 1974 paper, I see no need to revise my earlier comments on Finance models (characterizations of special cases of the solutions to general equilibrium models) only because Merton writes that the Black and Scholes options pricing model is a ‘complete general equilibrium model’. It is not. However, I must mention that my comments are written from the perspective of about 1990 rather than 1974.

    Perhaps physicists should be consulted on the possibility of humans being able to observe a potentially large set of instantaneous variances in an economy where trading of financial securities (called assets in the Merton model) takes place in discrete but varying time intervals. I observe that computing systems can’t handle handle the volume of trade in financial securities resulting from variations in individuals’ risk assessment. However, it is exactly at such times when the special assumption in Merton’s model should be tested (within the narrow framework of Finance) – no? And this is only 1 problem on the path from finance theory models to finance in practice.

    Nevertheless, Merton’s continuous time model is a particularly interesting one because ‘continuous time models’ are still the only ones which deal with risky debt – as far as I know. I don’t buy the argument that the continuous time trading assumption is ‘only an approximation’. It is crucial.

    ‘Quantification of uncertainty’ is, I believe, a separate and much broader question. Perhaps JQ is opening up another related thread in the near future and, assuming I have read the Basel II reference by then, we might be able to continue our conversation.

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