Home > Economics - General > Now for the really big one

Now for the really big one

September 19th, 2008
.!.

While reviewing this post from 2002, foreshadowing a derivatives crisis like the current one, I found the following:

“At the end of 2002′s first quarter, the notional value of derivatives contracts involving U.S. commercial banks and trust companies was $45.9 trillion, according to the Office of the Comptroller of the Currency’s bank derivatives report. ”

The bulk of the exposure is in interest rate swaps, which are fairly well understood and seem to pose only modest risks in themselves. But there’s still around $1 trillion in more recent derivatives involving securitisation of various kinds of debts. This securitisation is sound only if the credit rating agencies have got their risk assessments right, which in turn requires that the accounts on which those assessments are based should be valid. A few years ago, when the market in debt derivatives was starting up, this assumption seemed safe enough, but now it looks a lot more dubious. The big danger is that defaults in the debt derivatives market could spread to the much larger interest rate derivatives markets.

As an update, the $1 trillion in credit derivatives has exploded to around $50 trillion. While less dramatic in proportional terms, the growth in interest rate swaps is actually more alarming, having reached around $300 trillion in notional values.[1]

It now seems pretty well certain that, as the quote above suggests, the chaos in debt derivatives will shortly spread to interest rate swaps.

Update Unless that is, all normal calculations are rendered irrelevant by a US government asset purchase on a scale that will make all past nationalizations look puny. How that will play out I have no idea. For example, will US-based ratings agencies take the step (automatic if it were anyone else) of downgrading US government debt? End Update

There are two reasons for this. First, swaps are essentially bets on interest rate spreads and these have gone wild in the last week, with interest rates on Treasury notes dropping to zero while commercial paper is just about unsaleable at any price. Imperfectly hedged players in the market must be sitting on losses of several percentage points. Depending on how much of this there is, the implied losses could be anywhere from tens of billions to trillions. Crowdsourcing plea: anyone who has a better estimate is welcome to offer it.

Second, hedging only works if you can collect from your counterparties. This Economist story indicates that Lehmans was a big player, but no-one really knows who is owed money by them. And it seems certain that there will be large-scale failures among hedge funds in coming months.

It’s hard to see this crisis being resolved by normal commercial or regulatory means. The hundreds of billions tipped into the market by central banks yesterday is just a drop in the bucket compared to the sums at risk here.

fn1. Under normal conditions, the exposure associated with a swap is of the order of 1 per cent of the notional value. But (a) 1 per cent of 300 trillion is 3 trillion (b) conditions are not exactly normal right now.

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  1. gerard
    September 23rd, 2008 at 20:42 | #1

    the latest Rightwing internet meme is that this crisis was “not because of deregulation, but because brokers were pressured into making loans to “minorities and risky folks”,”. Pressured by who? By ‘the Left’ – exhibit A: The Homeownership Alliance, headed by Mr Davis.

    Ok, so what? It’s not like this guy can represent the values of “the Right” can he now? He’s just a bad apple. Republicans and Democrats are both in the pay of mortgage companies. some Republicans, were in the pay of Fannie and Freddie’s competitors and some in the pay of Fannie and Freddie, like McCain’s campaign manager.

    that’s not surprising, the surprising thing is that you’re saying it’s “the Left” that has to “take responsibility” – so is McCain’s campaign advisor part of the Left now? Does he need to take responsibility? Does the wonderful Alan Greenspan have to take responsibility? Does the Chicago School need to take responsibility? Do the people who turned billions of mortgages into trillions of derivatives take responsibility?

  2. Bingo Bango Boingo
    September 23rd, 2008 at 21:18 | #2

    Jeez, gerard. I make it easy for you by deliberately conflating McCain’s advisor with ‘Republicans’ and you blow it. You can lead a horse to water…

    Anyway, you’ve managed to get something right: no one forced these investments banks to take on the risk. They can’t blame anyone, certainly not Teh Left, for their own predicament. But that’s the thing: it’s their predicament. Take a step back and ask: why would such risky behaviour occur in the United States, and not in places like Australia, whose mortgage lending controls (I understand – AR?) are more or less the same. One answer: massive US government intervention encouraged it by creating a conduit through which the risk could be passed (ie. the GSE and their recent role in absorbing hundreds of billions of dollars in subprime debt). Indeed, the state (not the market) required, by way of executive policy, the conduit to be used in this way. Not to mention the CRA, which seems to have played a genuine (but minor) role. These government interventions were, always, a creature of leftist politics. Just look at the quote above from the Democrat championing the damaging government intervention in the form of the GSEs. Wait, no, the Democrats aren’t the left anymore. War is peace, Ignorance is strength, etc.

    “that’s not surprising, the surprising thing is that you’re saying it’s “the Leftâ€? that has to “take responsibilityâ€? – so is McCain’s campaign advisor part of the Left now?”

    Hmmm… this is shockingly obtuse, even for you. No, he is a hired gun. He was able to operate as a hired gun because there was no free market. In a free market, in which government intervention isn’t taken for granted, such lobbying is ineffective. It won’t surprise you to know that liberalism (and, wait for it, neoliberalism) is opposed to such chicanery. Actually it probably would surprise you. But you still haven’t caught on, have you? The measures advocated by McCain’s apparently right-wing advisor would have (inadvertently) helped! The GSEs wouldn’t have absorbed so much high-risk lending, and the market for such lending wouldn’t have been artificially expanded by government decree. And taxpayers wouldn’t be on the hook for nearly as much. Oh, the irony…

    “Does the Chicago School need to take responsibility?”

    Not sure about this one, but I am sure there’s a Naomi Klein book somewhere blaming them. Perhaps you could quote the relevant paragraphs?

    “Does the wonderful Alan Greenspan have to take responsibility”

    What, for the biggest monetary expansion in history and the resulting asset price bubble? Hell yes! The head of an effective government agency he was, wasn’t he? Yes, I think he was. Yet another state failure. And you want the state to run everything? Jiminy.

    BBB

  3. Bingo Bango Boingo
    September 23rd, 2008 at 21:31 | #3

    “The latest right-wing internet meme is that this crisis was “not because of deregulation, but because brokers were pressured into making loans to “minorities and risky folksâ€?”

    It’s wrong, but it’s also a little more credible that the latest leftwing meme that “this crisis represents the end of capitalism”, don’t you think? Wait, don’t answer that.

    BBB

  4. Ian Gould
    September 23rd, 2008 at 21:51 | #4

    “1) Republicans were opposed to the GSEs abusing their position to crowd out private interests;”

    Yet mystifyingly they never got around to do anything about it even when they controlled the Presidency and both houses of Congress.

    I guess it’s like their opposition to excessive government spending, George Bush’s promise of an end to “nation-building” and Larry Craig’s opposition to homosexuality.

  5. Bingo Bango Boingo
    September 23rd, 2008 at 22:05 | #5

    Ian

    Bush tried to rein in the GSEs in 2003 or thereabouts, but was rolled by Congressional Democrats. Later, Bush’s HUD forced the GSEs to take on hundreds of billions of dollars of subprime debt but not account for it properly. So the administration is clearly at sea.

    The other examples you’ve mentioned merely demonstrate what everyone already knows: the Republicans are not the least bit principled. They are for themselves, their mates, whatever is politically expedient and whatever will mobilise the conservative base every four years.

    And gerard, I do apologise for any confusion I have caused. But really, if a person is hired as a lobbyist to effectively oppose “de-regulation minded Republican” wishes, but then goes on to become a Republican advisor, it hardly makes sense to conceptualise his/her actions as right or left, does it? Much better to think of it as: paid work for Mr X or paid work for Mrs Y.

    BBB

  6. September 23rd, 2008 at 22:10 | #6

    BBB,
    Australia’s mortgage market is in some ways less regulated than the US and in some ways more. The US has much more directed credit regulations then we do (for example, US banks are prohibited from taking the area the borrower lives in into account) but they are also (slightly) freer to lend on higher gearing. The combination of these two is (IMHO) part of the problem.

  7. Bingo Bango Boingo
    September 23rd, 2008 at 22:19 | #7

    Thanks for that AR. Wow, so in the US the state removes their ability of lenders to properly manage risk by prohibiting them from making a full assessment of the borrower? How absurd.

    Anyway, am I right in assuming that a major reason why we in Australia have far less subprime lending is that there is no government-mandated GSE-like conduit through which to pass the risk? Or is it really a function of consumer credit legislation, etc.?

    BBB

  8. smiley
    September 24th, 2008 at 01:14 | #8

    The latest right-wing internet meme is that this crisis was “not because of deregulation, but because brokers were pressured into making loans to “minorities and risky folks��

    No negatively amortised, no-doc, liar loans and no problem. The wonders of “market innovations”.

    Pressured my a$$.

    But of course it was all part of a grand scheme to give poor people a chance to live in a McMansion for a couple of years. Just such a shame they’ll be living in tents for the next ten years.

  9. Ian Gould
    September 24th, 2008 at 08:28 | #9

    “Wow, so in the US the state removes their ability of lenders to properly manage risk by prohibiting them from making a full assessment of the borrower? How absurd.”

    No, the state told them that if they wanted to operate (federally-insured) branches in poor black communities and make money from doing so they couldn’t then turn around and automatically reject all loan applications from those same communities without an assessment of the individual borrower’s creditworthiness.

  10. Bingo Bango Boingo
    September 24th, 2008 at 12:38 | #10

    Well that doesn’t sound so bad.

    BBB

  11. gerard
    September 24th, 2008 at 13:44 | #11

    Bush tried to rein in the GSEs in 2003 or thereabouts, but was rolled by Congressional Democrats.

    Bush only wanted to ‘rein in’ the GSE to the extent that the non-GSE mortgage companies (who owned Bush and the anti-regulation Republicans) expand their market share in the then-booming mortgage securities game.

    and how did the democrats manage to ‘roll’ Bush in 2003, when they held no power in Congress?

  12. gerard
    September 24th, 2008 at 13:50 | #12

    I’m glad you are willing to assign to Greenspan his share of the blame. But although you may try to disown him, his widely hailed ‘genuius’ represents the best of Chicago School orthodoxy – that the governments should avoid recessions using monetary stimulus and upper-class tax cuts and by fiscal stimulus. the result is that you end up with bigger deficits than anything you’d get under Keynesianism but nothing to show for all the money except speculative stock and real-estate bubbles – precious little investment in infrastructure or productive physical capital. It works out very well for the mega-rich who own most of the price-inflated assets, especially once the bubble pops and the government comes along to rescue them while letting all the millions at the bottom of the heap go homeless and without health insurance.

  13. gerard
    September 24th, 2008 at 13:53 | #13

    that should be:

    - the governments should avoid recessions using monetary stimulus and upper-class tax cuts and NOT by fiscal stimulus.

  14. gerard
    September 24th, 2008 at 13:55 | #14

    By the way BBB you really seem obsessed by Naomi Klein, so this one’s for you.

    http://www.huffingtonpost.com/naomi-klein/now-is-the-time-to-resist_b_128433.html

  15. Bingo Bango Boingo
    September 24th, 2008 at 13:58 | #15

    Congressional Democrats rolled him alright. Along with a few Republicans (the former and latter no doubt all recipients of some completely kosher campaign contributions)…

    Again with the lack of responsibility: “We didn’t control Congress, therefore we are not at all responsible for voting against reform. We are not responsible for blocking this in Committee. We are not responsible for our public comments that reform is unnecessary. We don’t control Congress!” It’s absurd, and demonstrates a complete misunderstanding of US Congressional party politics.

    BBB

  16. Bingo Bango Boingo
    September 24th, 2008 at 14:02 | #16

    A compelling piece, gerard. Thanks. It seems to implicity back the gerard ‘start from scratch’ proposal (although to be fair it’s not clear), so you may have some company on that. Luckily for, well basically everyone, it’s probably only going to be you two.

    BBB

  17. Bingo Bango Boingo
    September 24th, 2008 at 14:13 | #17

    And gerard, your attitude that if someone disagrees with you, they ‘own’ all opinions and philosophies (and even people) that you disagree with, is revealing. It’s a tell-tale sign of immaturity of argument. While you have shown that you are capable of cutting and pasting arguments from Naomi Klein books (it’s a fair cop – I am obsessed with her) and left-wing blogs, you haven’t quite demonstrated that you are capable of independent thought and the inescapable nuance that attends such thought. Try it. Seriously. I, for one, have faith in you.

    BBB

  18. gerard
    September 24th, 2008 at 21:26 | #18

    why do you have to be so insulting? do you really think that I’m cutting and pasting here, incapable of independent thought? or have you just run out of things to say?

    yes I must admit I am tying you to some well known New Right figures because by that’s the well-understood meaning of the term ‘Neoliberalism’ which you are defending.

    but you don’t want to defend it in practice so you defend it in theory, saying it’s not “real” Neoliberalism, sounding just like an old Trot.

    Of course it’s not real Neoliberalism – nothing is. but maybe if we cough up a trillion to fix up this little hiccup we might be lucky enough to have Neoliberalism live to fight another day, and then maybe one day if the left doesn’t get in the way all the distortions with wither away and we’ll see the real thing.

    go on complaining about people associating you to the New Right while you associate the opponents of the New Right with North Korea, the eastern bloc, and the abolition of private property. and of course the dreaded Naomi Klein, who you mention every second post.

  19. Bingo Bango Boingo
    September 24th, 2008 at 22:28 | #19

    Hey, I’m happy to defend it in practice. 90% of the broader neoliberal programme is encapsulated by the historical economic development of the West over two centuries. This is why I had to point out to you that neoliberalism and social democracy are only marginally different in modern implementation. As we know from the other thread, broadly speaking, neoliberalism seeks the following in a modern context:

    (1) fiscal policy discipline – this is important to ensure that wasteful public spending does not . Disciplined fiscal policy does not preclude borrowing for productive investment. In fact, there is a strong argument that failing to borrow for things like physical infrastructure and structures that improve the stock of human capital. In the long term fiscal policy discipline is highly correlated with economic growth, and therefore less poverty;

    (2) redirection of public spending from subsidies (“especially indiscriminate subsidies”) toward broad-based provision of key pro-growth, pro-poor services like primary education, primary health care and infrastructure investment – this ought to be self-explanatory: any moral state must invest for the future and must assist its most vulnerable. However, this assistance should be general and must resist the temptation to protect particular producers or sub-groups of consumers (ie. it must resist the corruption of special interests). Assistance by way of well-designed markets is usually better, since it discourages waste and encourages innovation (see, for example, state-funded but market-based health systems such as Singapore’s). Fully government-controlled assistance is very often effective, but also far from optimal.;

    (3) tax reform, broadening the tax base and adopting moderate marginal tax rates – the elimination of loopholes, special exemptions, etc. means lower business costs (which actually matter), easier-to-understand regimes, and generally higher rates of compliance. Note that business itself is usually for exemptions, since they are in a position to exploit them. This must be resisted. As for moderate marginal tax rates, the science shows clearly that very high tax rates discourage productive activity, and therefore impoverish society.

    (4) interest rates that are market determined and positive (but moderate) in real terms – simple macroeconomic orthodoxy which not even social democrats (I think) worry about these days.

    (5) Competitive exchange rates – see above.

    (6) Trade liberalization – liberalization of imports, with particular emphasis on elimination of quantitative restrictions (licensing, etc.); any trade protection to be provided by low and relatively uniform tariffs – trade is one of the greatest forces for good in this world. it unambiguously helps the general citizenry, although of course some capital is opposed to it because it usually threatens some domestic industry. capital has managed to enlist the unions to oppose free trade on the basis of labour protection, when in fact protectionism is really protection of capital. the theory of comparative advantage remains essentially unchallenged, and has been proven correct in practice over centuries;

    (7) Liberalization of inward foreign direct investment – should be self-explanatory. The importation of capital for productive investment always benefits the host country. China is a good example here.

    (8) privatization of state enterprises: in the long-term private enterprises are usually run better than state enterprises. see, for example, the massive improvement in telecommunications where state monopolies were privatised following the introduction of genuinely competitive firms. of course, privatisation is defensible only if there is a true and uncorrupted market for the assets. In Victoria, for example, electricity assets were auctioned at genuine market prices and the people benefited enormously (they are still benefitting from efficient private investment). there may be scope for continuing price monitoring if the commodity is an essential service (although direct assistance to households may be better if competition is fierce enough). natural monopolies are a different matter. there may be good reason to keep these in public hands.

    (9) deregulation – abolition of regulations that impede market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudent oversight of financial institutions – if citizens are to get the best out the free market, the state must not impede entry on behalf of well-heeled incumbent firms. This is no small matter. Even generally free societies like Australia and the US are riddled with unnecessary regulations that protect corporate producer interests rather than consumer interests. Note also the last part!;

    (10)Legal security for property rights – no explanation necessary, except to note that this wasn’t a feature in “North Korea, [or] the eastern bloc”

    So there you have it, neoliberalism in a nutshell. Now don’t pretend that this isn’t neoliberalism. Teh Left has been going on and on about the Washington Consensus and the World Bank and the IMF for years, and I’ve just cut and paste the precise policy prescriptions of the Washington Consensus and added some of my own commentary, so there’s no denying it!

    Finally, your comment does raise an interesting question (for me, right now, not for anyone else I’m sure): would you like to be associated with socialism or social democracy (or something else)?

    BBB

  20. Bingo Bango Boingo
    September 24th, 2008 at 22:50 | #20

    Well (1) is poorly written and incomplete, but you get the gist. Governments should not spend money they don’t have on consumption, but they ought to be free to borrow to invest. That is fiscal policy discipline.

    BBB

  21. Bingo Bango Boingo
    September 24th, 2008 at 23:43 | #21

    You know, the more I think about it, the more South Korea is a pin-up for (anticipated) neoliberal thinking, despite it’s serious level of government intervention throughout the 1960s and 70s.

    In the 60s the South Koreans:

    (*) accepted that globalised trade was the answer – they adopted export-oriented programmes in line with classic conceptions of comparative advantage, and did away with import restrictions on critical intermediate and capital goods, both of which were almost all imported up until the late 70s (!) (this is a big one – this was probably enough to overcome the damage caused by import tariffs in respect of consumer goods, some of which were produced by the favoured industrial concerns) – see (6) above;

    (*) encouraged private enterprise by providing low-interest loans;

    (*) got rid of foreign capital restrictions, which precipitated a massive and prolonged influx of FDI from Japan, etc., (easily the most important factor in South Korea’s development, something which simply blew away any negative effects of inefficient state direction – easy from the low base) – see (7) above;

    (*) implemented higher positive interest rates to encourage savings (domestic capital);

    (*) significantly reduced both direct and indirect tax rates.

    Of course, they had a massive head start with all the capital that the US pumped in after the war, but still. These factors produced the South Korean economic miracle, but because the government still had its hands all over the shop, the leftists think it’s all an advertisement for protectionism (or even socialism). Many places had the same kind of protectionist attitude (for example, India), but they went nowhere (comparatively) because they did adopt prescriptions (3), (4), (6) and (7) of the neoliberal programme I have set out above. More’s the pity.

    BBB

  22. Bingo Bango Boingo
    September 25th, 2008 at 01:27 | #22

    Make that “they did NOT adopt prescriptions (3), (4), (6) and (7) of the neoliberal programme…”

    BBB

  23. gerard
    September 25th, 2008 at 19:05 | #23

    would you categorize what J. Quiggin terms ‘the US model, early C21′ as more or less ‘Neoliberal’? If different, would you say that the problematic differences involves an excess of ‘social democratic’ policies?

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