Streetwise Professor

January 28, 2009

Fools and Drunkards

Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 11:26 pm

I have always held Congress in low regard, but never so low as now.  Capitol Hill has become a veritable vortex of stupidity.  

Exhibit 1: The laughably mis-characterized “stimulus” bill, which will do nothing of the sort.  If a private business engaged in such blatant false advertising, the FTC would shut it down tomorrow.  This bill is nothing more than a Trojan Horse stuffed with every political boondoggle conceived over the last decade.

Exhibit 2: “A draft bill circulated in Congress that would change how over-the-counter derivatives are regulated might ban most trading in the $29 trillion credit-default swap market.”  The bill forces central clearing of CDSs.  As I’ve argued ad nauseum, this is a bad idea.  But that’s not the worst of it:

House of Representatives Agriculture Committee Chairman  Collin Peterson  of Minnesota unveiled an updated draft bill today that would prohibit credit-default swap trading unless investors owned the underlying bonds. The draft, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the$684 trillion  over-the-counter derivatives market to be processed by a clearinghouse.

This requirement that CDS traders “own the underlying bonds” would prevent the credit derivatives market from performing its vital risk transfer function.  Note to Congress, and to Rep. Peterson: Hedgers (who own the bonds) want to reduce their exposure to that risk.  They do so by buying protection FROM SOMEBODY THAT DOESN”T OWN THE BOND.  That is, the bond owner can’t hedge unless he can buy protection, almost always from somebody who doesn’t own the bond.  The CDS market effectively transfers risk from the current bondholder to a speculator.  This is a transaction between consenting adults that presumably makes both of them better off-or else they wouldn’t do the deal.   Put differently, if you want to permit bond holders to reduce their exposure to the risk of that bond’s default, you need to let somebody else increase that exposure.  

But this is apparently lost on Rep. Peterson, and the bill’s supporters.  They have apparently internalized the view that hedging is good but that speculation is bad.  But you can’t have hedging without speculation.  

This is especially true in the corporate debt market.  In commodities, you have natural long exposures (e.g., oil producers) and natural short exposures (e.g., airlines) who can hedge by trading with one another.  Speculators are necessary only to the extent that the hedging demands of the natural longs and natural shorts don’t match completely.  In corporate bonds, there is a lot of natural long exposure looking to hedge, but not a significant natural short exposure.  Hence, speculators–market participants willing to absorb exposure to default risk–are especially important.  

Some reporting I’ve seen about the bill talks about how its supporters denigrate “naked shorting” via the CDS market.  Sheesh, just when I’m glad to see Christopher Cox’s taillights fade to black, here are legislators parroting his moronic moralizing about perfectly legitimate–and essential–actions.  

Peterson is (as I recall) a former insurance commissioner in Minnesota.  Perhaps he would understand this analogy: his bill makes as much sense as one that would allow only firms that own high rise buildings to insure high rise buildings.  

This measure is exactly NOT what is needed in the market right now.  If anything, our shaky banking system needs better, more robust mechanisms to manage credit risks.  It definitely does not need the decapitation of the existing mechanism for managing these risks, as imperfect as that mechanism may be.  

I actually wonder why the bill even bothers to mandate creation of a clearinghouse.  The provision I’ve just discussed means that there won’t be any trades to clear.  So what’s the point of creating a clearinghouse?  

Who knows whether this absurd provision will actually become law.  Of course it will be distressing–and very costly to the market and to the economy–if it does.  But even if it doesn’t, it is bad enough that such a clearly idiotic proposal, predicated in a complete and willful misunderstanding of the role of derivatives markets, has made it this far.  It is a testament to a truly frightening combination of ignorance and arrogance that is rife in Congress.    So convinced of their own rectitude, and their own ability to control complex markets, they meddle ceaselessly in what they do not understand.  They are modern day sorcerer’s apprentices, who wreak havoc in the vain belief that they are doing good.  

I say again: I hope Bismarck was right when he said there is a special providence for fools, drunkards, small children, and the United States of America, for we have fools and drunkards (on power) governing America, and imposing crushing burdens on small children–and the children of today’s small children.

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  1. Warren Buffett stayed away from credit default swaps. Good move.

    What I am trying to understand is why institutions in the US to foreign institutions like the Bank of Scotland did not “know” from wheom they were buying “insurance.” These are institutions supposedly equipped with analysts and analytical tools. How on earth could they not know that the CDS’s were being “issued” by firms that had no capital, no reserves, no nothing?

    And, more importantly, why it is the obligation, suddenly, of the US taxpayer to “bail out” not only them, but also mortgage INVESTORS?

    The Dems have found a great excuse to cause panic, and to use predictions of disaster as an excuse for government control of everything, and to finally socialize everything, including auto manufacturing.

    Bawney Fwank blew it in the mortgage market, so now he and his Dem buddies want to make cars, and everything else.

    I can just imagine what a Bawney Fwank/Nancy Pelosi/Harry Reid car would look like – like one of those little toy cars that one peddled as a kid, with a mortgage on it, no less.

    Ah, well, I guess the exercise would be good for us all.

    Comment by elmer — January 29, 2009 @ 11:13 pm

  2. Quick comment after a long day & night of teaching–Yes, Buffet avoided CDS, but he (Berkshire Hathaway) sold boatloads of index options, and took a major hit due to the volatility spikes. So, he didn’t insure corporate bonds/loans (as CDS protection sellers do), but he did sell insurance on equity portfolios. So, he’s not as much as a derivatives virgin as he’d like people to believe.

    Well, maybe time and energy for one more comment–a lot of the protection was bought from AIG, which did once upon a time have a lot of assets–just not enough. Those who bought CDS from monolines–that was another story.

    Well–maybe one more;-) Yes, use a panic to stampede Congress into voting a bill that will (a) enact every Democrat policy wetdream, and (b) do nothing to address the underlying structural problem. Once that $1 trillion is appropriated, Obama/the Treasury will come back asking for another $1 trillion–or maybe 2–to deal with the banking system.


    The ProfessorComment by The Professor — January 29, 2009 @ 11:39 pm

  3. The Dems have us morphing towards European style socialism plain and simple. After all of the useless pork is spent, we still have bad paper floating around our banking system which must be resolved. The Dems leaned on Freddie and Fannie to accept risky mortgages. It turns my stomach watching that gadfly Franks get a pass on that.

    My head spins every morning reading the WSJ. Sadly, the level of economic literacy in this country is at an all time low. Well, we’ll see at mid-term elections if the same clowns are voted back into Congress. Of course, the way districts have been skillfully gerrymandered to ensure that they probably will.

    elmer, there is a probably one year glut of cars rusting globally. Dealers are refusing to accept any new cars. With oil at or below $40/barrel no one wants the mandated hybrids, another political contrivance.

    Comment by penny — January 30, 2009 @ 11:31 am

  4. Penny, at least before the bailouts there was some resistance.

    But, in the last days of the Bush administration, the floodgates were opened with the Wall Street bailout. Disgusting.

    I joke with the guy down the street who owns a little sandwich shop whether he’s asked for a bailout. He’s a Vietnam Vet, and he always scoffs at the notion – and the notion of bailouts in general. West of the Mississippi, until you get to California and the Left Coast, people still have some sense and measure of self-reliance. Of course, not all government handouts are refused in that territory, but at least there is some semblance of self-reliance.

    People elsewhere have rejected communism, for good reason. Obama and Billary and the Dems, with the cooperation of the lame Repubs, will put us into communism, complete with platitudes and a fawning media.

    Comment by elmer — January 31, 2009 @ 11:16 am

  5. “What I am trying to understand is why institutions in the US to foreign institutions like the Bank of Scotland did not “know” from wheom they were buying “insurance.”
    — I don’t think buyers were that ignorant. My understanding is that the traders who bought and sold these things were motivated by commissions per trade. All they needed was couple of years time to bail out quietly. I am sure that the CEOs and other bigwigs pretty much knew what was gonna happen as well. They kept this mess from appearing on balance sheets(using the Kool-Aids sold by the Big4) as long as they could, to reap hefty bonuses(McKinsey + HR 80-20 Kool-Aid 😉 ) and were confident that since the whole system was in a ditch , they wouldn’t be singled out(We-dint-really-know-he-he-he Kool-Aid).
    All this helped Obama to sell his change-change-Kool Aid :-), which I guess is gonna morph into a we-really-meant-large-scale-corruption Kool Aid.

    Comment by Surya — February 1, 2009 @ 12:15 am

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