My startle reaction went numb about four years ago.

Sure. But … suppose an insurance company collects premiums against the promise that it will pay for catastrophic health costs. But then we get an epidemic new disease that has a treatment which is very costly. Nobody planned that. Suddenly there are lots of liabilities that the insurance company can’t pay. If the insured victims write off the money and die, that’s a decrease in liability and an increase in the net-worth of the insurance company. A good thing for all the other kinds of victims who need the money. But….

There’s something screwy about this whole idea that a big company will accept risk in return for a steady income stream, and it will depend on the risks to average out. But far too often the risks do not average out.

The idea is to accept a whole lot of liabilities, far more than you can cover, on the assumption that you won’t have to cover very many of them.

Is there anything about this that bothers you?

It’s not net zero over time. Some say (if I understand correctly what LP was saying) that what is considered “bad debt” now may turn out to be “good debt” after all – later, when the dust settles. And then the US government will make a bunch of money and give us some.

I find this scenario… hmm… let’s say ‘highly unrealistic’ . Not because I know anything about economics, but just the way the world normally works.

Except maybe for people who have Social Security.

It looks to me like we have a bunch of people who say that SS will fail, who repeat that over and over, so that voters will be resigned to it and won’t get too upset when they divert money to something else and SS fails.

By all means, we ought to start planning for the next collapse right away.

Let’s look for ways to make the next collapse run a lot smoother.

I’m not ragging on you, what you say makes a lot of sense. Just….

Well, part of that is that there’s not much to be done about it until everyone figures out precisely what their exposure is and how much will be realised from the remains of Lehman. In many cases, counterparties will actually owe Lehman money. It’s not like Lehman were taking huge (relative to their balance sheet) one way bets on interest rates and currency movements. They were offsetting trades against other trades.

One other reason to be somewhat optimistic is that the fallout makes a central clearing house for derivatives almost a certainty, which should make the next counterparty collapse (after its creation) much more manageable.

Yeah, LP, I remember about 10 years ago I lent a few grand to my ex-wife, and she promised to pay it back soon; still waiting. Would you like to take this ‘chunk of intermediation’ off my hands and, perhaps, make a nice profit?

Ginger Yellow’s analysis of the interest-rate swaps seems spot on to me but I think John is pretty much right all the same: the chaos is caused in the main by lack of information about who has lost and how much.

1) I don’t mean to downplay the chaos that has and will be caused by the Lehman bankruptcy, but as far as I know the recent moves in bond rates aren’t that huge a deal in themselves. Most interest rate swaps in my world (structured finance) are between a fixed rate and a floating rate (eg Libor, Euribor, Eonia, Bank of England base rate). Therefore a move in Treasuries will only have an impact on existing swaps in so far as it affects the floating rate. There have been pretty huge fluctuations in Libor and similar rates over the last year and they haven’t caused a swap crisis.

2) Lehman’s collapse is causing big problems in both interest rate and currency swaps, in that lots of people who thought their positions were hedged now find they aren’t. That may not be too big a problem for operating companies, because they could just novate them to another counterparty, probably at a somewhat higher cost. But it’s a big problem for securitisations which don’t have a whole lot of spare cash lying around by design, and which will find their excess spread eaten up even if they can find a replacement quickly.

3) Credit ratings don’t take into account inflation, except in so far as it is an economic stress. The exact definition depends on the agency, but is either the probability of default or the expected loss by final maturity, according to the terms of the deal. It doesn’t matter what the money is worth, as long as it’s paid.

4)

CDO’s! these are ce essentially structures that by Treasuries and then write a credit default swap(s) – In other words, an insurance company!!

There’s a lot more to it than that. Most synthetic CDOs are effectively bets on correlation in the underlying pool of reference entities (typically investment grade companies, sovereigns or junk bonds). The value of the different tranches depends on whether people think systemic or idiosyncratic credit risk is more likely. The purchase of Treasuries (or other eligible investments) is just to park the investors’ cash safely and prevent negative carry. If there are defaults in the underlying pool, a proportional amount of the cash is used to pay the buyer of protection under the CDS (typically the bank which arranged it), while the same amount is written off from the bottom of the CDO’s capital structure. That’s a simplified picture, of course.

The point is just that inflationary episodes comparable to ones the US has expeirenced in the relatively recent past would entirely wipe out the additional liabilities the US is taking on in this bailout. Assuming, again, that there are net liabilities at all—http://delong.typepad.com/sdj/2008/09/thoughts-on-the.htmlBrad DeLong, e.g., doesn’t think there will be.

You’re forgetting here that fully anticipated inflation will be built into the interest rates the US pays when it rolls over its debts. So, you need to keep on surprising the markets by 2.5 per cent. Three surprises would take you into double-digit range.

And of course, you can’t just cancel the inflation when you’ve got rid of the debt. Starting at 10 per cent it takes at least a decade to wind it back down.