Now for the really big one

That last link is broken – apparently it’s got “ttp” where it should have “http”.

Off topic, but I have worked out why your footnotes don’t work: you are doing Textile2 markup, and processing it with textile1

Lex, I am not sure, but I suppose that a lot of these swaps have been used as hedges for other positions. If some of those other positions are not swaps, companies will be left exposed to to much larger risks than planned.

I guess a total ‘void’ would have the same effect as an unraveling of the market.

I think Saudi Arabia can probably cope – after all, how many diamond-encrusted Mercedes can one man eat?

I seem to remember an article somewhere several years ago talking about how across the board counterparty risk was systematically underestimated, or even completely ignored. One suggestion was that it the fairly unequivocal implicit guarantees of government that any major financial player wouldn’t be allowed to fold – as a worst case the company would be merged into another big player in some way so the intermeshing complex of risk transference that locks all the banking system together can’t be dragged down by a single bad choice.

This reminds me of a gambler using the Martingale system, it looks like a way of guaranteeing winning in the long run, but it will always fail in the end in reality (considering no one has infinite wealth playing against a casino with infinite bet limits).

One other thing I was thinking about as it was being discussed last night on TWIP – the ban on shorting strikes me as being high risk. My understanding is that in recent months a lot of hedge funds have been losing money for their investors, or having trouble finding a way to profit, and that one tool that is being used a lot is shorting stocks. If this means hedge funds lose the confidence of their investors, it seems possible there could be a run on some of these funds as they can’t unwind their positions fast enough, possibly causing a domino effect similar to the one hitting confidence in the banks. Clearly if something like this happens it could have a big impact across a wide range of asset markets which could pile more problems on the banks, insurance companies, etc.

As an insurance professional, my understanding of what is happening is that people who had no understanding of insurance got involved in insuring risk. Insurance is a seductive business – people give you large amounts of cash now in exchange for a contingent promise to pay in the future – and it’s always very tempting to charge premiums that are too low. That’s why insurance is regulated – to make sure that premiums are sufficiently high to pay claims. But Congress prohibited regulation of credit default swap transactions and what happened is what you’d expect: the insurers cut premiums, and justified their actions by systematically underestimating risk. Since there was no history of losses for these instruments, the risk analysis was entirely speculative anyway, and could easily be manipulated by those whose self-interest consisted in entirely in maximizing cash flow.

The reason there is no academic field of “trust studies”

There is, actually. A substantial literature, anyway.

will US-based ratings agencies take the step (automatic if it were anyone else) of downgrading US government debt?

Why on earth should they? There is literally no conceivable situation in which the US government would be unable to cover its liabilities, given that they’re denominated in dollars.

Having a background in both the brokerage AND the insurance industries in part of my former life, let me second Bloix in his analysis.
The mind-set of those who populate the insurance industry and those
who populate the brokerage and financial services conglomerates are not just worlds apart, but many parsecs worth of Galaxies apart. One set is akin to a town full of nothing but gunslingers, the other a town of
nothing but trappist monks (I exaggerate, but not by much.)

As someone who has a piece coming out in the forthcoming capstone volume of the Trust project, I can testify that it is still alive.

As to the lack of work on the doubtless essential topic of Trust Engineering, I look forward to reading your own insights when you get around to publishing them (unless, natch, the system is _so_ totally corrupted by the Worship of the Lie that it fails to recognize the blinding truths that you have to offer). In the meantime, I’m off to mind me kids …

But the dollar now is 10% higher against the Euro than it was a couple of months ago. What’s the explanation of that?

If sovereign debt ratings ignored inflation risk, Zimbabwe would indeed be AAA.

But presumably Zimbabe’s debt is denominated in dollars, or some other international currency?

Are you sure that the credit rating of US debt takes inflation risks into account? Why should it?

I mean, this means that demand for dollar-denominated stuff has not fallen. So, what exactly is it that foreigners are buying these days?

30: I am also curious about this. But if you consider a government bond denominated in the currency backed by that government, the likelihood of default could always be presumed to be zero. But in actuality, the market rate for these bonds will depend on some kind of expectation in the future value of that currency (ie inflation), right?

abb1:

The U.S. $ has appreciated a bit lately not only because foreign economies have tipped into recession faster than the U.S. economy, (at least, according to official GDP statistics), but because wealthy U.S. investors long since got out of the dollar and invested in booming foreign equity markets, but now are withdrawing funds from them to cover their distressed liabilities at home. (Have you looked at the Brazil index lately?)

(and in the case of the USA, this is not necessarily theoretical. There are plenty of people in the USA who believe that, under the guise of “Social Security restructuring”, the USA ought to default on billions of dollars of “non-marketable” Treasury bills, and I have occasionally, although not successfully, raised the question that if a state is prepared to bilk their own grandmothers, why on earth would I assume as an investor that they wouldn’t do the same to me?)

But if you consider a government bond denominated in the currency backed by that government, the likelihood of default could always be presumed to be zero. But in actuality, the market rate for these bonds will depend on some kind of expectation in the future value of that currency (ie inflation), right?

First of all, historically sovereign debt ratings have mostly been for bonds denominated in other currencies. Second, there could still be a default for bonds denominated in the government’s own currency if it simply chose not to honor them, e.g. after a revolution. Third, the credit rating of a bond and its market value can move independently, precisely because there are other risks beside credit risks.

Someone reading this must be able to provide a definitive answer whether credit rating is simply a measure of credit (i.e. default) risk, as I believe, or if inflation risk is independently taken into account. It is certainly true that inflation is taken into account as a predictor of default risk, but that’s different. Note however that the linked article (from the NY Fed) defines credit ratings as “assessments of the relative likelihood that a borrower will default on its obligations.” (Which, if true, means that Moody’s, S&P et al. agree with me and not John Q.)

Another question would be, how much inflation would be required to monetize all the new debt acquired as a result of the bailout? A back of the envelope calculation is that since current debt is at ~40 percent of GDP, an extra 2.5 points of inflation over ten years would get the real value of the debt back to the pre-bailout level. Sustained inflation rates much higher than that have been experienced by the US (and lots of other countries) without sovereign debt downgrades or other serious adverse consequences.

To carry bloix and stuart’s examples even further into the absurd, I personally know an enormous Insurance company (NOT American) whose investment dept. was buying synthetic CDO’s! these are ce essentially structures that by Treasuries and then write a credit default swap(s) – In other words, an insurance company!!!!!

Well, you’re right … unless nominal rates hit 0, which is possible. And depending on the term structure of existing debt — even fully anticipated inflation will reduce the value of existing bonds until they have to be rolled over. With ~50% of the debt in notes and another 10-15% in bonds, even anticipated inflation still gets several years to reduce the outstanding debt. And of course inflation isn’t fully anticipated.

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.

It strikes me that these are exciting times to be an economist.

America won’t be downgraded because there’s no way it will default. Your credit rating is a rating of how likely you are to pay. The US is nowhere near defaulting on any of its debts. John, it’s pretty close to unthinkable that the US would “stiff” any creditors this side of Armageddon.

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.

“Reading this thread, everybody here is surprisingly cool about this thing, I must say.”

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.

John, it’s pretty close to unthinkable that the US would “stiff” any creditors this side of Armageddon.

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.

The key to remember is that the net sum of all financial assets is zero.

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.

The key to remember is that the net sum of all financial assets is zero.
A bad debt write-off for a bank is a decrease in the liability and increase in the net-worth of a consumer and vice versa. All those derivative bets net out to zero also.

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?