Back in November, Michael Lewis wrote a great story in Portfolio on the financial crisis, focusing on the traders who saw that the housing bubble was going to crash, bringing mortgage-backed securities down with it – and made lots of money betting on it. Now Lewis is back with his article in Vanity Fair on AIG Financial Products (FP) and its last head, Joseph Cassano. This time, though, it feels like it’s missing the usual Lewis magic.

Lewis sets out to tell the untold story of FP, based on extensive interviews with people who actually worked there. He starts by laying out the conventional wisdom about FP, which presumably he is going to debunk. The conventional wisdom, according to Lewis, is that the problem lay in credit default swaps: “The public explanation of A.I.G.’s failure focused on the credit-default swaps sold by traders at A.I.G. F.P., when A.I.G.’s problems were clearly much broader.” Indeed, Lewis implies that the government essentially framed FP: “Why were officials, both public and private, so intent on leading others to believe all the losses at A.I.G. had been caused by a few dozen traders in this fringe unit in London and Connecticut?

The problem is that, having actually paid for the magazine and read the article, it seems to me that Lewis only reinforces the case against FP and credit default swaps. He says that all of the FP people he talked to “were fairly certain that if it hadn’t been for A.I.G. F.P. the subprime-mortgage machine might never have been built, and the financial crisis might never have happened.” That sounds to me like a more damning case than I would have made.

In Lewis’s story, it was credit default swaps sold by FP that enabled banks to issue securities backed by subprime mortgages earlier this decade. He has evidence that the people at FP who were insuring these securities had no idea how much subprime debt was inside them. When Gene Park figured it out around the end of 2005, Joe Cassano actually agreed to stop insuring subprime-backed securities. Yet Lewis even holds FP responsible for what came later:

“A.I.G. F.P.’s willingness to assume the vast majority of the risk of all the subprime-mortgage bonds created in 2004 and 2005 had created a machine that depended for its fuel on subprime-mortgage loans. . . .

“The big Wall Street firms solved the problem by taking the risk themselves. . . . Unwilling to take the risk of subprime-mortgage bonds in 2004 and 2005, the Wall Street firms swallowed the risk in 2006 and 2007.”

This is somewhat plausible, but it’s a funny argument. Essentially it says that: (a) FP was responsible for subprime lending because, without insurance, investment banks wouldn’t have been willing to take on the risk of the securities in the first place (and demand from investment banks is what caused frontline lenders to originate these loans); but (b) when FP stopped insuring the securities, investment banks suddenly decided they were willing to take on the risk. I say it’s plausible because it could be that FP enabled a profit machine in 2004-05 and the banks were unble to shut it down in 2006-07 without torpedoing their earnings. But if that were the case, they would all have behaved like Goldman – shorting the mortgage-backed securities markets with one hand at the same time that they originated the stuff with the other. In 2006-07, most banks simply underestimated the risk of the stuff they were holding; that is FP’s fault only if you claim that FP made banks like Bear and Lehman stupid.

So when Lewis says, “A.I.G. F.P. wasn’t an aberration; what happened at A.I.G. F.P could have happened anywhere on Wall Street . . . and did” (ellipsis in original), I’m not sure which side he is arguing. Is he saying that FP is to blame for the crash? Or is he saying that FP caused the crash, but doesn’t deserve to be singled out because it “could have happened anywhere?”

The latter argument, to me, doesn’t make sense. The problem is better illustrated when Lewis describes the rise of credit default swaps in the 1990s:

“The traits required of this corporation were that it not be a bank – and thus subject to bank regulation and the need to reserve capital against the risky assets – and that it be willing and able to bury exotic risks on its balance sheet. There was no real reason that company had to be A.I.G.; it could have been any AAA-rated entity with a huge balance sheet. Berkshire Hathaway, for instance, or General Electric. A.I.G. just got there first.”

I don’t think anyone has ever argued that for some structural reason AIG was the only company that could have created the mess it did. AIG created the mess because it made stupid business decisions that other companies did not make. Other companies made other stupid decisions, but not the one to take a huge, one-sided bet, with no reserves, on the solidity of the housing sector and the entire economy.

Ultimately, I think Lewis is actually too harsh on FP. They made bad decisions, they essentially blew up all of AIG, and they required an enormous taxpayer-funded bailout to limit the collateral damage. But holding them responsible for the bad decisions at all the Wall Street investment banks seems a bit much.

By James Kwak

I originally published this post over at The Hearing on Monday, but it feels more like a Baseline Scenario kind of post.

One part of the Obama Administration’s financial reform plan is tighter regulation of credit default swaps – those previously unregulated derivatives that brought down AIG and nearly the entire financial sector with it. One of the problems with AIG was that its regulators were apparently unaware that it had amassed a huge, one-sided portfolio of credit default swaps that amounted to a massive bet the economy would do just fine; another problem was that, because credit default swaps were “over the counter,” custom transactions between individual private parties, they created a large amount of counterparty risk – the risk that the party you were trading with might not be there to honor the trade.

In response, the administration proposes to “require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).” In addition, “regulated financial institutions should be encouraged to make greater use of regulated exchange-traded derivatives.” Major players in the market will also be subject to conservative capital requirements (making sure they have enough money in case their trades go badly) and reporting requirements. These provisions aim to increase regulatory oversight and minimize the chances that a derivatives dealer will fail and take its counterparties down with it, and as far as they go they are a good thing.

However, there is one potential loophole that, according to UCLA law professor Lynn Stout (on Friday’s Morning Edition), is “potentially big enough to put the state of Texas into.” The loophole is that “customized bilateral OTC derivatives transactions” would remain out of the reach of both exchanges and CCPs.

Custom derivatives would still have to be reported to regulators, so what’s the problem? The small problem is that unnecessary customization of financial products is a great way for derivatives dealers to jack up unnecessary transaction fees. The big problem is that custom derivatives are by their nature harder to oversee. Regulators want to be able to estimate a firm’s potential exposure across all its tranactions under various scenarios; the more complex those transactions, the more difficult this becomes. Regulators already had the power to demand access to banks’ books before the financial crisis; the problem was that they lacked the staff and skills to understand the complex structured products those banks were manufacturing and trading. As a result, custom products become a way for market participants to hide risks from oversight, and a potential means for systemic risks to build up out of sight.

The conventional wisdom is that some firms have unique needs and therefore there have to be customized derivatives contracts. But the real question to ask is why we need customized derivatives in the first place. For example, you can only buy U.S. Treasury bills and bonds that mature on specific dates, and in specific denominations (although perhaps there are banks that will custom-manufacture a Treasury-like security for you, and charge you a transaction fee – while throwing in counterparty risk for good measure). What’s wrong with a world where you can buy a credit default swap on any fixed-income instrument, but only for certain maturities (including the maturity of the underlying instrument) and on standard terms (such as the definition of a credit event and how the swap will be settled)?

I know the high-level answer (in fact, I already said it): firms have unique hedging needs. But I want to hear some good examples. On that same Morning Edition segment, Cory Strupp, a lobbyist at the Securities Industry and Financial Markets Association, gave this example: “If you have a company that wants to hedge a credit exposure in an odd amount of money – $156,217.25 – they can enter into a credit default swap that covers exactly that amount of credit risk, to the penny.” This is a terrible example, because if I’m a company of any size, and I have a credit exposure of $156,217.25 but I can only buy credit default swaps in multiples of $10,000, that’s perfectly fine with me. Strupp must know it’s a terrible example, but must have decided the better examples were too complicated for NPR.

And once we know what the good examples are – and I imagine there are some – the question is whether the benefits they provide to the parties involved outweigh their costs. And by costs, I don’t mean just the transaction costs; I mean the fact that customized derivatives make regulation harder and increase the risks of a costly failure. This is an externality, pure and simple, and it should be deterred or taxed.

(I’m guessing someone will point out that the Constitution limits the ability of the government to interfere in the freedom of contract. But remember, this is a regulated industry. Custom derivatives increase the cost of regulation; it would be perfectly constitutional to say that firms that trade in custom derivatives must pay a hefty tax on those products to offset the increased regulatory cost. If the tax is big enough, that would deter banks from using custom derivatives when standardized ones would do.)

There’s actually an interesting point behind this question. Someone – I think it was Felix Salmon, but now I’m not so sure – said that the real problem wasn’t that firms weren’t perfectly hedged; it’s that they believed they could be perfectly hedged. Risk never goes away; if you think you’ve eliminated it, it’s just gone someplace else to hide. Instead of a system where companies think they can hedge their risks perfectly because financial products are infinitely flexible – and therefore don’t manage their risks effectively – it would be better to have a system where companies can’t hedge their risks perfectly, and know that, and behave accordingly.

By James Kwak

The Washington Post (hat tip Mark Thoma) has a profile of Brooksley Born, who has been credited by dozens of commentators (including us) for unsuccessfully attempting to increase regulation of derivatives in the late 1990s while serving as the head of the Commodity Futures Trading Commission. There’s much to admire, including being the first female president of the Stanford Law Review, making partner while working part-time, and, most importantly, this:

Born keeps informed, but she has other concerns, bird-watching jaunts and trips to Antarctica to plan, mystery novels to read, four grandchildren to dote on. “I’m very happily retired,” she says. “I’ve really enjoyed getting older. You don’t have ambition. You know who you are.”

Then there are the frightening flashbacks to the regulatory battles we are sure to relive this fall:

Greenspan had an unusual take on market fraud, Born recounted: “He explained there wasn’t a need for a law against fraud because if a floor broker was committing fraud, the customer would figure it out and stop doing business with him.”

Translation: Imperfections in free markets are logically impossible.

She wanted to release a “concept paper” — essentially a set of questions — that explored whether there should be regulation of over-the-counter derivatives. . . . [Robert Rubin, Larry Summers, and Arthur Levitt] warned that if she did so, the market would implode and predicted tidal waves of lawsuits.

Translation: You cannot say anything that might upset the markets.

In one call, Summers said, “I have 13 bankers in my office and they say if you go forward with this you will cause the worst financial crisis since World War II.”

Translation: The Deputy Treasury Secretary should listen to the thirteen bankers in his office.

Mark Thoma sums up:

The people in charge of the regulatory agencies were convinced that unregulated markets were self-correcting, and that regulation was not needed and would more likely do harm than good. As this shows, no amount of convincing from people who weren’t as smart as the smartest guys in the room was going to change that. The question for me is whether those in charge now, Summers for example, have learned their lesson and the humility to be derived from it, or whether they will be defensive of their own role to the extent that it affects the type of regulation they can support. I’d very much like to believe they have learned their lesson, though humility seems to be lacking, but watching Summers and others argue that the private sector and the market is preferable to temporary government takeover of banks (i.e. his and the administration’s opposition to temporary nationalization),  – the continued faith that the market always knows best – makes me wonder if they have.

By James Kwak

I want to pick up on a theme Simon discussed in his last two posts: the recent panic over bank debt, particularly subordinated bank debt. I’ll probably repeat some of what he said, but with a little more background.

Remember back to last September. What was the lesson of Lehman Brothers? The most important asset a bank has is confidence. If people are confident in a bank, it can continue to do business; if not, it can’t.

For the last six months, where has that confidence been coming from? Not from the banks’ balance sheets, certainly. And not, I would argue, from the dribs and drabs of capital and targeted asset guarantees provided by Treasury and the Fed. It has been coming from a widespread assumption that the U.S. government will not let the creditors of large banks lose money, out of fear of repeating the Lehman debacle.

The story goes something like this. Let’s say that Citigroup were restructured – via bankruptcy, or via government conservatorship – in such a way that creditors did not get all their money back. (None of this applies to FDIC-insured deposits or to recently-issued senior debt that is explicitly guaranteed by the government.) They might be forced to convert debt for equity, or they might be stiffed altogether. The first-order concern is that this would have ripple effects that could take down other financial institutions. According to Martin Wolf, bank bonds comprise one quarter of all U.S. investment-grade corporate bonds; losses would be spread far and wide, hitting other banks, pension funds, insurance companies, hedge funds, and so on. If Citigroup did not support its derivatives positions, then institutions that bought credit default swap protection from Citi would face further losses. (I believe that most U.S. banks were net buyers of CDS protection, however.) The fear is that it will be impossible to predict how these losses will be distributed and who else might go down.

The second-order concern is bigger. After all, Lehman did not seem to force any major financial institution into bankruptcy, although it may have twisted the knife that AIG had already stuck in itself. Once investors figure out that bank debt is not safe, they will refuse to lend to any banks, and we are back in September all over again. Or almost: it is possible that the Federal Reserve’s massive efforts to provide liquidity to the banking system will be enough to keep banks functioning. But who wants to take that risk?

This is why, for the last five months, the government has been doing everything it can to imply that bank creditors (at least for “systemically important” banks) will be protected, without saying so explicitly, because that would suddenly increase the potential liabilities of the government by trillions of dollars.

So what changed this week?

Simon’s theory is that the semi-forced conversion of Citigroup preferred into common shares was taken as a sign that the government may try to force creditors to exchange their bonds for common stock in future bailouts. Preferred shares are not, technically speaking, debt. But they are a lot like debt, and once you finish converting preferred into common, the next layer of the capital structure is subordinated debt. Now, Tim Geithner could come out and say, “Yes, we forced a conversion of preferred into common, but we’re going to stop there and not do the same to creditors.” But no, actually, he can’t say that, because that would constitute an explicit guarantee of all bank liabilities. So the market is left wondering, and we know by now that markets don’t like uncertainty.

Another possibility is simply that more and more people are thinking that the government may end up restructuring debt. Martin Wolf and Willem Buiter, both very serious people, both have raised the question of whether the government should be protecting creditors. Wolf, I believe, doesn’t answer the question (although he discusses the issue very well); Buiter says no.

Each time the lines on that chart above have spiked upward, the government has taken some action to imply that creditors will be protected, without making any promises. Chances are we’ll see another action along those lines. At some point, though, the government may lose credibility.

As an aside, one of the steps in Sweden’s sometimes-heralded bank rescue program was an explicit government guarantee on all bank liabilities. If any country could guarantee its banks, you would think it would be the U.S. But the real barrier to taking such a step is probably political more than anything else.

Update (3/8): Krugman says:

[S]ome decision must be reached on bank liabilities. Sweden guaranteed all of them. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership. And I’m ready to be persuaded that some debts should not be honored — this is a deeply technical question.

The credit default swap market is a modern Delphic Oracle.  It speaks loudly and profoundly – these days at regular intervals – albeit using somewhat arcane terminology.  And after major statements such as yesterday (or perhaps this week in general), it’s worth pausing to reflect on, and argue about, what it really means.

Thursday’s statement, to me, was about US banks (graph).

The risk of default for US banks, according to this market, is rising back towards levels not seen since mid-October.  That is striking enough – but remember what has changed since then: (1) the G7 promised not to let any more systemic banks fail, (2) Treasury has provided repeated recapitalization funds on generous terms, and (3) the Fed offers massive, nontransparent funding to anyone in distress.  How can it be that the credit market still or again feels the risk of default rising so sharply and to such high levels?

The most plausible interpretation - and here I’m willing to debate what the Oracle meant exactly – is that people expect the government will force the conversion of junior bank debt into equity.  The treatment of private preferred shareholders at Citigroup, last week, is seen as the harbinger of further losses for investors.

In a comprehensive systemic clean-up approach and complete recapitalization approach, debt-equity swaps could potentially play a sensible role, particularly in countries without the fiscal capacity to sustain guarantees of all bank liabilities.  But if they are done in chaotic crisis mode – as the government appears to be signalling - the additional damage to confidence around the world will be huge.

The events of mid-September 2008 were traumatic and awful to behold.  I saw that trailer and I don’t want to see the movie.  But it is exactly into that scary future that we now head.

It’s never too late to change policy, to make a difference, and to turn things around.  But it is already very late.

If you think credit default swap (CDS) spreads are informative with regard to developing pressure points and issues that policymakers should focus on (or will likely spend hectic weekends dealing with), you should look at the latest CDS spreads for European banks.  The Irish story we have already flagged.  I’m also concerned that developments in East-Central Europe are starting to affect the prospects for West European banks, most notably in Austria.

My point is not that collapse is imminent.  Rather, I would suggest that now is the time for preemptive policy action – presumably at the European Union level – to head off these problems.  As we have been arguing since last October, there needs to be an integrated European-wide approach to these problems, including agreement on who receives what kind of financial support and under what circumstances.  The roles of the European Central Bank and the IMF (if any) in this context are in particular need of further explicit elaboration.

It is simply astonishing that, after all we have seen, senior European policymakers remain in substantial denial about the depth of global problems, the way in which these have direct impact on Europe, and value of thinking ahead.

Even if you are convinced that the CDS market represents pure speculative pressure, i.e., unrelated to “fundamentals”, spreads at this level are still a call for action.  In fact, in that case there is no excuse for not putting in place transparent and well-communicated fiscal policies with massive external financial support.  That should scare any speculators away.

Of course, if you believe that the CDS market is completely uninformative, there is nothing to worry about.  And there was, in retrospect, nothing to worry about when the same market pointed to growing dangers for UK mortgage lenders in fall 2007, US banks in 2007-2008, Iceland in fall 2008, and emerging markets right before the IMF started handing out big loans.

No, this isn’t another article about how credit default swaps (CDS) have ruined or are going to ruin the economy. It’s about one of the nice side benefits of CDS: the habit they have of pointing out who is going to get into trouble next. And it has pretty Bloomberg charts!

As everyone probably knows by know, a CDS is insurance against default on a bond or bond-like security. If you think about it for a while, you will realize that this means the price of the CDS reflects the market expectation that the issuer will default.

The price of a credit default swap is referred to as its “spread,” and is denominated in basis points (bp), or one-hundredths of a percentage point. For example, right now a Citigroup CDS has a spread of 255.5 bp, or 2.555%. That means that, to insure $100 of Citigroup debt, you have to pay $2.555 per year.

CDS exist for various durations and on many different kinds of debt. If someone doesn’t specify the duration or the type of debt, he is usually referring to a 5-year CDS on senior debt. That means that the contract will be open for 5 years, during which one party (the insured) pays premiums and the other (the insurer) promises to pay off if Citigroup defaults. If there is no default within 5 years, the insurer gets to keep the premiums.

Look at it from the standpoint of the insurer. If Citi doesn’t default, I get $2.555 x 5 = $12.775. If Citi defaults immediately, I have to pay $100. That implies that I think there is about a 12.8% chance that Citi will default (ignoring the time value of money). Actually, my expectation of a default is actually somewhat higher, for a couple of reasons. First, if Citi defaults 4-1/2 years from now, I have to pay $100, but I’ve collected the $12.775 in the meantime (assume premiums are paid at the beginning of each year for simplicity), so my loss is only $87.225. Second, in any case I don’t have to pay the full $100; I only have to pay $100 minus the value of the security, which is unlikely to be zero even in the case of a bankruptcy. For example, Lehman bonds were only worth 9 cents on the dollar (so insurers had to pay out 91 cents), but Washington Mutual bonds were worth 57 cents. So my net loss will be lower, which means that my expectation of a default is higher. (The expectation is the money I expect to gain if there is no default, divided by the net amount I expect to lose if there is a default.)

Luckily, Bloomberg can calculate all of this for you, and right now they say the chance of a Citigroup default in the next 5 years is 16.2%. (That’s using a recovery rate of 40 cents on the dollar, but you can type in whatever rate you want.) You can see the valuation on the right side of the screen below.

OK, that’s interesting, but why call credit default swaps heralds of doom? Because CDS have shown the ability to identify what financial institutions (or countries) are going to get into trouble next. When the market starts getting nervous about a company and thinks it is more likely to default, insurance on that company’s debt starts getting more expensive. And this tends to happen before you start reading about that company in the newspaper.

Here are a few examples, in which I compare CDS prices to my home-grown “mainstream media” indicator, which is when the first article appeared in the New York Times saying a company was in danger of failure (as opposed to just taking writedowns along with every other bank). This is not scientific, because really you would want to compare the company’s CDS curve to an index of other companies in the industry to separate out sector-wide trends, but you get the point.

This is the chart of Bear Stearns’s CDS. Note that the price started climbing steeply in late February.The first Times article about Bear Stearns’s troubles was published on March 11, referring to the plunge in the stock price the previous day.

This is AIG. It looks like an instantaneous spike in mid-September, but the price had been climbing steadily, from double digits in May to 300 bp in mid-August to 430 bp on September 4. The first Times article appeared on September 12, again describing events on September 11. By September 10, however, CDS spreads were already up to 517 bp.

And this is Iceland. In the middle of 2007, Iceland’s CDS were priced below 10 bp. They spent most of July and August this year in the high 200s, passed 300 in mid-September, and reached 395 bp on Friday, September 26. Iceland only reached the attention of the mainstream media on Monday, September 29 (Times article the next day, in which Iceland barely got a mention).

So whose CDS spreads are climbing now? That will have to wait for another, or several other, posts.

Update: Felix Salmon says that CDS spreads are no longer accurate predictors of defaults. Maybe he’s right.

Since the Lehman credit default swaps settled without the sky falling, there has been a small wavelet of support for the once-obscure financial instruments that are widely blamed for amplifying the effects of the financial crisis, including a Forbes.com op-ed entitled “Credit Default Swaps Are Good for You.” I happen to agree that CDS can play a useful role in enabling bond investors to hedge against the risk of default, and thereby make it easier for some institutions to get credit. But it’s a bit premature to proclaim that all is well and good in swapland.

Most obviously, there is the troubling matter of AIG, which has recently received additional scrutiny from the likes of the New York Times and the Wall Street Journal (subscription required). AIG has already burned through most of its initial $85 billion loan from the government, has drawn down half of a separate $38 billion loan for its securities lending business, and recently got permission to sell up to $20 billion of commercial paper to the Fed. (And remember, when negotiations over the AIG bailout began around September 12, the company was saying it only needed $20 billion.)

Most of the cash has gone to post collateral for CDS deals in which AIG was guaranteeing various bonds against default. As the risk of default goes up, counterparties demand collateral (cash, or cash-like securities); the amount of collateral they want goes up with the likelihood that AIG would have to pay out on a default. (The WSJ article sheds some light on the negotiations that other banks had over collateral; Goldman Sachs, when it couldn’t get as much collateral as they wanted, hedged themselves by buying insurance on AIG’s debt, which is a clever move I wouldn’t have thought of.) If AIG hadn’t been bailed out, its counterparties would be looking at tens of billions of dollars in losses in the form of write-downs on their CDS portfolios, because a bankrupt AIG could not be counted on to pay off on those contracts. Not knowing who was bearing those losses would have increased the fear that for several weeks was paralyzing the credit markets. So arguably, the potential damage of CDS was only contained precisely because the government elected to bail out AIG.

Now, how did the brilliant minds at AIG Financial Products – and they are, or were, brilliant – get into this situation? Like every other financial institution in these markets, they were using models – models, in this case, that estimated the probability of default on the various bonds AIG was insuring by “selling” credit default swaps. The WSJ article says that AIG was (a) using default-prediction models to determine the likelihood that it would ever have to pay out on credit default swaps, but did not have models (until it was too late) for two other risks: (b) the risk that increasing probability of default (as reflected in CDS spreads) would trigger collateral calls by counterparties, and (c) the risk that increasing probability of default would show up as write-downs on AIG’s balance sheet.

I don’t buy this distinction. Risks (b) and (c) occur precisely because the underlying bonds are becoming more likely to default. In order to distinguish risk (a) from risks (b) and (c), you have to have a theory that (1) the probability of default of the underlying bonds is separate from (2) changes in prices of the credit default swaps on those bonds – but (2) is nothing more than the market’s assessment of (1). This amounts to saying that your default-prediction model is right and the market is wrong, even when the market is composed of other banks with similar models; that’s not an argument you’re likely to win.

More fundamentally, there is a question about how valid even the best of these models are. In the last two decades, a new discipline of risk management has been developed in the financial sector. The basic approach is to estimate the variance of the values of the different assets that make up a portfolio, and the variance of the events that can affect the values of those assets, taking into the account the correlations between all of these values and events (that is, the chances of GM defaulting and Ford defaulting are not independent events). Once you’ve done that, you can estimate the likelihood of your portfolio losing X% of its value; if you don’t like the answer you get, you can use hedging strategies to reduce that likelihood. (This movement toward risk management modeling was so successful that the 2004 Basel II Accord recommended that banks be allowed to use their internal models in determining their own capital requirements.)

The problem is that, in general (most of these models are proprietary secrets, so I can’t speak with complete confidence), these models are fed by historical data – because, by definition, that’s the only data you have. So estimates of price volatility or of other events are based on past experience – experience that may only cover a very short period of time, especially where new and complex financial instruments are concerned. More importantly, even a long period of time is not relevant if there is a fundamental difference between the period your data is from and the current moment. To sum this up: Let’s say housing prices have never declined by 30%. You can’t assume they won’t fall by 30% in the future, for two reasons. First, it could be that they only fall by 30% every 100 years, and you only have 50 years’ worth of data. Second, it could be that in the past housing prices couldn’t fall by 30%, but the world has changed in a significant way, and now housing prices can fall by 30%.

As a result, early in the crisis (back in 2007), you would hear people saying that they were seeing “six-standard-deviation” events, or events that should only happen every hundred thousand years. This is just a silly thing to say. As a statistical matter, if your model says that some event was virtually impossible, it is generally more likely that you made a mistake than that an extremely unlikely event occurred.

In any case, the scale of the losses that have occurred in the last year and a half, and the pronounced failure of every financial institution to anticipate them – see the successive earning calls of every large US bank in 2007 – are as good proof as we will ever find that their risk management models simply didn’t work. If something called a “risk management” model doesn’t work under the the most extreme conditions, what’s the point of having it?

Yesterday was the last day for settlement of credit default swaps linked to Lehman debt. One of the fears raised in the dark days of September was that the failure of a bank like Lehman would create hundreds of billions of dollars of liabilities for companies that had sold insurance on Lehman debt, and that market participants had no way of knowing who was good for that money, because many sellers were hedged and might be counting on payment from another seller, who might be counting on …

Well, the financial system is still standing. While we won’t know who lost money until the next quarterly earnings are announced, no one defaulted on the CDS. In part, this was due to the fact that as Lehman bonds fell in value, sellers of CDS had to post collateral to buyers, so a lot of the losses had already been recognized. (I believe AIG was an exception to this, because they had a AAA bond rating and hence did not have to post collateral until they were downgraded.) Perhaps things would have been worse without the many liquidity-increasing steps the Fed took over the last month; if you have to raise cash in a hurry, it is far easier to get it from the Fed now than it was in the past. In any case, it appears we have one less thing to worry about, at least for now.