Reader Question Roundup

In addition to answering questions in the comments on each post, we try to do a weekly roundup of questions that may be of general interest. Some are in comments we didn’t get to, some in emails. Please continue giving us questions – they help us understand what is important to our readers.

What can we (readers) do to help?

This one got its own post all to itself.

Three questions from a prescient reader

One of our readers goes by “pk” on our blog. On September 27, he sent us an email asking three questions:

  1. Is the size of the bailout (independent of the technical aspects) sufficient?
  2. Will what has happened in the US be repeated across the globe?
  3. If economies come unhinged across the globe, what are the geo-political implications?

Since that date, the general consensus is that original bailout was too small (at least on its own), and we have clearly seen the U.S. experience echoed in other countries. And the third question is the subject of our Washington Post article. (pk also predicted a global interest rate cut, which has since happened; in my comment, I said that would be nice but not sufficient to stem the crisis, which I still stand by.)

What are credit default swaps?

We got a few requests for an explanation, which I have since added to the Financial Crisis for Beginners page. There were also questions about when they will expire, or even potentially making them illegal.

Credit default swaps are a form of insurance, and as such can play a valuable function. The two most commonly cited problems with them are (a) the fact that they can be bought independent of the underlying securities and (b) they are completely unregulated, so you can have no assurance the seller will actually be able to pay them off. My opinion is that they need to be regulated – and there are already discussions of creating transparent exchanges for them. They did not cause this crisis on their own, and at this point the crisis has reached a point where magically making them disappear would not solve our problems.

On credit default swaps – what was the thinking behind selling insurance products to people who didn’t own the insured asset? Maybe the answer is “because they could, and there was no one there to stop them, and they got filthy rich doing it.”

I think that’s exactly right. I could make an argument that allowing more people to participate in the market provides more liquidity and hence more pricing efficiency. But I’m not sure I see any compelling reason for it, given the trouble you can create for yourself. The other argument would be if that you use regulation to eliminate this kind of gambling, it will only show up someplace else – which may be true.

How much of this downward spiral is unfettered panic? I realize that there is a real decrease. But like speculators who drive a price up, I see the same happening in reverse. Any there any signs to be able to better judge this?

Probably a lot of people are interested in how far the stock market will fall, where it “should” be, and when it will start going up again. We try to scrupulously avoid anything that might be interpreted as personal finance advice, because we don’t have any particular expertise in that area. But for those interested in this question, I can point you to an article by David Leonhardt – a smart financial journalist – in the New York Times. He points out that, based on P/E ratios, stocks are below their long-term average now. However, he also points out that, in market declines, the market often swings well below the long-term average before rebounding.

6 responses to “Reader Question Roundup

  1. Nadine MacLane

    What will be the effect of the low value of Lehman at auction Friday? How did/will the CDS web unwind?

    If I was an institutional investor, who bought a CDS, but did not own the underlying stock which went “bad” (and didn’t buy a CDS to cover one that I sold), would I be entitled to the same money as someone who actually sustained a loss due to the asset depreciaton? Would making good on investor’s CDS costs (ie: money paid) allow more stable unwinding of these tangles? It seems that there are multiple institutions at the end of the chain.

  2. A bit of background for those now following the Lehman auction: There are theoretically two ways to settle a CDS. One is that the insurer pays the full face value to the buyer, and the buyer gives the bond to the seller. The other is that the insurer pays the buyer the difference between the face value of the bond and the current value of the bond. In practice, the latter method is far more common (if not universal) – in part because the buyer of the insurance often doesn’t own the bond in question.

    In Lehman’s case, the question was, what is the current value of the bond (the senior debt)? There was an auction on Friday which determined that it was worth, for CDS settlement purposes, 9 cents on the dollar, which means CDS buyers should get 91 cents on the dollar from CDS sellers. Bloomberg estimates that, as a result, $270 billion will change hands to settle the CDS.

    So the short answer to the first question is that it doesn’t matter if you hold the bond or not. If all of that $270 billion can move through all of the chains without anyone running out of cash, then everything will be more or less fine, because this is a zero-sum game; it’s just money moving around. The fear is that somewhere along the chain someone will not have the cash to pay the next person, with potential ripple effects.

  3. Could you offer an analysis as to the cause of the general collapse in closed end bond funds, please? What are the factors that may lead to their return to value? How is one to evaluate them as to their worth?

    Thank you

  4. Nadine MacLane

    How long should it take to settle the bond, so that banks can breathe a sigh of relief or endure another round of panic? Can’t multiple people have a CDS on the same bond, thus requiring multiple payments of that $270 billion?

    I see this is a zero sum game if you’re in the middle, but what about the person at the end of the chain? Doesn’t someone have to pony up the cash?

  5. I have heard that the cash settlement date is 10/21, though I’ve only seen that in blogs, not traditional news sources. Here’s one article: http://www.nakedcapitalism.com/2008/10/good-and-bad-news-on-lehman-credit.html. The face value of all Lehman bonds is a good deal less than $270 billion, so that number is the total of all the payments that are supposed to zip through the ether on that day. Cash will definitely have to move around.

  6. Looking at the big picture, in the spirit of Capitalism wouldn’t the $700 Billion be better used by a cabinet appointed ivestment team to help emerging industries versus supporting failing one?
    Woul it not be safe to say that our dependence on foreign oil, that has lead to billions lost in war, gas prices going up, auto industries failing tell us VIA the marketplace that we need to go into a different direction?
    For one use the bailout money to support the infrastructural developement for bullet trains and light rail systems and slowly start shifting tax dollars away from highway development to mass transit.

    Invest some of th $700Billion into solar,wind etc…

    Invest into NEW financial institutions that have new guilelines and new regulation versus just more of it.