President Obama’s Implied Future For Derivatives

If you’ve worked on economic policy formulation – or in any large bureaucracy – you know how to get your boss to make the decision you want.  The key is to frame the options in such a way that he or she feels that your preferred course of action is the only plausible direction.  Alternatives need to be undermined or discredited.

Smart bosses know this, of course, and they seek out sources of information or analysis that are not managed by their subordinates.  The problem is that, traditionally, most such sources are not sufficiently well informed, at a detailed level, to be really helpful in the decision-making process.  The format of most mainstream media – 800 words for the general reader, 4 minute stories, etc – does not allow engagement at the technical level; and, to be honest, technocrats are very good at manipulating the information flow to even the best journalist (who is usually a generalist).  And while there are always outside technical domain experts, research papers appear with a lag and op eds usually have a broad brush (again, a format constraint).

Seen in this context, President Obama – on the face of it – has the role of blogs exactly backwards.  But perhaps he is instead telling us something more profound.

In Sunday’s NYT, the President is quoted as saying (at the end of the story),

Part of the reason we don’t spend a lot of time looking at blogs is because if you haven’t looked at it very carefully, then you may be under the impression that somehow there’s a clean answer one way or another – well, you just nationalize all the banks, or you just leave them alone and they’ll be fine.

Blogs relax previous format restrictions.  Length can vary, as can technical content.  Comments allow immediate feedback, clarification; debate is healthy for ideas.  Experts can now express a view or an endorsement immediately to a broader audience – and get pushback, as appropriate. 

And, on the President’s point, experts can now talk directly to other experts at a very detailed operational level, and the results of that conversation are now public – and again attract public content (let’s be honest: sometimes experts are way off-base and they need to be told).  This is very threatening to official technocrats, both because their monopoly on expertise crumbles and because a broader set of people become skilled at criticizing their ideas.  These technocrats would much rather have their boss read newspapers and weekly magazines.

There is a good reason that the IMF is not free to speak candidly about the United States; it is full of experts who know what they are talking about. 

But the President knows all this, which suggests another interpretation for his remarks.  Perhaps the financial situation – e.g., in and around derivatives – really is too complex for anyone to understand, unless they have the inside knowledge of regulators.  This would mean, of course, that going forward no one can question Treasury about anything important. 

But that, in turn, makes congressional oversight impossible – even if we move to closed door hearings.  And it raises the question: if our financial system has become so economically complex that President Obama is right, then is it also too complex to be politically sustainable?

Big financial players now know they have a colossal potential put or bailout option.  They can also construct interconnected structures that no one can understand, except possibly the Treasury.  So every 10-20 years (or more often?) we will experience a crisis of current proportions?

There is a growing consensus that large banks should be broken up; no more “too big to fail”.  But the President’s implied point about economic/political complexity suggests that derivatives – for all their obvious potential benefits – are too dangerous to be allowed at anything like their current scale.  Who will be willing down the road to let Treasury, without outside comment or oversight, repeatedly provide massive amounts of resources to financial system insiders?

Derivatives have the potential to create a rent-seeking structure that is unparalleled in human history.  No society can afford to allow that kind of financial system to operate.  Either we figure out how to make it much more transparent – and amenable to outside review – or the re-regulation process currently in the hands of Senator Dodd and Congressman Frank needs to consider more radical alternatives.

62 thoughts on “President Obama’s Implied Future For Derivatives

  1. Hopefully, this comment is applicable to what Simon is saying. One of the best examples of the big banks wanting–and having–things both ways has to do with credit default swaps (CDS)
    The largest issuer of CDS was AIG. But CDS was specificly exempted from regulation by the states as insurance through federal legislation. Thus, no reserves were set up to pay future losses (in part, because none were anticipated–by AIG, at least) NOR was the unit of AIG that issued CDS requried to contribute to a guarantee fund to pay claims if AIG’s unit could not.
    Those who bought CDS from AIG were fine with this arrangement until they started having claims. Now they want AIG’s CDS unit treated like any other insurance company. Heads they win and tails we lose.
    It may be even worse with respect to hedge funds. The ones that have made the most money recently bet (literally) against U.S. home mortgages they had no other financial interest in by buying CDS. Again, the CDS trade was specificly expempted from state GAMING laws by the federal government. The hedge fund’s knew what kind of unsecured CDS arrangements they were playing with but now, of course, they want their gains paid to them–even if AIG cannot afford to do so. You cannot make this stuff up.

  2. That was a depressing quote from a president who uniquely harnessed the power of the social web to get elected. His websites (change.goc and have made a big show of broad involvement in policy making (as have numerous mailings and online fora that his team has generated). Suddenly, only the opinions of insiders are interesting. Sad.

    I think your extrapolation from this quote is insightful and scary. I appreciate the utility of derivative markets, and I hope that a way can be found to make them well functioning and transparent.

  3. Seems like recent events make it clear that any loophole will be discovered and exploited. Every type of financial market has been contaminated. There really is no (honest) way forward except the elimination of all these instruments, especially derivatives.

    The world has changed. It’s time to move on. We need a fundamental change in how we do business.

  4. Interestingly, if you look at the set of questions Obama was asked, the reply about “blogs” was almost completely out of context. That he would indirectly address economic blogs in particular is even more telling. I think there’s a profound level of insecurity in the man; this crisis is beyond all experience, and he’s being asked to make decisions on a subject he knows nothing about.

    The fact that he would use bloggers’ ignorance of the facts as an excuse to dismiss their advice is not a good sign. If we’re all so uninformed, please enlighten us!

  5. @Peter

    Yes, it’s depressing.

    Frankly, a cursory look at reveals it’s more of a public relations tool to convince people that the administration cares than to actually seek feedback.

    For example, the “suggestions box” tool to allow Americans to suggest/vote on policy proposals is ludicrously bad. The tool locks-in early suggestions by this mechanism:

    1) During review, show the highest scoring items first, guaranteeing that these items get more reviews
    2) Determine score by net positive votes (total positive reviews – total negative reviews), without regard to _proportion_ of positive reviews.

    Thus, an item submitted earlier with 1.5 million positive votes and 1 million negative votes (a 60% win rate) will dramatically outperform a later item with 100,000 positive votes and 1,000 negative votes (a 99% win rate).

    Last time I checked, 3 of the top 5 items were about legalizing marijuana.

    One can certainly guess at many motivations for Obama’s comment – one is quite simply that his administration feels threatened by bloggers who understand the technical issues, and thus seeks to discredit them.

    Or, perhaps, they truly think we’re all dumb.

  6. High quality, technical or subject-rich blogs should be considered as essential to the discussion as any ‘official’ news site. I wonder if when the President uses the broad term ‘blog’ he has not already put high value discussion sites such as this one into a different category.

  7. Excellent post. Unfortunately, the technical term “rent seeking” does not connote what it actually means. “Legalized theft” comes to mind but I’m sure someone has a better description.

    It is also unfortunate that one of the chief enablers of the rent seeking behavior that precipitated the current massive problem is the President’s gate keeper on economic information. BO hardly has the time to read enough blogs to sort good information from bad.

    I don’t know Summers except by reputation. However, if those of you who do know him can reassure me that despite apparent past behavior he understands the problem in the same terms you do, I would feel much better.

  8. Presidents seem to believe that they are put into office to enact an ‘agenda’ for which they campaigned. The reality is that they are they to manage the events of their time and anything they can do to move an agenda is limited.
    Just as Bush got sidetracked by events and then locked in by his own unwise response to them, Obama is now being carried along by a financial situation that makes most of his espoused goals quite impossible to achieve. He has responded very poorly to that situation.
    Let us hope he is not as pigheaded as Bush.

  9. Very insightful, Simon. We are embarked on yet another Road to Serfdom, which we must not take. The managers at these failed financial institutions are now in a state of bug-eyed desperation to co-op the government and convince Obama and his appointees that the problem is too complex, too far-reaching and too scary to be left to open and verifiable resolution. At the end of the day, these sub-rosa machinations reflect the last-ditch efforts of people with everything to lose — i.e., their remaining wealth and status, most of which is tied up in the equity and good name of their companies — if they cannot find an alternative to bearing the loss of contracts they willing executed with counterparties now unable to perform.

    All of the problem derivative contracts can be settled in fairly short order: Most of the banks and former investment banks (FIBs) have offsetting exposures to each other, or hedge funds, or unwitting customers who thought they were getting a superior yield and now find themselves with claims against insolvent counterparties. This is the legal and economic reality of the current situation. It is a problem for the courts, which have long experience with such matters.

    To the extent the federal government needs to step in, it needs to be along the lines developed in Thomas Hoenig’s paper, which is on the post you provided a couple of days back ( As president of the Federal Reserve Bank of Kansas City he is a trustworthy voice: The government has taken over failed financial institutions, replaced their managements, and re-privatized them after their balance sheets are cleaned up.

    We need to wield Ockham’s razor here: These are contracts entered into by willing counterparties, using whatever risk metrics gave them the comfort to execute these transactions. These failed banks and FIBs employed some of the smartest people on the planet (math, physics, comp sci PhDs from wall to wall) to model and price these contracts: It was a point of pride for all of them, and a differentiating feature they all used in their marketing materials. And they all ran the exposures and credit analysis thru their own in-house credit-analysis programs to assess the risk on a contract-by-contract basis, vis-a-vis the total exposure to the counterpart with which they contracted, and the bank’s balance sheet.

    These contracts were not entered into lightly. Far from it. Now they need to be hived off the balance sheets of the failed banks and FIBs, netted and settled, with the courts adjudicating the valuation disagreements and alleged contractual misrepresentations. As long as these deals were confirmed under ISDAs, they have a legal recourse for recovering losses. That is the basis under which the contracts were executed, and that must be the basis under with settlement and ultimate disposition is resolved.

    Otherwise we destroy the underpinnings of the market itself and all of its supporting mechanisms. Chief among them are the sanctity of contracts, and the ability to contract with strangers knowing your valid contractual claims will be resolved by a disinterested judiciary, before which all are equal. These mechanisms took centuries of social and legal evolution to develop, and the bounty produced by them is unrivaled in the history of the world. We cannot sacrifice all of this to serve the narrow, self-seeking interests of a desperate few who would destroy all of it to preserve their wealth and status.

  10. sometimes experts are way off-base


    Technocratic experts with a lack of humility in the face of complexity got us into this mess and, by gum, technocratic experts with a lack of humility in the face of complexity are going to get us out.


  11. There are two fundamental issues.

    The first is whether the president has access to a full range of public information, the famous “bubble” that they all live in.

    The second is whether the president has access to a full range of private information, the institutional filtering mentioned above.

    I should say that these same issues apply to legislators as well.

    Blogs and other online sources do allow for a wider range of thought to be expressed and more quickly than in prior eras. No longer are ideas constrained by the limited outlets of the major media. No longer are policy ideas slowed by the long cycle of professional publication. This is all good, but the signal/noise ratio is quite small. For every really new idea there are hundreds of echoes of old ones. Every real study takes just as long to produce as before, even if the results can be disseminated more quickly. Furthermore most studies of interest are liable to distortion as partisans cherry pick the parts that favor their positions.

    It probably would be good for the Whitehouse and the CBO to set up groups tasked with sifting through the online media looking for gems. It would only take a few staff people to do an adequate job.

    The second point is more troubling. I like to cite the case of Truman taking over from FDR and not knowing anything about the A-bomb program. All the advice he got as whether to use the bomb and where came from people on the inside with their own agendas. He was duped. To maintain his sanity he spent the rest of his life maintaining that Nagasaki and Hiroshima were “military” targets because that was what his advisers told him.

    The military is the unacknowledged fourth branch of government and is feeding Obama and congress highly distorted and self-serving information. Just today there is a NY Times article on the resistance forming to any cutbacks in exotic military hardware. The argument being used is one of Keynesian stimulation.

    Where would he get impartial information? Not from bloggers, we don’t have access to classified information. There is evidence that information has been deliberately withheld from Bush and certainly from Congress. Some of this may have been to give them plausible deniability, but if the president says he wants all domestic electronic spying to cease and would he know that the orders have actually been carried out?

    Secrecy and information filtering is the death of democracy.

  12. Politicians are often given far too much credit as to what they in a positive sense can and cannot control. They have a talent for making matters worse by implementing constant rapid fire “plans” and now “bailouts” rather than actually correcting problems with well thought out effective actions.

    Of course, their policies can make some difference at the margins but every one or two hundred years powerful forces evolve that are far stronger than the politician’s ability to control them, even the President of the United States. We are now in such a time.

    As the present crisis evolves President Obama and his team will be more like cheerleaders and hand holders than saviors and will likely be carried along by events rather than controlling them.

    I agree with Max that insecurity is shown by Obama’s dismissal of the value of blogs. President Obama and his team imagine that they are the expert “leaders”, even if it is in areas that they know little about. The Obama team would find it difficult to embrace a good plan even if well informed thoughtful respected bloggers proposed it.

  13. I think they do read blogs, even on President’s Blackberry… The Geithner’s financial rescue plan was actually a cut and paste from the blogsphere and that can be proved. The point is the lack of follow up and “concrete” action…

  14. I love it. The first “web savvy” president says he doesn’t listen to bloggers (like Simon) because they just don’t understand the problem or solutions well enough.

    See, only the President’s select group of high priests with their legal pads & closed door political-strategy sessions could possibly have any of the answers for the rest of us little people (bloggers included)

  15. For what it’s worth, I interpreted the comments a bit differently.

    Obama often makes his comments with a particular audience in mind. In this case, I don’t think he was talking to the relatively small handful of bloggers with keen economic insight and their readers.

    Rather, he’s talking to a more general public here. A general public who hears “bloggers” and starts thinking about DailyKos and HuffingtonPost and so on.

    If you begin with “blogs” and look at the whole universe of blogs, his remarks are unsurprising and quite accurate. The vast majority of the blogosphere and its audience “haven’t looked at it very carefully”. And that’s true for any antecedent of “it”.

    If you begin with “blogs authored by experts”, however, you’re looking at a dramatically smaller subset. As the authors and readers of such blogs, that’s naturally what we’d think of when we hear “blogs”, but we’re a bit anomalous in that regard. Simon’s observations are quite right for “blogs authored by experts”.

    But I think Obama is more or less sincerely interested in the views of such people. When he says “blogs” he’s talking about the other 99 percent of the blogosphere; not this part of it.

  16. Mr. Johnson’s comments on financial oligarchy are well-taken. However, the most direct route to bust-up is via reforming boards of directors. Who were AIG’s directors in 2006? Why have their names not been read in public, and these people not banned from future service on boards or as officers of any publically traded corporation? Don’t sue them — hold them to account by humilition and shunning.
    I wish that the normal IMF/FDIC approach would work in the overall banking crisis, but it will not. The losses are too deep and the problem is systemic. Too deep even for sales of sovereign debt, and anything but long-term earnout; the emergency need is to stop the global asset spiral by restoring credit.
    Fixes appropriate for single institutions, groups, sectors, or the systems of small nations — these are pleasant hopes, but no soap. We must nationalize (euphemize) in situ to preserve values of franchises for ultimate cost-recovery IPOs — Bernanke is right about that. Certainly absurb supermarkets, BoA and Citi, should be broken to manangeable pieces.
    Broadsides against derivatives and rent-seeking are not much use. Most derivatives are helpful innovation (true hedging, for example). The trick is to discover useless ones (most tax schemes), and suicidal ones (CDOs and CDS) before widespread roll-out. A plain-spoken “utility model” for ALL too-big-to-fail institutions is the right thing. If you want a career in Gucci-and-suspenders banking, start your own Lazard Freres.

  17. Agree with jZumbrun. I was rather disappointed in his remarks, too, but since he talked about “people who are very sure what to do” he couldn’t have meant anything but the more vocal dumbed down ones…and Paul Krugman. In any case, I think you’re over-thinking the implications.

  18. re: “…derivatives… are too dangerous to be allowed at anything like their current scale…”

    haven’t derivatives, at least in part, grown to the current scale as innovative means to hedge against or skirt regulations meant to affect various aspects of market activity – and if that is the case, is it possible to ‘dis-allow’ or limit certain types of derivatives without sparking the creation of new instruments meant to game the next regulatory response

    re: too big to fail – hasn’t a big part of the problem with the U.S. /global banking/regulatory system been blamed on claims that it is too fragmented

  19. Then there’s the obvious…politicians survive on campaign contributions. Somebody who contributed to campaigns like candidate Obama’s probably doesn’t want transparency or anything changed that would threaten the greed machine they’ve built. They probably don’t want people reading blogs either.

  20. <ahref="; title="Here’s an interesting paper by the IMF that quantifies bank derivative exposure"></a>

    Bottom line: According to the paper, if more than one big bank should fail, losses may approach $1500 billion. This would more than wipe out the Fed’s balance sheet, and send a tsunami-sized shock through the world’s financial markets.

    Another cause for concern is the Banks’ exposure to industrial metal commodity derivatives, which amounts to roughly $2000 billion. That’s far more than the total market value of all metal inventories in the world. As most banks don’t produce anything, one could speculate most of these interests are long. If that is true, the current value of these derivatives is almost certainly a good deal less than the book value.

    After a closer look, one could argue financial stocks are still grossly overvalued.

  21. Simon,

    I don’t know what Obama reads on his blackberry and what he does not, but your remarks about opacity of derivatives and the possibilities of rent-seeking, plus the need for the Treasury to simply keep its mouth shut appear to come to a head in the case of AIG, whose near failure back in September coincided with the Minsky Moment following the collapse of Lehman Brothers. The truth was shown when Fed Vice Chair, Don Kohn, refused to state who is on the other side of the AIG deals that keep going sour. Looks like the ultimate sinkhole of the leftover derivatives mess and the related rent-seeking.

  22. Derivatives are only complex to those who lack the will to take necessary action. Insolvent corporations should fail, the sooner the better. Then we can take our medicine, and find ways to move forward. This is not easy stuff. It is difficult stuff and consequences will have to be experienced. It is better to deal with the enemy you know than one you do not (complexity). Complexity is a scam to fleece the taxpayer. There is clarity in bankruptcy.

  23. Obama’s statements about blogs seem designed to defend his administration’s actions on economic policy. Given the current level of criticism from the left and right, this is not an unexpected move.

    I am more concerned about the fact that Obama’s actions toward the economic crisis are far too similar to Bush’s actions toward terrorism. The administration does not proffer a clear plan of action and there is little transparency. All criticism is dismissed (both illegitimate and legitimate critiques) as emanating from a view of the world that is too simple. We (the American people, both informed and uninformed) are expected to blindly agree with the president because the issues are far too complex for an outsider to comprehend.

  24. I agree with JZumbrun. Don’t add 2 and 2, from two throw away remarks about ‘blogs’, and make 5 or more. BHO’s NYT interview contains the following – far more interesting – observation from the President about how policy is being and is going to be made:

    “What I expect from my team is to constantly be guided by evidence, facts, talking through all the best arguments, drawing from all the best perspectives, and then taking the best course of action possible given…some big uncertainties”.

    Even so Obama does have a problem – a very big problem – but it is one that isn’t going to be resolved simply by reading blogs, however insightful. Though Robert Kutner (has offered a helping hand from the blogosphere – see below).

    Obama’s team is made up of people whose world view has been shattered by what has been going on around them. They are like the fire fighters who were about to be overtaken by a blaze. One member of the team (the only one to survive) stopped, set the ground around him alight, and lived to tell the tale; he survived in the midst of the blaze. His ability to think clearly meant he lived to rewrite the fire fighting manual. Obama’s team is fortunate – none of them have to write a new manual; what needs to happen, conservatorship, has been carried out on a modest scale in Sweden. It allowed the Swedish authorities to reboot their financial system – to get the control and transparency that was needed to clean it up.

    Robert Kuttner – in his White House Confidential – has done his best to help the President and his team do precisely what the President says he expects his team to do. Why read blogs, when you can invite the best bloggers in for a chat?

    Six weeks in we are about to find out if this is a reality based presidency – one that is unapologetic about being committed to evidence-based policy making. I cannot believe that Obama subscribes to the views of a recently departed predecessor whose acolytes explained: “”We’re an empire now, and when we act, we create our own reality.”

    There is no doubting that the Bushmen were creative. Now its time to expose what they created. Covering it up isn’t a option if we want a financial system that is fit for purpose.

  25. Hardly.

    Derivatives have grown to their current scale due to a misperception of risk and the presence of extreme leverage.

    The misperception of risk has two components – psychological and methodological.

    The psychological component has been well discussed. Humans tend to discount low probability events (black swans). They also use signalling behavior from other humans to make decisions (herd dynamics). Our brains do other funky things too (your hormones can change your risk perceptions from day to day).

    Now, one would hope that our fancy statistical tools can protect us against our biology.

    Sadly, no.

    Enter the methodological components of risk perception. They generally have to do with two components:

    1) All of the models used in assessing risk are partial models. They typically do not account for many things, including feedback to the rest of the economy. (That is, they take certain things as static, and these factors become exogenous to the model. However, they are really endogenous, and that feedback loop can be really nasty.)

    2) Many of the models are much more simplistic than you would imagine. For instance, the models which said that the mortgage-backed securities were AAA because they were in the highest traunch among a bundle of mortgages.

    These models looked at historical default trends, and generally assumed that the probability of any given home default could be modeled as if that default were an independent event. This implies that the probability that more than 50% of the homes default together is ridiculously small.

    However, these events are not independent – they are highly correlated due to common linkages to external factors (e.g. house prices, employment, interest rates, etc.)

    It’s like this: The models assumed that a thousand mortgages are a thousand separate coin flips. Add them up, and you’re bound to get close to 50% heads. The chance of getting 90% heads is really really tiny.

    But in reality, it’s just one big coin flip, multiplied by a thousand – so the risk is much higher.

    In conclusion – we constantly hear that derivatives are good because they stabilize risk. That is utter and complete hogwash. No one who invests in the derivatives market believes that line of free-market ideology, though they spout it to defend their activities. How many of the people who invested in oil in July 2008 did so because they needed to hedge their own future consumption? A few, yes. But many were speculators. Many others used oil as a hedge for their other investments – thus turning a commodity that is necessary to conduct almost all commerce into a financial hedging instrument with incredible volatility. Consider the efficiency impact of that event…

    The simple truth of the matter is that:

    A) Humans, even with our computers, our fancy models, and our PhDs (of which I am one), are pathetically innacurate about forecasting.

    We are a lot dumber than we think, and the dumbest experts are those who do not realize they are dumb.

    B) If we build a megasystem (like the international 60 trillion dollar CDS derivatives market) which is fundamentally based on the assumption that humans are hyperrational and generally smart, we are asking for trouble.

    That trouble is horribly magnified because the failure of the megasystem impacts everyone on the planet, regardless of whether they participated in that megasystem.

    The resulting instability creates incredible costs for every living person. Thus, common people (in addition to holding down 50 hour a week jobs) have to closely watch arcane CDS markets to assess whether they should buy a car this year?

    The fact of the matter is, SOME MARKETS SHOULD NOT EXIST.

    Nor does every market have a _right_ to exist, because no one – has a RIGHT to demand the government create and maintain a market so they can put the world in jeopardy.

    I’m all in favor of people going out and writing whatever “free contracts” they want. However there is absolutely no reason why the US Federal Government is required to spend taxpayer resources to create socially dysfunctional markets by enforcing legal contracts that are decidedly harmful to our national interests.

    There is ample legal precedent for refusing to enforce classes of contracts that are deemed socially harmful. (Loan sharking, for example.)

    Does this mean the government is robbing you of your freedom? Heck no!

    And if you can manage to create a 60 trillion dollar market based on contracts that governments refuse to enforce, more power to you. There are plenty of island nations where you can set up shop.

  26. Thank you for your viewpoint, markets. I have often wondered why Ockham’s Razor was NOT being applied to this whole entire mess.

    My conclusion was that the truth would be on the level of horror of actually seeing Satan in the flesh; it would be a level of greed incarnate the ’80s were the testing (and proving) grounds for.

    This site is truly very, very vital in aiding the average Joe (like me) on the state of the global economy. Thanks to all of you who regularly contribute. It really aids in my edification.

  27. lots of blogs seem to be designed to spin/defend the Obama administration’s actions on economic policy

    still can’t see how something/somebody can dis-allow the universe of derivatives from becoming ‘too big’ without, in itself, him/herself being very, very big/powerful.

  28. I think an alternate way (as mentioned by many above) to parse Obama’s comments is that no <10 page answer to a very complex problem should be taken. And even if Calculated Risk or Naked Capitalism writes 5 page documents on the Swedish option, that doesn’t make it a good idea.

    Or more to the point, NEVER trust anyone with a trivially simple answer to a complex and long growing problem. Here is a thought exercise, use Occams razor to diagnose and treat cancer. Teh answer of ‘kill the cancer cells’ is what Occam tells you. Now do the surgery…

    The prescriptive case for banks ‘nationalization’ seems easy, but it is far, far from clear that this works. Say, I nationalize citibank. I kill the (foolish) bondholders, who then preoceed to devalue all other big banks. 40% of my banks then crash completely, so you end up nationalizing 65% or so of my system all at once. What happens then. Oh, you don’t know? How long does this take? What are the consequences? How do you do the step by step actions? If this is a 5% scenario, is it still worth pursuing.

    For more pespective, the largest single S&L failure was probably First Republic at 32.5B. Citibank is/was a 2000B bank. The RTC disposed of, in 6 years, 125B of assets. So now you want to nationalize Citi? What size bureacracy sets this up. Ho do you recharter something that large, effectively. Who works there? Are there rules on the involved parties that caused the issue. What about cascade effects on other banks…

    This isn’t easy. That, I tend to think, was the heart of Obama’s issue. I would like them to spend 6 months coming up with an actual, actionable plan. I also believe Geithner is not the person to do it. Maybe involved, but he is too close to the system as it stands today, which is not the system we ought to have.

    Does no one else feel that the irony is astounding? A market falters because ‘astoundingly simple’ ideas about mortgage, stocks always going up, and risk were made….and the reaction of everyone is to look for a simple fix.

  29. Simon:

    Very insightful, your remarks about how the flow of information affects decision-making. They suggest why the on-going debate lurches this way and that with frustration on all sides. It’s your closing paragraph, however, that prompts a question, your warning, “…Derivatives have the potential to create a rent-seeking structure that is unparalleled in human history….”
    Aren’t derivatives one aspect of a rent-seeking structure that has already failed? Isn’t that the implied meaning in Thomas Hoenig title “Too Big Has Failed”?

  30. Maybe short of eliminating derivatives, they just need to be standardized so that we can regulate them.

    It seems that the problems with regulation result from the huge number of different types of “creative” derivatives.

    If there were just a few regular types, then it would probably be easier to formulate policy to deal with them.

  31. I think it’s obvious the financial system is toast and soon to be very burnt toast. Also that the political establishment can’t admit to this, both because they don’t want to encourage general panic and because they are wards of the system.
    So I think the discussion among interested observers will soon turn from how to save this system, to how to build a new system, because the current discussion is like trying to figure out how to fix the World Trade Centers after the planes struck, but before they collapsed.
    My thought is that since the monetary system is a federally supported public utility, the banking system should be a function of local governance, so that banking profits return to fund the communities which generated them. It’s not the top down order which needs to be organized. It’s the bottom up growth that needs to be maintained.

  32. This problem is going to end up a lot simpler. I don’t think we’re going to like how it gets there. I think we’ve hit the absurd limit of financial complexity, for this generation anyways.

  33. this blog – and the comments which follow each article – is proof positive that all knowledge and wisdom does not reside in some sort of centralized source.

    from a political perspective, places like baseline provide insight into what opinion leaders are thinking. from a substantive standpoint, they offer fresh thinking and ideas.

    i hope geithner is reading some good blogs. he isn’t getting any decent help from the inside if the current chattering is to be believed.

    it seems that if a bank is ‘too big to fail,’ it is too big to exist. sheer size creates systemic risk.

  34. kirk, i have been curious lately, i know its swapp markets like aig should have had money on hand for payments, but it was such a crash, even companies like gieco that follow the rules would be up shit creek if everyone put in a claim , no?

  35. and max, i only get my news from blogs, they are free, tv news is run by corporations intent on keeping me in the dark,

  36. I saw the above post just as I was preparing to say much the same thing. Even though comments come from different perspectives and certain ones sometimes cloud issues, comments to your blog play a valuable role in helping us understand and think through the problems.

  37. Yes, but no. With Geico the people who purchased insurance on their cars own the car and have a vested interest in protecting the car. Geico doesn’t want to give cheap insurance to reckless drivers or criminals. On the other hand, the people who were buying the CDS de facto insurance didn’t really own or write the mortgages. They owned “tranches” of securitized mortgage portfollios (Mortgage Backed Securities/MBS)which they knew very little about and couldn’t care less because they figured the CDS had their positions covered. The MBS tranches are similar to the hierarchy of preferred versus common stock but with three or four different levels of quality ranging from pretty good to radioactive garbage. The loan originators kept most of the best tranches for themselves passing along the lower quality tranches with an extreme amount of leverage and concentrated risk. The people writing the loans didn’t care if the borrowers taking the loans ever had any intention of making even one payment because they were going to sell the mortgages to someone else who would convert them into securitized products. Well that brings us full circle and back to you and I. Basically the free market/neo-liberal deregulation crowd in concert with Wall Street devised a way to spin 68 trillion of dollars out of a few lousy home mortgages by turning bad debt into an ever larger web of bad debt by passing the buck around. The jig is now up and the taxpayer is holding the bag for the weekend in Vegas but the losers have already split with the money.

  38. We tend to romanticize the ability of the President, however bright has access to a supply of distorted postings from individuals.

    It would seem to me that apart from politics the derivatives and financial engeneering problems could be solved. I will sketch some of this while its a first cut its unconventional and unconventional ideas rarely get discussed in any detail.

    The conventional part.

    1. Any option or derivative must trade in a public clearning house where information concerning the trade becomes a matter of record available at least to0 people of the state. At minimum the sale price, quantity sold needs to be rcorded. While one cannot prohibit arbitrary trading the state will not enforce any contract made by a sale not cleared by law.

    The Unconventional Part

    2. Any new financial instrument will only be cleared for sale by a board like the SEC. The applications for the financial security (like a CDS)
    have to be publicly made, the state will allow testimony on the value of the instrument. People can testify for an against at public hearings. Parties can argue for and against an administrative board and the security’s public trading can be approved or denied. Ultimate approval rights after dispute like in the Secretary of the Treasury or anybody he or she may appoint. No security on a public corporation stock bond or index shall be sold in public without approval and no private contract will have any legal force i.e. they can be dishonored at will. This will insure that only publicly traded contracts will be honored. Restrictions on trading i.e. CDS could be limited only to the owners of Credit.

    As James Tobin suggested a small tax on securities trade shall be levied to provide income and discourage speculation.

    I personally find it outrageous that any of these Credit Default Swaps are guaranteed by the government. The banks should have to eat their losses. After all they lobbied for the law that said they cannot be state regulated. Let the Credit Default Swap Owners take their losses. If the Creditors force AIG into banckrutcy so be it.

  39. Bundled derivatives are a fairly new occurrence in the finance world, are they not? I think the derivatives market could use some paring down. Case in point: repackaging mortgages is absolutely ridiculous. Didn’t the old school futures, options and swaps serve us well? I’m no expert, but when a market becomes too complicated to regulate, it’s time to pare it down.

  40. A lot of the pain with derivatives can be avoided via a simple accounting rule – simply make CDS and unfunded synthetic CDO to appear at par on the owner’s liability.

  41. It is worth remembering that “swaps” actually began life as “contracts for differences” and still are referred to as CFDs among old-timers in the derivatives markets. The operative word there is CONTRACTS. Over time, there evolved in the CFD markets a complete set of master CONTRACT terms developed by the International Swap Dealers Association (ISDA), which all banks and FIBs use as a template to develop bilateral contracts with trading counterparties. In CFD-world, or “swaps” world, ISDA is to contracting as kleenex is to tissues. For those not familiar with ISDAs — i.e., the International Swap Dealers Association — this is a good summary:

    It’s dense, but worth reading. Of particular note: “The enforcability of the close-out netting provisions is absolutely vital to financial institutions active in the derivatives market since the ability to net allows them to allocate capital only against the net figure they would have to pay on close-out of an ISDA Master Agreement rather than the gross amount. ISDA has obtained legal opinions from all important jurisdictions confirming the effectiveness of the close-out neting provisions in those jurisdictions. Members of ISDA are entitled to rely on these opinions. ISDA also produces a model “Netting Act” which can be adopted by jurisdictions where close-out netting does not work effectively at present.”

    Why ISDA contracts are not being referenced and enforced first and foremost — prior to having the US Treasury (i.e., taxpayers) pay AIG so it can pay its banking and FIB counterparties — is a true mystery. Unless we’re dealing with massive criminal malfeasance: It is possible the banks and FIBs realized — one by one, or all together in a collective, blinding satori — they were in too deep to AIG et al, and decided they had to push their exposures to an absurd limit, so the federal government had no choice but to bail them out. Even so, the first loss should be borne by the firms contracting with AIG et al. I do not recall any instance of AIG being sued for failure to perform. This entire process has been silenced by the banks and FIBs getting the US Treasury to keep them whole. How exactly was that done? Is anyone aware of any legal action along these lines?

  42. Barack Obama’ Election and Kenyan politics of Identity

    Hi guys! This Conference sounds to be great! They have very interesting panels on identity and a featured panel on Barak Obama and you can also make a real African Safari…
    The Institute of Identity Research (IDmap) announces an international conference
    on Identity Politics on the Internet to be held in Kenya on the 27th to 29th of
    August 2009. The aim of the Conference is to create discourse in the area of
    Identity politics on the Internet and other related topics.
    The Conference will be graced by several leading scholars who have written and
    researched extensively on issues of Identity. We hope that this conference will
    result in solutions and better understanding of the problems facing issues of
    identity in the contemporary context.
    August 27-29, 2009
    Organized by Institute of Identity Research (IDmap)
    Will be held in Amboseli Wildlife National Park, Kenya
    Featured panel: Barack Obama’ Election and Kenyan politics of Identity:
    Will he identify himself with the World or with his People?

    • The Dead line for submission of the Abstracts is 01.05.2009 (200-500 words)
    in Word or PDF formats
    • The Dead line for submission of full-text papers is 01.07.2009
    Preliminary program of the Conference includes the following panels:
    • Kenyan 2007 Presidential elections and the Internet
    • Traditions and Identity in Kenyan politics: Barak Obama as a Luo
    representative of Kenyan identity politics
    • Facebook and Identity: do old ethnicity definitions still matter?
    • World Identity politics: Case-studies and Comparative Analysis
    • Parties and recruitment in the digital world
    • Gender, ethnicity and empowerment: what is better to be a white man or a
    black woman?
    • When religion comes to the Internet: the new ways to build and reinforce
    religious identity
    • Government on the Internet: new ways to preserve Nation-state and its
    identity on the Net
    • New English and E-Linguistic: jargon and vocabulary of Internet campaigns
    Participants are welcomed to join the following working groups:
    • Computers and identity
    • Culture and identity
    • Mathematical expressions of identity
    • Internet and Politics
    • Internet Vocabulary
    Best Identity MA/PhD Thesis work award:
    During the conference the Institute will award the best MA/PhD work submitted
    for the evaluation. The work should reveal an original and innovative approach
    in the field of Identity with its expression on the Internet. Information
    regarding submission procedure can be found on our site or through direct
    contact of our Administrators.

  43. Is one way to think about what we have is a “Financial Services Bubble”? Isn’t a state where the size of a derivative market dwarfs the size of the underlying market always a bad thing for the underlying market? (i.e. if the bookies get too large, won’t they just manipulate the underlying “game” to serve their needs?). It seems to me like the financial services industry looked for more and more “games” to bet on to feed their growth. Shouldn’t well functioning capital markets industry just grow in line with GDP?

  44. Thanks, StatsGuy,

    I’m one of the great unwashed who likes to read and comment at Daily Kos, and explanatory comments like yours help me to make somewhat informed decisions as to what I believe. Your posts seem concise and comprehensible.

  45. What a fantastic article. Blogs are a threat to the establishment. Clearly the implication by Obama’s remark on blogs is that those of us on the outside don’t know what those on the inside know, thus we can oversimplify the solutions. That’s such a specious argument.

  46. The CDS exemption from insurance regulation was arguably unconstitutional, and was certainly the stupidest financial idea in centuries. How about repealing it retroactively?

    FDR eliminated all “payable in gold” clauses from contracts by federal fiat. I think eliminating all CDS contracts which are not owned by holders of the actual bonds — all the ones which are gambling rather than insurance — could be done by fiat equally easily. Simply declare that said contracts are now and have always been against public policy and are void automatically, ab initio, and unenforceable. The Supreme Court will back Obama up if he does that.

    People who actually got them as insurance will get their payouts; gamblers won’t.

  47. We can all hope that President Obama changes his policy and starts reading James’and your posts!

  48. I think Obama should not laught about the legalization of Marijauna. I not only voted for him but I even call my congressmen and go above and beyond to support him. There are a lot of peoples live that are effected in a negitive way because people like him think it is a joke to legalize marijauna . How about the people patrolling the border ?I just heard they killed another U.S. marshall . I know the mojority of people in CA would like to see it legal and these are the people that rally for president Obama . So for him to act like that is not something that is on our minds will not get him more support. If it wasn’t so many people would not have brought it up… and no I do not smoke the stuff myself!

  49. But the President knows all this, which suggests another interpretation for his remarks. Perhaps the financial situation – e.g., in and around derivatives – really is too complex for anyone to understand, unless they have the inside knowledge of regulators. This would mean, of course, that going forward no one can question Treasury about anything important.

    Quite so. This isn’t a matter of such complexity that those with decent financial training couldn’t grasp it, though it is highly interconnected. It’s a matter of the Masters of the Universe not wanting the light of day shined upon their greedy and economy threatening machinations. It should be obvious to anyone paying attention that corporate interests have the ear of the politicians on both sides of the aisle, since campaign donations and lucrative lobbying gigs and the like grease most if not all palms in Washington. This is rent seeking at it’s most egregious and we are now living with it’s effects. When someone tells you it’s too complicated for you to understand, they are pulling a fast one. These are people we’ve endowed with our trust and the nation’s power, using tactics not unlike a used car salesman glossing over the terms of their lease paperwork. If this doesn’t change we can look forward to continued abuses of this sort and the continuation of taxpayers being offered up as lambs to the slaughter to take the fall.

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