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tomandlu

Whoops - Why Everyone Owes Everyone And No One Can Pay

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I'm in the middle of re-reading Lancaster's 'Whoops', and some of the numbers and practices leading up to the crash just stun me each time I come across them.

For example, the market in CDSs was $54 trillion - basically about the same as world GDP and larger than the world bond-market - and this was just one product. And all these products were largely designed with one purpose - to reduce risk to 0%. Zero-risk is great, because if there's zero-risk, then there's zero-risk of needing to ever back your bets, and if that's the case, then there's nothing to stop you lending more and more. And then, of course, it turns out that, in the real world, there's no such thing as zero-risk, particularly when you act as though there is...

AIG, the main insurer, had to be bailed out to the tune of at least $170 billion - more than twenty times the company's worth.

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I'm in the middle of re-reading Lancaster's 'Whoops', and some of the numbers and practices leading up to the crash just stun me each time I come across them.

For example, the market in CDSs was $54 trillion - basically about the same as world GDP and larger than the world bond-market - and this was just one product. And all these products were largely designed with one purpose - to reduce risk to 0%. Zero-risk is great, because if there's zero-risk, then there's zero-risk of needing to ever back your bets, and if that's the case, then there's nothing to stop you lending more and more. And then, of course, it turns out that, in the real world, there's no such thing as zero-risk, particularly when you act as though there is...

AIG, the main insurer, had to be bailed out to the tune of at least $170 billion - more than twenty times the company's worth.

Most of the delinquent trading was done via AIG Financial Products in London because of the complete absence of regulation.

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One of the books I have borrowed from the library and gave up with. I didn't think it was the best of narratives and a bit muddled. Perhaps there was something there if I had persevered but it wasn't the easiest of reads.

Edited by crashmonitor

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Most of the delinquent trading was done via AIG Financial Products in London because of the complete absence of regulation.

Indeed. As the book point out, the US taxpayer bailout of AIG was largely a payout to European banks.

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nd all these products were largely designed with one purpose - to reduce risk to 0%.

No. To generate fees.

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No. To generate fees.

Well, yes. I was more thinking about the fundamental nature of the products.

What's more broadly interesting about the book (but hard to encapsulate) is the way banking became divorced from reality. The real world became irrelevant - banking seemed to function purely by trading financial product derivatives between banks. The real world was just the silly little zero-risk bit that could be effectively ignored.

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CDS are just insurance though, right?

Like the value of all car insurance liabilities could be trillions too....if everyone crashed and crashed at once.

OK, most CDS are, AFAIK, rate swaps, so i guess its feasible rates could rise everywhere and all CDS go boom at once.

I'd put a 100% tax on all payouts as they cant payout anyway. And never could. Entering into a contract knowing you cant fulfill it is fraud, no?

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Like the value of all car insurance liabilities could be trillions too...

But if the value of all car insurance approached world GDP, might that not indicate a bit of a problem?

My (limited) understanding is that it was the constant trade and churn of CDSs that allowed the market value of the trade to move into la-la land.

Entering into a contract knowing you cant fulfill it is fraud, no?

'knowing'. A bank generally can't pay back all of its deposits in one go. If the risk is X and you can cover X, then it's not fraud. The problem was that the risk was actually Y.

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Well, yes. I was more thinking about the fundamental nature of the products.

What's more broadly interesting about the book (but hard to encapsulate) is the way banking became divorced from reality. The real world became irrelevant - banking seemed to function purely by trading financial product derivatives between banks. The real world was just the silly little zero-risk bit that could be effectively ignored.

fees of course...but sadly the idea about the risk is wrong.

Take an example...you hire a car to a client...you are worried he might crash...so you buy another...thus, if he crashes you still have a car to hire out, and your business is therefore insured to carry on.

And of course, the insurance will pay out on the car....

Where are the risks...well, someone has to be paid to take the risk on..bankers proved mathematically that by diluting the risk over enough players, any one failure would mean that the total cost of the failure would be shared around the group.

going back to the car, well there are other costs that may not be taken into account...the purchase of the spare, which they dont take delivery of unless needed, the fees to the Insurance firm to repair the broken one...and of course, society is paying for the injuries, the pickup and treatment of the crashed car driver.

Edited by Bloo Loo

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Well, yes. I was more thinking about the fundamental nature of the products.

What's more broadly interesting about the book (but hard to encapsulate) is the way banking became divorced from reality. The real world became irrelevant - banking seemed to function purely by trading financial product derivatives between banks. The real world was just the silly little zero-risk bit that could be effectively ignored.

Generating fees is the fundamental nature of the products. The entire raison d'etre of their being. Even when Blythe Masters was creating the very early swaps, which actually might have served some limited purpose matching off liabilities between JPM clients, she still wouldn't have created them had it not generated fees for JPM.

'hedging risk' is just marketing spiel to sucker in the punters. Once these products get propagated throughout the system and sold by people who have no idea how they work then they must do more harm than any possible initial good that may (or not) have been present on a small scale in certain specific circumstances.

Except for the bankers who extracted (and kept) the fees of course. For them it's a completely rational asymmetric payoff.

(Gillian Tett's 'Fools Gold' is an excellent and detailed account of these products from their inception to their catastophic abuse - highly recommened read)

Edited by R K

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Crashes are caused by too much leverage and not enough earnings to meet the debts and interest payments when they fall due

IMHO all the financial gerrymandering leading upto 2008 was designed to obscure the risk rather than being the original cause of the bubble itself though it did enable people to lever up their gearing to extraordinary levels.

In the end it is real world events that cause bubbles to burst such as company A goings bankrupt and having no assets to pay off its loans or, person B not being able to service his mortgage and the property falling into negative equity etc.

Edited by stormymonday_2011

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Generating fees is the fundamental nature of the products. The entire raison d'etre of their being. Even when Blythe Masters was creating the very early swaps, which actually might have served some limited purpose matching off liabilities between JPM clients, she still wouldn't have created them had it not generated fees for JPM.

'hedging risk' is just marketing spiel to sucker in the punters. Once these products get propagated throughout the system and sold by people who have no idea how they work then they must do more harm than any possible initial good that may (or not) have been present on a small scale in certain specific circumstances.

Except for the bankers who extracted (and kept) the fees of course. For them it's a completely rational asymmetric payoff.

Well, you could describe a car in terms of its value to the car manufacturer or in terms of what, physically, a car is, and I take it as a given that manufacturers want to make money, but I take your point. However, the nature of these products does strike me as significant if I want to try and understand why they blew up (likewise, with a car).

Fundamentally - and a point you touch on - what was so toxic about these products is that the quants seemed to have assumed that reducing risk would not impact the riskiness of the risk that the institutions took on. Or, as Lancaster puts it (roughly), "it's as though the invention of the seat-belt encouraged everyone to take up drink-driving..."

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Generating fees is the fundamental nature of the products. The entire raison d'etre of their being. Even when Blythe Masters was creating the very early swaps, which actually might have served some limited purpose matching off liabilities between JPM clients, she still wouldn't have created them had it not generated fees for JPM.

'hedging risk' is just marketing spiel to sucker in the punters. Once these products get propagated throughout the system and sold by people who have no idea how they work then they must do more harm than any possible initial good that may (or not) have been present on a small scale in certain specific circumstances.

Except for the bankers who extracted (and kept) the fees of course. For them it's a completely rational asymmetric payoff.

(Gillian Tett's 'Fools Gold' is an excellent and detailed account of these products from their inception to their catastophic abuse - highly recommened read)

I think Bookies invented these things long before banks...they called it "Layoff"..a punter took a large hi odds bet and the bookie had to decide to take the ride on his own, or lay off part of the bet with another or many other bookies, in the hope that their combined loss wouldnt take them all out.

Course, bookies decide the odds too...and there lies their fees....banks just skim on each sale.

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For example, the market in CDSs was $54 trillion - basically about the same as world GDP and larger than the world bond-market - and this was just one product.

People like to quote figures like $54 trillion because they are big and sound scary, but in reality its very misleading because a lot of those assets are directly offsetting each other. If I buy a bond for $x and simultaenously buy a CDS for $x, then the total value isnt x+x, its x-x because the trades are offsetting and partly cancel each other out (obviously it isnt exactly zero since the hedge isnt perfect, but its certainly a lot less than x).

Its exposure that matters, not the total traded value. If I'm a bookie and Manchester United are playing Chelsea in a cup final where both sides are equally likely to win, and I take $20m of bets on United and $15m of bets on Chelsea, then my total exposure is $5m because thats the most that I would have to pay out regardless of outcome (and any sensible accounting method would put my book value at $5m). Saying that there are $35m of bets is technically true but incredibly misleading, because bets of the same size in opposite directions directly cancel out.

Edited by Smyth

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People like to quote figures like $54 trillion because they are big and sound scary, but in reality its very misleading because a lot of those assets are directly offsetting each other.

<snip>

Tosh. Simply put, a large part of the problem was that the trades had got so obscure (and were inherently obscure) that no one knew who was holding the baby. When WB called them "weapons of mass destruction", he was referring to both their riskiness and the untraceablity.

Your take amounts to declaring pepper-spray is 'just a food product'.

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But if the value of all car insurance approached world GDP, might that not indicate a bit of a problem?

No, because again its offsetting. Governments and private companies issue bonds to raise money. People buy bonds as a way of investing their money. A bond is essentially a loan; you give your money to the government/company by buying the bond, and you get paid interest on that. So there is always a risk involved, because the government/company might go bankrupt and so cant pay you.

CDS is a way to insure yourself against that risk; its essentially an insurance contract which pays out if bankruptcy happens. So if you hold both a bond and a CDS of equivalent value then (in a perfect hedging scenario) you have zero risk exposure because a) if the company doesnt go bankrupt you gain nothing, because the interest you are receiving on your money is funding the CDS, and B) if the company does go bankrupt then you lose your original investment but gain the equivalent amount from a CDS. So essentially buying a CDS is equivalent to selling the bond, so companies use this as a way of closing a position in situations where they may not want to sell the bond (perhaps because the market is illiquid so there is a high transaction cost due to the bid-ask spread).

Of course, the hedge between a CDS and a bond isnt perfect, and everyone realises this. If you (eg) hedge an equitiy position with a vanilla equity derivative then in theory you can get a perfect hedge because there is a necessary long-term convergence between the price of the derivative and the price of the stock as the derivative approaches its expiration date (although even this 'perfect' hedge is theoretical since it requires delta hedging in continuous time without transaction costs, which is a purely mathematical construct, but its 'good enough' in practice). But there is no such convergence between CDS and bonds, and there is a lot of empirical evidence that shows that the implict bankruptcy probability that you back out of a CDS spread is different from the bankrupty probability implied by bond yields. There are literally hundreds of papers on this, but here is a random one from 10 years ago: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.199.937&rep=rep1&type=pdf . But anyway, everyone knows about this and noone thinks that CDS perfectly hedges a bond (nor was this the case before the ifnancial crisis). Despite the media narrative to the contrary, traders arent idiots and this is pretty basic stuff.

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Tosh. Simply put, a large part of the problem was that the trades had got so obscure (and were inherently obscure) that no one knew who was holding the baby. When WB called them "weapons of mass destruction", he was referring to both their riskiness and the untraceablity.

Your take amounts to declaring pepper-spray is 'just a food product'.

They are 'obscure' to the general public because the average person knows nothing about finance. To anyone who has taken even a basic first year class on fixed income instruments, the mechanics of CDS are pretty opaque.

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They are 'obscure' to the general public because the average person knows nothing about finance. To anyone who has taken even a basic first year class on fixed income instruments, the mechanics of CDS are pretty opaque.

Oops, I mean transparent not opaque!

Anyway, the problem with CDS during the crisis was increased counterparty risk due to contagion. Basically, if you buy an insurance product then the whole point is that the insurance company pays you if a problem happens. But what if the insurance company itself goes bankrupt? That was basically the problem; in 2008 it looked for a while like the whole market was going to break, which included the banks who were acting as the insurers (counterparties) backing certain CDS instruments. So a lot of these had an increased probability of being worthless simply because there wouldnt be any 'insurance' company to pay you, since they themselves may have went bankrupt. So CDS lost a lot of value during the period where it wasnt clear which banks were going to go bankrupt.

This is a genuine problem and yeah, people werent really ready for it beforehand. Its been studied a lot since; contagion is one of the areas which has received a huge amount of attention in the last 5 years, both in the popular media and the academic literature.

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Netting exposure all well and good until a counterparty fails and a link in that netting chain suddenly disappears. Gross exposure becomes very important then.

AFAIK all banks nowadays perform periodical compression trades of all their cds positions. So every month they work out the net position and compress all the myriad of offsetting trades down to that.

Also very few cds are for default protection (ie insurance) purposes. They're pretty much exclusively bought for hedging and speculation and rarely run to maturity, being closed out way before that.

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But if the value of all car insurance approached world GDP, might that not indicate a bit of a problem?

My (limited) understanding is that it was the constant trade and churn of CDSs that allowed the market value of the trade to move into la-la land.

'knowing'. A bank generally can't pay back all of its deposits in one go. If the risk is X and you can cover X, then it's not fraud. The problem was that the risk was actually Y.

The problems arise because in a zero sum game worth $53trillion, where half are long and half are short , then a one percent move in rates(as most are actually rate derivatives) , the one half goes into a 1/2 trillion margin call that effectively makes them insolvent, and the side with 1/2 trillion paper profit cannot collect on.

It is like a giant wrecking ball where the leverage is so huge that small moves wipe out one side or the other. It is systemic. and when one side, or even a small part of one side fails, it brings the entire interconnected system down.

$54trillion is just one small part of the derivatives outstanding. Some say $700trillion, some say a quadrillion. In any case There is not enough money or equity in the world to monetise this. I believe we are in a more perilous position than 2008 with no prospect of an exit.

It may portend the equivalent of the financial Armageddon of Venice in 1340 that brought the entire known world down for 100years and ushered in the dark ages.

edit, this probably traps us into near zero interest rates for ever. If not it blows up.

Edited by evetsm

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Netting exposure all well and good until a counterparty fails and a link in that netting chain suddenly disappears. Gross exposure becomes very important then.

AFAIK all banks nowadays perform periodical compression trades of all their cds positions. So every month they work out the net position and compress all the myriad of offsetting trades down to that.

Yeah counterparty risk is a genuine problem and its not clear how to solve it completely. Its not that banks/traders/etc are somehow stupid or immoral, its just a genuinely difficult issue that doesnt have any obvious solution.

Also very few cds are for default protection (ie insurance) purposes. They're pretty much exclusively bought for hedging and speculation and rarely run to maturity, being closed out way before that.

A lot of CDS trades are just to close bond positions. With the exception of government bonds, CDS tends to be a lot more liquid than bonds so it can be a lot cheaper to just buy a CDS than sell your bond, since you are paying less bid-ask spread.

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They are 'obscure' to the general public because the average person knows nothing about finance. To anyone who has taken even a basic first year class on fixed income instruments, the mechanics of CDS are pretty opaque.

By 'obscure', I mean that the ownership and liabilities were obscure, not the mechanics of cds themselves. Nuclear missiles and material may (or may not) have gone missing from some of the former soviet republics - that is the obscurity I refer to.

That aside, using these products to then build risk up again was an act of hubris that you seem to want us to ignore. Here's an idea - why not use banking for its real purpose, to support real-world activity, rather than celebrating its dislocation from anything but itself?

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They are 'obscure' to the general public because the average person knows nothing about finance. To anyone who has taken even a basic first year class on fixed income instruments, the mechanics of CDS are pretty opaque.

They are obscure because the very clever men in the CIty make them so.

Even a real Insurance company thought they were insurance instruments, but ended up busted and broken..and they needed bailing so the bankers could get 100% on the dollar.

There are many types of swaps and instruments, all are obscure and all command a fat fee...Indeed, many firms can bet on an outcome which they are directly involved in...total fraud...

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Yeah counterparty risk is a genuine problem and its not clear how to solve it completely. Its not that banks/traders/etc are somehow stupid or immoral, its just a genuinely difficult issue that doesnt have any obvious solution.

snip

you mean they cant work. they are flawed from the outset.

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you mean they cant work. they are flawed from the outset.

Well, quite. And let's be clear here, the quants claimed they had eliminated counter-party risk. Smyth's claim are akin to saying "well, it's hard to be sure ships won't sink." Meanwhile, the claim had been made that ships no longer sank and consequently the life boats could be removed to make room for more cabins...

Jesus - pump up the world with more credit than the underlying reality can support and then claim "it wasn't us, guvnor..."

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