Tuesday, March 10, 2009

bloggers and pundits are the last people who should be making such determinations

From Felix Salmon:

Quick Hits

I'm about to get on a plane, and don't have the time to get to all of the stuff I want to write about. So a few quick hits:

Paul Krugman grapples with the question of where to draw the line in the capital structure when you nationalize a bank:

Some 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.

My gut feeling is that equity gets wiped out, preferred debt gets a haircut, and senior unsecured debt is untouched. But Krugman is right that bloggers and pundits are the last people who should be making such determinations: you really need the kind of detailed analysis that only a team of Treasury wonks can come up with.

¶ Krugman's blog entry is partly a response to Alan Blinder, who does a good job of running through most of the strongest anti-nationalization arguments, and some of the weaker ones, too. The column is, however, weakened by the way in which it ends up advocating a good-bank/bad-bank solution in which the government takes all the downside while getting very little upside.

¶ And John Hempton and Warren Buffett both hint that they might be interested in investing in the bad banks, should they ever get the opportunity.

Myron Scholes wants to "blow up" the derivatives market -- unwinding "all contracts at mid-market prices". This is an astonishingly bad idea which would devastate the cash markets. Let's say you're a bank which has hedged your loan exposure through buying credit default protection. If you're forced to unwind the CDS contract, yes, you might make a profit on it, but at the same time you'll be left with a large amount of unwanted credit exposure which you'll want to dump onto the open market. And no one wants that. Besides, it's not at all clear that the CDS market in particular, or derivatives markets in general, have caused anything like enough damage to warrant these kind of drastic measures.

Josh Marshall gets an email saying that "derivatives claims are not stayed in bankruptcy" and that therefore AIG's policyholders are actually junior to its CDS counterparties. This is not good regulatory policy.

A credit trader has a very good and extremely wonky post on what went wrong at AIG. This looks as though it's going to be a fantastic new blog in the fixed-income space.

James Kwak says that "most financial advice floating around is worth less than nothing": he's right.

¶ Edward Lam has a 29-page paper on the subject of bank capital.

¶ The trustees of the Conserve School in Wisconsin also control the Central Steel and Wire Company; they seem to be happy to sacrifice the former in order to maximize the value of the latter. There's something nasty going on here, with echoes of the Brandeis scandal -- where, incidentally, all the blame was pretty much shouldered by the president, with the trustees getting off very lightly. The press should do a much more assiduous job of holding trustees to account, since no one else will.

¶ And without meaning to be rude about Joe Hagan, who wrote a very good profile of Vikram Pandit, it's worth noting that both he and the editors of New York magazine were happy with this:

"He was talking about fat-tailed risks fifteen years ago," says a former colleague from Morgan, referring to the concept eventually popularized in Chris Anderson's 2007 book, The Long Tail.

Clearly levels of financial sophistication in the mainstream media remain extremely low, even when the subject matter is finance. Fat tails and long tails are entirely different things -- long tails, pretty much by definition, are thin, not fat.

But more to the point, bankers have been talking about fat tails for a very long time indeed. Similarly, they love to talk about advising their clients not to do M&A deals. But in the real world, precious few bankers actually did anything about fat tails, just as the empty tombstone generally existed more in theory than in practice. Most bankers can talk fluently about the right thing to do. Almost none of them actually do it."


From A Credit Trader:

"AIG did not have to post collateral on the trades which, combined with their view of these trades being “free money”, meant they sold protection in astounding size"

In other words, the whole point was to have investments with lower capital requirements, I believe.

"Why did Banks buy Protection from AIG?
Did the banks realize the value of its protection held against AIG was zero? Of course they did - they aren’t as dumb as the media suggests. The reason they continued to pay the full market CDS offer (rather than a much lower level due to AIG’s massive wrong-wayness) to AIG was because they considered it a cost that allowed them to continue originating CDOs. If they could not offload super-senior risk to someone, their originating desks would be effectively shut down.

So, while the trading desks continued to buy super-senior protection from AIG, the risk management desks, realizing that the protection was effectively worthless, bought protection on AIG itself from the street and clients in large size. In fact, I would imagine the size they needed to buy was too large and they likely ended up buying puts on the AIG stock or just shorting outright. Let’s hope the Fed unwinds of AIG’s trades took into account the huge gains these banks took on the AIG hedges."

Bingo. Yes, I find this an excellent blog. Good find.

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