Wednesday, March 11, 2009

Lost through destructive creation (FT)

From Paul Kedrosky:

"
Readings 2009/03/11
By Paul Kedrosky · Wednesday, March 11, 2009 · ShareThis
  • Gosh, Alan Greenspan doesn't think Federal Reserve caused the housing bubble (WSJ)
  • Citi's Long History of Overreach, Then Rescue (WashPost)
  • China Trade Surplus Plunges as Exports Fall by Record (Bloomberg)
  • China's Way Forward (The Atlantic)
  • The Revenge of Karl Marx (The Atlantic)
  • The Shrinking Superpower (The Atlantic)
  • A Lot of Bucks, How Much Bang (Pimco)
  • A failure to control the animal spirits (FT)
  • Lost through destructive creation (FT)
  • Charting remaining resources around the world (New Scientist)

Me:

From Gillian Tett:

"Last September, the final pillar of faith collapsed. Most investors had assumed the US government would never let a large financial group fail. But when Lehman Brothers went bankrupt, distrust and disorientation spiralled. Most funding markets seized up. Prices went haywire; banks and asset managers discovered that all their trading and hedging models had broken down. “Nothing in the capital markets worked any more,” says the chief risk officer at a large western bank. The system, as Mervyn King, governor of the Bank of England, noted a few weeks later, was “on the precipice”.

I agree with this. What's interesting to me is how hard it is to get people to see that this presupposition of government intervention played a huge role in the excessive risk. Yet, if the mere possibility that it wouldn't be forthcoming can cause a panic, doesn't that suggest that it was a fundamental assumption?

"That made a mockery of the idea that innovation had helped to disperse credit risk."

I keep reading this, but it seems just plain incorrect to me. The point of CDSs and CDOs was to have investments that lowered capital requirements. What investors were looking for was a way to increase leverage. In that search, they came across CDSs and CDOs. Then they created an enlarged market for them. They sold them. This is an inherently risky move, which makes sense since these investors found safer investments not lucrative enough. All the dispersion could do was to spread this higher risk around like a hot potato. Somewhere in all of this people are playing fast and loose with the meaning of 'risk'.

I can easily imagine valid uses, and even prudent uses, of CDSs and CDOs, as a marginal risky investment. But, because of the lower capital requirements, I can't imagine basing a system on them. That's what happened. But the idea that investors didn't understand that they were increasing leverage, since that was the point of the investments, I simply don't believe. It's as if we're accepting an explanation like this:

Take a very risky investment: Spread it around: We'll keep the safer parts: Or we won't, if we can get a high enough return: Ergo, Risk has been lessened.

This is like a Ponzi Explanation.

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