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Wanna Bet?

Suppose something happens in your neighborhood, such as a new family moving in next door or a new business opening up in the vacant restaurant space on the strip.  You look them over and become convinced that there is no way that they are going to make it – they can’t possibly cover that huge new mortgage or the business seems likely to fail.  There are three things you can do, economically, to take advantage of your assessment – shake your head and wonder who loaned them the money, make a bet with a friend that they don’t make it to the end of the year, or you can go around with a notebook betting everyone in the neighborhood and keeping track of the money put down and the odds that you were given for each bet like any good bookie.

You might say, “Aren’t the last two illegal?”  And the answer is, surprisingly, no – they aren’t illegal if you do it right.  And you don’t have to tell anyone what’s in your book, either.  That’s what Goldman Sachs did and continues to do.

These bets are called “Credit Default Swaps” (CDS).  A CDS is, essentially, a kind of insurance that someone holding a big wad of debt takes out to minimize the risk that they won’t be repaid.  It seems simple and reasonable enough that they would do this.  What is less obvious is that this market is not only unregulated it isn’t listed on any kind of trading exchange, meaning that we have no idea at all who is taking out insurance on who.  You can bet on either side by either buying long or selling short the contract, holding onto a liability if a given loan craps out or making a profit if it dies.

This may not seem like a bad thing in and of itself, but the lack of transparency has some very strange side effects that continue to ripple through the economy.  The most important is that as banks buy and sell these insurance contracts they wind up tying themselves together in ways that make the entire financial system deeply connected – everything has become “Too big to fail”.  The lack of disclosure meets and matches “Too big to fail” with “Too big to understand”.

This is at the heart of how we successfully socialized risk by making the US Government ultimately responsible for nearly all of the debt held.  Once it became clear that a wave of defaults would trigger payments by nearly every investment house that they couldn’t pay, the TARP became the only possible course of action.

Why is this practice not only legal but held as close to the chest as a bookie’s ledger?  If you guessed it’s because of the money that is made, you’d be right. Goldman makes an estimated 2-3% selling CDSs, representing an enormous profit center for them. If they were put on an exchange like just about any other derivative, you’d see e-Trade and others quickly advertising that you can buy them for a fixed rate.

But what is in Goldman’s interest is not, of course, in the interest the US taxpayer who has gotten stuck with the tab for socializing credit risk over the last decade.  A few simple reforms could make all the difference:

1. Setting up markets where CDSs are traded like any other  derivative.
2. Disclosure of who owns what position in a CDS, just like any security or option.
3. Limiting the size of a “naked” position you can take in a CDS, which is owning the insurance without owning the underlying position.

These are very simple reforms that do nothing more than make CDSs the same as any other tradable security.  Who can argue with that?  Apparently, the US Senate still sees that as a bit too much to contemplate, despite the public humiliation of Goldman over their role in selling CDSs.  Simple and obvious regulation such as this is still not a part of the complex financial reform bill.  The Senate has buried the need for the obvious in a big pile of complex nonsense.

Wall Street has been compared to a casino by many people, but the worst excesses of the big investment houses show that this comparison is unfair – to casinos.  It doesn’t take much imagination to see that they are operating more like a garden variety mafia bookmaking operation.  Failure to fix the problem will continue to put the risk of our system exactly where it doesn’t belong – not on the people who are connected enough to get big loans, but on the US taxpayer.  We can expect more of the same as long as this is the case.

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22 thoughts on “Wanna Bet?

  1. With a lot of money involved I know one bet we can all make – that the Senate is getting their share for looking the other way. Thanks for explaining this in simple terms, I hope people are watching.

  2. Excellent blog. This has gotten pushed to the back burner by people who hope we aren’t paying attention, so it’s a real service to start talking about it again, especially in such direct terms. I want to hope we can do something about this, but I won’t bet on it even if it is legal.

  3. This i a great post Erik, thanks. I was wondering how all this bad debt got passed from one financial house to another, now I know. The new coalition government has just announced its economic measures mainly an emergency budget in five weeks. They s up an independent department who will take responsibility for all financial forecasts from now on – call me a pessimist- but once the brief honeymoon period is over can’t really see how this will help. They’ve already started to slag of the previous administration blaming them for the current economic state (not strictly true as the rot set in at the start of the Thatcher administration!). Sigh all we can do is hope.

  4. “Too big to understand” is a very important concept. I’ve never understood any of this, but it was a real eye-opener to realize that no one really does. This has gotten really crazy. If you think the reforms you suggest will get a handle on it that’s great, but it seems like a lot more is needed.

  5. Thanks everyone.

    Gwei, I think we’ll just have to wait and see on the coalition. I agree that this goes way back, but as much as you might want to blame Thatcher there’s a point where we get to blame Clinton – and we all have to blame no one but ourselves.

    I recently dug this up from July of 2008, before many people were aware of what was really going on (on both sides of the Atlantic):

    https://erikhare.wordpress.com/2008/07/01/housing-bubble-toil-and-trouble/

    In addition, I think I neglected to link to this article I did on game theory that showed how at least one important economist, Graciella Chichilnisky, saw all this playing out:

    https://erikhare.wordpress.com/2007/12/10/the-game/

    Note that this last one is from December 2007. Many people have known about this problem for a long time, but getting it into popular debate has bee thwarted by a group of insiders with a very strong personal interest in preventing it.

  6. The more I read about this the angrier I get. Wall Street is so obviously rigged that there is no chance for ordinary investors to get a fair deal and that’s all we hear about on money programs 24/7. It’s one big scam after another.

  7. Jim, a long time ago a very old accountant who remembered the “Great Depression” (ie, Depression 4) told me that the Stock Market is nothing more than a market of stocks. That may sound stupid, but it’s a very wise statement that asks us all to remember that it’s nothing more than a matter of supply meeting demand, like anything else. Fundamental value? There’s no basic law of physics at work here, but what goes up can, in fact, go down about as easily.

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