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What’s Wrong with the World is dedicated to the defense of what remains of Christendom, the civilization made by the men of the Cross of Christ. Athwart two hostile Powers we stand: the Jihad and Liberalism...read more

Capital market fragility: an object lesson.

Folks have regularly challenged my contention that the integration of capital markets, which was promoted in part as a political and economic force for stability, actually engenders perilous fragility. Here we have a striking example: and it’s our old friend the credit-default swap. These are the now infamous derivative securities designed to provide liquidity to bond markets by allowing investors to buy and sell “protection,” or what amounts to insurance, on various classes of debt. A CDS contract pays out in the event of the underlying debt’s default; and its own value fluctuates according to the expectation of that default, which is important because the sellers of these derivatives — those writing the insurance contracts, usually investment banks or funds of some kind — must post collateral against declines in the underlying security.

So in case before us, we have CDS on notes and bonds issued by BP and other oil firms entangled in the ghastly Gulf disaster. Just two months ago, these bonds were staid and stable instruments that few paid any attention to. The sellers of protection (i.e., the third-parties writing default swaps on those bonds) were taking in steady fees to insure the debt, and other parties were buying the CDS to hedge their exposure, and everyone was feeling hunky-dory.

Then there was the calamity on the Deepwater Horizon, the destruction of the underwater well, and the subsequent venting of massive quantities of crude oil into the Gulf of Mexico, an environmental disaster that continues to this day.

BP’s stock price has tanked; its debt rating has been downgraded; and it has lost tens of billions in equity capital. Similar woes have beset the other oil and gas firms with exposure to the lost platform. For these companies the possibility of default or even bankruptcy has gone from unthinkable to chillingly plausible in a matter of weeks. The cost of default protection has soared; the credit-default swaps are much more valuable.

In a word: if you were a net seller of CDS protection on bonds issued by these firms, you are in a world of hurt.

Now, keep in mind that chances are you never expected to have to post sizable collateral against these obligations. The default of BP was unthinkable as recently as April. It is still rather unlikely, but far from unthinkable. That unanticipated shift in the risk horizon has put a big hole in your capital base. CDS contracts mark-to-market regularly; the collateral calls can be swift and unforgiving. It was a rapid series of collateral calls, after all, that sunk AIG back in 2008.

The upshot of all this, from the Bloomberg report: “An indicator of corporate credit risk in the U.S. rose to the highest since July as the cost to protect BP Plc bonds against default rose to a record.” The risk contagion spreads; corporate credit fears broaden well beyond the one affected sector because of the tight integration of global capital. In the UK, where BP’s steady dividend payments are integral to many pension funds, a similar dynamic afflicts equity markets.

The pulverizing paradox is that the attempts of investors to protect, hedge, secure, and otherwise guarantee their holdings actually accomplishes the opposite, systemically. These derivative instruments can, of course, be used to speculate. (A speculator might get wind of another debt rating downgrade, say, and rush to purchase CDS protection, angling to make a quick profit on the subsequent collateral owed him in the downgrade.) But even the normal and legitimate effort of hedging exposure, undertaken by millions of actors around the world, produces this brittle structure of ever-shifting payments, abbreviated securities, and abstractions on property claims of extraordinary subtlety. The structure is not characterized by stability but rather the reverse.

Comments (10)

One would think that a form of insurance on investment is intrinsically dangerous here because it reduces the perception of risk for the investor, which causes a form of moral hazard.

"The 82-year-old Mr. Greenspan said he made "a mistake" in his hands-off regulatory philosophy, which many now blame in part for sparking the global economic troubles. He quoted something he had written in March: "Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief.'"

"He conceded that he has "found a flaw" in his ideology and said he was "distressed by that." Yet Mr. Greenspan maintained that no regulator was smart enough to foresee the "once-in-a-century credit tsunami.'"

And yet Hayek is #1 over at Amazon and Ayn Rand's nonsense is selling briskly (sigh).

What we are seeing is the zombie-like persistence of an 19th century ideology designed to justify rape and pillage.
After the Guilded Age, the Great Depression. and the Great Recession it still stalks the earth, never truly alive and yet refusing to die.

Recall Dani Rodrik as this "is yet another manifestation of the political trilemma of the world economy: economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time."

Free market based ideology has been ascendant for well over 30 years. The result has been economic globalization prevailing at the expense of the other two.

There is only going to be a political solution to this. The problem is that we no longer have a nation with many rational political actors. We have a Constitution that, due to time and place, hasn't given us the necessities to deal with the modern corporation and whose structure requires a commitment by nearly all to the common good.

That, as things have evolved, our system requires two functioning political parties. However, because of our zombie ideology, we have only about two thirds of one party that actually works.

Mike, as with taxes, moral hazard is only for the little people.

Mr. Greenspan maintained that no regulator was smart enough to foresee the "once-in-a-century credit tsunami."

al (quoting someone not identified)

I'd like to see al's list of regulators who foresaw either BP's current woes or the "credit tsunami" to which Mr. Greenspan refers in al's unattributed quote.

Put not your faith in regulators...

What we are seeing is the zombie-like persistence of an 19th century ideology designed to justify rape and pillage.

al

Yes, progressivism is an ideology that claims regulation can, like an erroneous belief in what indulgences are for, cover for a multitude of sins against common sense.

Recall Dani Rodrik as this "is yet another manifestation of the political trilemma of the world economy: economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time."

al

Advocates of autarkic empires ruled by despots have been around since, oh, at least the days of Egypt's union of the kingdoms of the Upper and Lower Nile. Now there's a "zombie ideology" if there ever was one. Even in the 19th century it was tried. Ever heard of Napoleon?

Free market based ideology has been ascendant for well over 30 years.

al

That sure beats the alternative, a slave market based ideology.

Of course, some people don't like freedom. Freedom (as Ayn Rand correctly pointed out) requires one to think.

In the case of the funds whose operators were buying and selling BP stock derivitaves, the moral is one shouldn't buy shares in companies and funds one doesn't understand. The stock market is for adults only (regardless of whatever ones physical age may be). This fact of reality is mightily resented by people who worship the Regulatory State.

"Free market based ideology has been ascendant for well over 30 years."

It's all so strange, al. I've spent the last couple of decades in a state of near despair over the seemingly inexorable rise of the managerial state, while you look at the same events and see the ascendancy of "free market based ideology."

It's all so strange.

"Free market based ideology has been ascendant for well over 30 years."

This is an ironic accusation in light of the fact both major parties have moved toward greater reduction of economic liberties. The last time there was a real de-regulation was when trucking and the airlines were deregulated. Everything since then has been shifting the existing regulations to benefit big business.

"Everything since then has been shifting the existing regulations to benefit big business."

Precisely, that is why we will never have laissez faire capitalism any more then we will have a workers' paradise or the withering away of the state.

Its seems to be a simple principle that one hires folks to do a job who believe the job is possible and should be done to the benefit of the common good. If one hires folks who see no problem with externalities and rent seeking don't be surprized when the bodies start stacking up.

Effective regulation can't be accomplished from the right - all we will get is regulatory capture. Conservatism is incapable of producing effective policy and the Republican Party (and too many Democrats) is owned by large corporate interests.

Steve, all you are indicating is buyers remorse (assuming you vote Republican). It would have been nice if the Obama administration would have

I can’t believe we have a Randroid here. I feel the toxic spill effects of his gusher of magical theories and factoids already seeping into my bones. From horizon to Deepwater Horizon, we are trying to recover from the catastrophes of these failbots and all they can do is tell us how they are so superior to all the victims of their schemes.

Are we saying that it is economically risky to reduce economic risk?

Clever, but no.

We're saying that it is economically risky to sell off credit risk (or market risk, or any other risk that can conceivably be securitized and sold) and then pretend it has vanished from the world.

Al --

Effective regulation can't be accomplished from the right - all we will get is regulatory capture. Conservatism is incapable of producing effective policy and the Republican Party (and too many Democrats) is owned by large corporate interests.

Everything after the fifth word in that sentence is redundant.

The only thing more touching that the right-liberal's faith in efficient markets is the left-liberal's faith in the managerial state.

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