Credit Default Swap

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pages: 265 words: 93,231

The Big Short: Inside the Doomsday Machine by Michael Lewis

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Asperger Syndrome, asset-backed security, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, facts on the ground, financial innovation, fixed income, forensic accounting, Gordon Gekko, high net worth, housing crisis, illegal immigration, income inequality, index fund, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, medical residency, moral hazard, mortgage debt, pets.com, Ponzi scheme, Potemkin village, quantitative trading / quantitative finance, short selling, Silicon Valley, too big to fail, value at risk, Vanguard fund

Stock prices could rise for a lot longer than Burry could stay solvent. A couple of years earlier, he'd discovered credit default swaps. A credit default swap was confusing mainly because it wasn't really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term. For instance, you might pay $200,000 a year to buy a ten-year credit default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for ten years. The most you could make was $100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders recovered nothing. It was a zero-sum bet: If you made $100 million, the guy who had sold you the credit default swap lost $100 million. It was also an asymmetric bet, like laying down money on a number in roulette.

On March 19, 2005, alone in his office with the door closed and the shades drawn, reading an abstruse textbook on credit derivatives, Michael Burry got an idea: credit default swaps on subprime mortgage bonds. The idea hit him as he read a book about the evolution of the U.S. bond market and the creation, in the mid-1990s, at J.P. Morgan, of the first corporate credit default swaps. He came to a passage explaining why banks felt they needed credit default swaps at all. It wasn't immediately obvious--after all, the best way to avoid the risk of General Electric's defaulting on its debt was not to lend to General Electric in the first place. In the beginning, credit default swaps had been a tool for hedging: Some bank had loaned more than they wanted to General Electric because GE had asked for it, and they feared alienating a long-standing client; another bank changed its mind about the wisdom of lending to GE at all.

It was also an asymmetric bet, like laying down money on a number in roulette. The most you could lose were the chips you put on the table; but if your number came up you made thirty, forty, even fifty times your money. "Credit default swaps remedied the problem of open-ended risk for me," said Burry. "If I bought a credit default swap, my downside was defined and certain, and the upside was many multiples of it." He was already in the market for corporate credit default swaps. In 2004 he began to buy insurance on companies he thought might suffer in a real estate downturn: mortgage lenders, mortgage insurers, and so on. This wasn't entirely satisfying. A real estate market meltdown might cause these companies to lose money; there was no guarantee that they would actually go bankrupt. He wanted a more direct tool for betting against subprime mortgage lending.

 

pages: 543 words: 157,991

All the Devils Are Here by Bethany McLean

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Asian financial crisis, asset-backed security, bank run, Black-Scholes formula, call centre, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Exxon Valdez, fear of failure, financial innovation, fixed income, high net worth, Home mortgage interest deduction, interest rate swap, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, market fundamentalism, Maui Hawaii, moral hazard, mortgage debt, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative trading / quantitative finance, race to the bottom, risk/return, Ronald Reagan, Rosa Parks, shareholder value, short selling, South Sea Bubble, statistical model, telemarketer, too big to fail, value at risk

Once this risk-based methodology took hold, banks had an enormous incentive to move into assets that would require less capital—or to invent new products that would have the same effect. Lo and behold, along came the product that would soon be the greatest capital reducer of them all: the credit default swap. In simplest terms, a credit default swap is designed to accomplish the same task as an interest rate or currency swap—move risk from a party that doesn’t want it to one that does. The risk in this case, however, is credit risk. A credit default swap is essentially an insurance policy against the possibility of default—credit protection, it came to be called. One party—a bank—would buy credit default swaps to protect against a default in its loan portfolio. A counterparty would sell the bank the credit default swap in return for a fee. So long as there was no default, the counterparty would keep collecting fees. But in the event of a default, the counterparty would have to pay the full amount of the loss to the bank.

“We were extending credit,” says one member of the credit derivative team, “and nobody was putting a price on it.” A tradable market for credit default swaps would change that. Traders buying and selling credit protection would allow the market to gauge the riskiness of a loan. If the cost of the credit default swap increased, that meant the chance of a default was rising; if it decreased, then the odds were decreasing. Even before a tradable market existed, J.P. Morgan’s quants began using credit default swaps internally, to put a price on the risk of its own commercial loans. The old-line commercial lenders hated it, but this was exactly the kind of approach to risk that Weatherstone favored. And the second reason the bank wanted to make credit default swaps a reality? If a tradable market developed, J.P. Morgan would certainly be a dominant player.

This was a mechanism created by Wall Street to allow investors to short the housing market similar to the way investors can bet against stocks. It was a natural development—at least from Wall Street’s point of view—but it evolved into one of the most unnatural and destructive financial products that the world has ever seen: the synthetic CDO. The key ingredient in a synthetic CDO was our old friend the credit default swap. For that matter, the key to shorting the mortgage market was the credit default swap. By 2005, credit default swaps on corporate bonds were ubiquitous, with a notional value of more than $25 trillion. (The notional value of credit default swaps peaked in 2007 at $62 trillion.) They were used by companies to protect against the possibility that another entity it did business with might default. They were used by banks to measure the riskiness of a loan portfolio, because their price reflected the market’s view of risk.

 

pages: 459 words: 118,959

Confidence Game: How a Hedge Fund Manager Called Wall Street's Bluff by Christine S. Richard

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Asian financial crisis, asset-backed security, banking crisis, Bernie Madoff, cognitive dissonance, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, family office, financial innovation, fixed income, forensic accounting, glass ceiling, Long Term Capital Management, market bubble, moral hazard, Ponzi scheme, profit motive, short selling, statistical model, white flight

It took another five years for Ackman to find a firm willing to represent him in meetings with the New York State Insurance Department. CONVERSATIONS ABOUT REGULATING credit-default swaps had a way of getting cut short. In the 1990s, Brooksley Born, the head of the Commodity Futures Trading Commission (CFTC), suggested bringing the credit-default-swap (CDS) market under the control of the commission. The CFTC already oversaw markets for futures and options, including those written on commodities such as pork bellies and corn. But Wall Street lobbyists, with the ideological backing of Federal Reserve Chairman Alan Greenspan, put up resistance. The Commodity Futures Modernization Act of 2000—buried in an 11,000-page budget bill and never debated—was passed the night before Congress recessed for Christmas in December 2000. It exempted credit-default swaps from federal oversight and from state gambling laws.

That would have brought the CDS business under the umbrella of state insurance regulators. Credit-default swaps were, after all, very similar to the product companies such as MBIA and Ambac already provided—a promise to cover losses if a bond defaulted. Financial Security Assurance, the bond insurer founded by Jim Lopp, asked the New York State Insurance Department to opine on whether it could enter into CDS contracts as part of its insurance business. The answer was no. Insurance was intended to provide protection against losses, regulators ruled. Although a company’s bankruptcy filing almost certainly results in someone losing money, there is no way of knowing that the person holding a credit-default-swap contract actually suffered a loss, the regulators reasoned. So credit-default swaps weren’t regulated—not as securities or gambling or insurance—and they proliferated at an astounding pace.

The SEC attorneys also were interested in Ackman’s use of the still relatively obscure credit-default-swap market to place his bets against the companies. “What was the notional amount of credit-default-swap contracts Gotham bought on Farmer Mac?” one attorney asked. “Two hundred twenty-five million dollars,” said Ackman. “At what level did the fund start buying?” “Fifty-five basis points,” Ackman said. That meant Ackman could buy protection against default on $10 million of Farmer Mac default for $55,000 a year. “At what level did you start selling?” “Three hundred basis points,” Ackman replied. That price indicated that the cost of buying protection on $10 million of debt had risen to $300,000 per year. “And what caused you to take these profits?” “I got a call from the head of the Merrill Lynch credit-default-swap desk begging me to take him out of the trade,” Ackman said.

 

pages: 430 words: 109,064

13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson, James Kwak

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Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, banking crisis, Bernie Madoff, Bonfire of the Vanities, bonus culture, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Edward Glaeser, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, financial intermediation, financial repression, fixed income, George Akerlof, Gordon Gekko, greed is good, Home mortgage interest deduction, Hyman Minsky, income per capita, interest rate derivative, interest rate swap, Kenneth Rogoff, laissez-faire capitalism, late fees, Long Term Capital Management, market bubble, market fundamentalism, Martin Wolf, moral hazard, mortgage tax deduction, Ponzi scheme, price stability, profit maximization, race to the bottom, regulatory arbitrage, rent-seeking, Robert Shiller, Robert Shiller, Ronald Reagan, Saturday Night Live, sovereign wealth fund, The Myth of the Rational Market, too big to fail, transaction costs, value at risk, yield curve

Orange County lost almost $2 billion on inverse floaters and similar trades that treasurer Robert Citron clearly did not understand; real-economy companies such as Procter & Gamble and Gibson Greetings similarly lost tens or hundreds of millions of dollars.75 But these transactions generated large fees for the dealers; Merrill Lynch alone made $100 million on deals with Orange County.76 One crucial innovation in the recent history of derivatives, which played an important role in creating the latest financial crisis, was the credit default swap. A credit default swap is a form of insurance on debt; the “buyer” of the swap pays a fixed premium to the “seller,” who agrees to pay off the debt if the debtor fails to do so. Typically the debt is a bond or a similar fixed income security, and the debtor is the issuer of the bond. Historically, monoline insurance companies provided insurance for municipal bonds, and Fannie Mae and Freddie Mac insured the principal payments on their mortgage-backed securities. With credit default swaps, however, now anyone could sell insurance on any fixed income security. Credit default swaps were invented in the early 1990s by Bankers Trust, but were popularized by J.P. Morgan later in the decade as a way for banks to unload the default risk of their asset portfolios; this enabled them to lower their capital requirements, freeing up money that could be lent out again.77 Credit default swaps also provide a way for a bond investor to hedge against the risk of default by the bond issuer.

Those mortgages and home equity loans were the raw material that Wall Street transformed into gleaming new CDOs for investors, taking a flat fee with each turn of the assembly line. In comparison with MBS and CDOs, credit default swaps (insurance against default), introduced in chapter 3, are a relatively simple product, but they played a special role in the finance boom. Because the boom was based on creating, packaging, and selling debt, it depended on the assumption that borrowers would pay off their debts—or that someone else would pay in their place. Credit default swaps made it possible to insure any pool of mortgage loans or mortgage-backed securities, seemingly eliminating the risk of default. In 1997, J.P. Morgan (part of today’s JPMorgan Chase) pioneered the use of credit default swaps to shift the default risk of loans off of its balance sheet. In the “BISTRO” transaction, J.P. Morgan’s derivatives team created a new special-purpose vehicle to insure loans the bank had made.

This meant that a bank could create a CDO based on the housing market without having to buy a pool of mortgages or mortgage-backed securities; instead, it only needed to find someone who would buy insurance (using credit default swaps) on securities that already existed in the market. No one, in other words, had to go to the trouble of lending new money. In the 2000s, as demand from investors and Wall Street banks for subprime loans outstripped supply, credit default swaps were used to fill the gap. As hedge fund manager Steve Eisman said, “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford. They were creating them out of whole cloth.”7 This practice ultimately magnified the impact of mortgage defaults; as borrowers stopped paying, their defaults hurt not only the CDOs that held bits and pieces of their mortgages, but also the synthetic CDOs that mirrored them. Credit default swaps also made possible another Wall Street business model.

 

pages: 374 words: 114,600

The Quants by Scott Patterson

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Albert Einstein, asset allocation, automated trading system, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buttonwood tree, buy low sell high, capital asset pricing model, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, Gordon Gekko, greed is good, Haight Ashbury, index fund, invention of the telegraph, invisible hand, Isaac Newton, job automation, John Nash: game theory, law of one price, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, merger arbitrage, NetJets, new economy, offshore financial centre, Paul Lévy, Ponzi scheme, quantitative hedge fund, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Sergey Aleynikov, short selling, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise

One concept they studied was the fact that after the death of a spouse, people tend to die sooner than their demographic peers. In other words, they were measuring correlations between the deaths of spouses. The link between dying spouses and credit default swaps was quant wizardry at its best—and its worst. Li showed how this model could assign correlations between tranches of CDOs by measuring the price of credit default swaps linked to the underlying debt. Credit default swaps supply a single variable that incorporates the market’s assessment of how the loan will perform. The price of a CDS, after all, is simply a reflection of the view investors have on whether or not a borrower will default. Li’s model supplied a method to bundle the prices of many different credit default swaps in a CDO and spit out numbers showing the correlations between the tranches. In April 2000, having moved on to J. P. Morgan’s credit department, he published his results in the Journal of Fixed Income in a paper called “On Default Correlation: A Copula Function Approach.”

The deal, announced soon after Weinstein joined the firm, would make Deutsche the world’s largest bank, with more than $800 billion in assets at its fingertips. Weinstein thought it might be a good fit—the job was for a small desk, with little competition, at a firm making a big push into a field he was certain had plenty of room to grow. Soon after joining Deutsche, he was learning how to trade a relatively new derivative known as credit-linked notes. Eventually they would become more commonly called credit default swaps. Credit default swaps are derivatives because their value is linked to an underlying security—a loan. They were created in the early 1990s by Bankers Trust, but it wasn’t until the math wizards at J. P. Morgan got their mitts on them that credit derivatives really took off. When Weinstein arrived at Deutsche, only a few notes or swaps traded every day—light-years from the megatrillion-dollar trading in swaps that went on in cyberspace a decade later.

Another boom came in the form of a new breed of hedge funds such as Citadel—or Citadel copycats—that specialized in convertible-bond arbitrage. Traditionally, just as Ed Thorp had discovered in the 1960s, the strategy involved hedging corporate bond positions with stock. Now, with credit default swaps, there was an even better way to hedge. Suddenly, those exotic derivatives that Weinstein had been juggling were getting passed around like baseball cards. By late 2000, nearly $1 trillion worth of credit default swaps had been created. Few knew more about how they worked than the baby-faced card-counting chess whiz at Deutsche Bank. In a flash, thanks in part to Russia’s default and LTCM’s collapse, Weinstein went from being a bit player to a rising star at the center of the action, putting him on the fast track to becoming one of the hottest, highest-paid, and most powerful credit traders on Wall Street.

 

pages: 350 words: 103,270

The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again by Nicholas Dunbar

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asset-backed security, bank run, banking crisis, Basel III, Black Swan, Black-Scholes formula, bonus culture, capital asset pricing model, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delayed gratification, diversification, Edmond Halley, facts on the ground, financial innovation, fixed income, George Akerlof, implied volatility, index fund, interest rate derivative, interest rate swap, Isaac Newton, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, Nick Leeson, Northern Rock, offshore financial centre, price mechanism, regulatory arbitrage, rent-seeking, Richard Thaler, risk tolerance, risk/return, Ronald Reagan, shareholder value, short selling, statistical model, The Chicago School, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, yield curve

They told me about a derivative that had been invented two years earlier. It was called a credit default swap. Rather than being linked to currency markets, interest rates, stocks, or commodities, these derivatives were linked to unmitigated financial disaster: the default of loans or bonds. I found it hard that night to imagine who might be interested in buying such a derivative from a bank. The nonfinancial companies whose activities in the globalized economy exposed them to financial uncertainty didn’t seem interested. The derivatives that were useful to them—futures, options, and swaps linked to commodities, currencies, and interest rates—had already been invented. It seemed to me as if the credit default swap was an invention searching for a real purpose. As it happened, the kind of companies that found credit default swaps most relevant were those that had lots of default risk on their books: the banks.

But Chase’s global entertainment group in Los Angeles wanted a piece of it, so in the late 1990s, the bank’s loan officers loaned some $600 million to producers of films, including The Truman Show, by persuading an executive working for French insurance giant AXA to write policies against poor box office results. Now suppose you preferred to work with people who swore by the market approach to credit, as Peter Hancock did. The credit default swap was the trading world’s modern solution. This industry had already created a thriving business enabling clients to protect themselves from—or speculate on—fluctuating interest rates, currencies, and commodity risk using derivatives. Why not expand the innovation to handle credit? For instance, if Hancock had been able to buy a derivative that hedged J.P. Morgan against clients’ defaulting, the bank would have been spared the embarrassment of its Korean swap fiasco. Like foreign exchange options, credit default swaps could be easily detached from any underlying exposure that might “justify” their existence as a hedge. Like those currency speculators in the 1997 Asian crisis, you could use them to place bets on disasters: in this case, the death of a company.

In fixed income, a company might have hundreds of different bonds in the market, repayable in different currencies, and with myriad maturity dates and interest payment profiles. Which one should you buy or sell? You had to be a geek to figure it out. With credit default swaps, all that detail could be stripped away. As with equities, there was a single “reference entity” or “name,” Walmart Inc., whose potential for default drove the price of the swap contract. Better still, the default swap distilled this crucial credit information out of the hundreds of Walmart bonds. And for Sherwood, information was power. He realized that by combining trading in credit default swaps and corporate bonds on the same desk, Goldman would have its finger on the pulse of the world’s biggest corporate borrowers: not only could Goldman control its own exposure, but it would control its clients’ access to the market for credit.

 

pages: 257 words: 64,763

The Great American Stickup: How Reagan Republicans and Clinton Democrats Enriched Wall Street While Mugging Main Street by Robert Scheer

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banking crisis, Bernie Madoff, Bernie Sanders, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, facts on the ground, financial deregulation, housing crisis, invisible hand, Long Term Capital Management, mortgage debt, new economy, Ponzi scheme, profit motive, Ralph Nader, Ronald Reagan, too big to fail, trickle-down economics

Five years later, the notional value of OTC derivatives had grown to $24 trillion, and after another ten years, when the meltdown occurred, we would be talking about $640 trillion in the notional value of all unregulated derivative trading. As for those “swaps” to which Gramm referred, scoffing at alarmists who thought “trillions” were at stake and that the swaps could “disrupt the financial system”—boy, did they ever. “The Monster That Ate Wall Street: How ‘credit default swaps’—an insurance against bad loans—turned from a smart bet into a killer” was the title and subheading of a Newsweek article on October 6, 2008, referring to credit default swaps, “which ballooned into a $62 trillion market . . . nearly four times the value of all stock traded on the New York Stock Exchange.” Of course in hindsight, Gramm’s glibness, whether cynical or naïve, seems patently absurd; the worrywarts were completely right. Clearly, as legislators across the board in the United States and the European Union have indicated with their votes on new regulations, the derivatives markets were not just underregulated but in no significant way regulated at all.

Not, it should be noted, on credit default swaps and how they came to be totally unregulated, thanks in part to Bush’s fellow Texan Phil Gramm and the legislation he pushed through the Senate with lame-duck president Clinton’s blessing. The level of ignorance on Bush’s part is alarming, given that he had made much of his Harvard MBA and his own business experience in campaigning for the presidency. But Paulson in his memoir offers a rare admission of how shallow was the understanding also of the key bankers, like those at Goldman Sachs, who were trading in the suspect derivatives with such abandon. When the president asked what might trigger the big disruption of the market, Paulson mentioned “the lack of transparency of these CDS contracts (credit default swaps), coupled with their startling growth rate, unnerved me.”

However, some years before Glass-Steagall was dismantled, Phil’s wife played a key role, as a member of both the Reagan and the Bush I administrations, in shaping the rapid changes in the financial markets brought about by internationalization, computer-driven trading, and the introduction of a whole new discipline of “risk management,” whereby Wall Street wizards deployed complex mathematical models to create a vast array of new financial products, such as the now infamous credit default swaps and collateralized debt obligations. As was seen throughout the Reagan and later the Bush I and Bush II administrations, the Republicans had realized they could impose de facto deregulation of Big Business by appointing to influential federal commissions and agencies “watchdogs” who were sympathetic to the corporations they were supposed to be monitoring. Of course, this end run around congressional authority was probably not as satisfying or foolproof as wiping out the regulation altogether, yet it proved quite effective in pleasing CEOs, who had spent the 1970s complaining about red tape and overzealous government investigators.

 

pages: 280 words: 79,029

Smart Money: How High-Stakes Financial Innovation Is Reshaping Our WorldÑFor the Better by Andrew Palmer

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Affordable Care Act / Obamacare, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, Black-Scholes formula, bonus culture, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Graeber, diversification, diversified portfolio, Edmond Halley, Edward Glaeser, Eugene Fama: efficient market hypothesis, eurozone crisis, family office, financial deregulation, financial innovation, fixed income, Flash crash, Google Glasses, Gordon Gekko, high net worth, housing crisis, Hyman Minsky, implied volatility, income inequality, index fund, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, loss aversion, margin call, Mark Zuckerberg, McMansion, mortgage debt, mortgage tax deduction, Network effects, Northern Rock, obamacare, payday loans, peer-to-peer lending, Peter Thiel, principal–agent problem, profit maximization, quantitative trading / quantitative finance, railway mania, randomized controlled trial, Richard Feynman, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, short selling, Silicon Valley, Silicon Valley startup, Skype, South Sea Bubble, sovereign wealth fund, statistical model, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

Big jumps in US interest rates in the early 1980s, as then Federal Reserve chairman Paul Volcker battled inflation, gave people more reason to hedge against interest-rate volatility. Globalization increased the complexity of multinational companies’ operations, and the Asian debt crisis in the late 1990s drove home the risks of operating in emerging markets. Credit-default swaps promised a way for banks to reduce the impact of defaults, in the aftermath of a wave of bank failures experienced during America’s savings-and-loan crisis in the 1980s, because the sellers of a swap promised a payout if the borrower in question was unable to pay. Needs are not always so noble, of course. By making their lending seem less risky, credit-default swaps also meant that regulators were happy to allow banks to fund themselves with less equity capital. That in turn made banks more attractive propositions to equity investors, who would have to put up less money in order to get a return.

“Whatever rule those fucking idiots come up with on Monday, I’ll have found a thousand ways around it by Friday,” he said. (Not if you’ve gone bankrupt, you won’t.) But even now it is hard to find fault with the concept, as opposed to the practical application, of many of the most demonized products of the recent past. Take securitization and credit-default swaps. It would be blinkered to argue they have no problems. By handing risks on to someone else, securitization gives banks an incentive to loosen their underwriting standards; they won’t be the ones picking up the pieces. The protection afforded by credit-­default swaps may similarly blunt the incentives for lenders to be careful when they extend credit, because they will get a payout in the event of a borrower defaulting. But the downsides should not obscure the good. India, with a far more conservative financial system than America’s, allowed its first CDS deals to be done after the 2007–2008 crisis, recognizing that the instrument would help attract creditors and build its domestic bond market.

They are then sliced into different tranches: the most senior tranches of CDOs of mortgage-backed securities were given high ratings during the most recent US housing boom because the performance of all the different mortgages in the pool was thought to be diversified. Counterparty risk: The risk that the other party to a contract will not live up to its obligations. The counterparty risk in an interest-rate swap is that one of the parties to the swap will not pay up. Credit-default swap: A credit-default swap is a form of insurance against default by a bond issuer. Credit ratings: An evaluation by a credit-rating agency of the creditworthiness of a debtor. Ratings are widely used by investors and are embedded in international rules, including those on how much equity banks have to use to fund themselves. Derivatives: A financial instrument that derives its value from another underlying asset or entity.

 

pages: 478 words: 126,416

Other People's Money: Masters of the Universe or Servants of the People? by John Kay

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Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, call centre, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, cognitive dissonance, corporate governance, Credit Default Swap, cross-subsidies, dematerialisation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, Elon Musk, Eugene Fama: efficient market hypothesis, eurozone crisis, financial innovation, financial intermediation, fixed income, Flash crash, forward guidance, Fractional reserve banking, full employment, George Akerlof, German hyperinflation, Goldman Sachs: Vampire Squid, Growth in a Time of Debt, income inequality, index fund, inflation targeting, interest rate derivative, interest rate swap, invention of the wheel, Irish property bubble, Isaac Newton, London Whale, Long Term Capital Management, loose coupling, low cost carrier, M-Pesa, market design, millennium bug, mittelstand, moral hazard, mortgage debt, new economy, Nick Leeson, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shock, passive investing, peer-to-peer lending, performance metric, Peter Thiel, Piper Alpha, Ponzi scheme, price mechanism, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, random walk, regulatory arbitrage, Renaissance Technologies, rent control, Richard Feynman, risk tolerance, road to serfdom, Robert Shiller, Robert Shiller, Ronald Reagan, Schrödinger's Cat, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, sovereign wealth fund, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, Steve Wozniak, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tobin tax, too big to fail, transaction costs, tulip mania, Upton Sinclair, Vanguard fund, Washington Consensus, We are the 99%, Yom Kippur War

Some doubt remained as to the legality of such transactions by US residents, but this was settled by the Commodity Futures Modernization Act of 2000, promoted by Fed chairman Alan Greenspan and by (now Treasury secretary) Larry Summers.11 Mr Potts’s benign opinion, and the enthusiasm of US policy-makers, set the scene for the explosive growth of the markets in credit securities – credit default swaps and collateralised debt obligations – which were at the centre of the financial crisis. But if credit default swaps were neither wagers nor insurance contracts, then what were they? In 1997 there was an answer to this question, although perhaps understandably it was not one on which Mr Potts chose to dwell. Much of the complexity of the modern financial services is the result of regulatory arbitrage. Such arbitrage is a process by which you avoid or minimise regulatory restriction by engaging in a transaction with more or less identical commercial effect but more favourable regulatory treatment. This was the origin, and initial purpose, of the credit default swap. The idea was to exploit differences between the regulation of banks and insurance companies.

In retrospect, the critical development during this period was the growth in trade in asset-backed securities, especially mortgage-backed securities, and subsequently collateralised debt obligations, between financial institutions. A false belief in the security provided by such packaging stimulated demand for these assets. Further reassurance appeared to be provided by the development of a market in credit default swaps – derivative securities that would pay out if there was default on the underlying security. Little thought was given at the time to the capacity of the institutions that wrote these contracts to pay in the event of widespread defaults. Thus a downgrading of the credit rating of AIG in 2008 – which had insured over $500 billion of securities through credit default swaps – was devastating in its consequences for the perceived safety of bond portfolios. The insatiable demand for asset-backed securities led to the pursuit of assets of lower and lower quality. In many US cities mortgage salesmen promoted loans to people who had no realistic prospect of being able to repay.

The English traded risks; the Swiss mutualised them.12 The Swiss practised Gemeinschaft; the English, not knowing the meaning of Gesellschaft, equated it with wagering. The elision would have profound consequences. In 1997 Robin Potts QC was asked by the International Swaps and Derivatives Association (ISDA) to review the new market in credit default swaps. Were participants in this market the modern counterparts of the gentlemen of Lloyd’s – engaged in a wager? Or were the buyers and sellers of credit default swaps more akin to the Swiss villagers, sharing the risks of disease and disasters? Mr Potts expressed Michel Albert’s distinction in legal terms. He drew attention to the famous case of Carlill v. Carbolic Smoke Ball Company. In 1892 a race-going judge, Sir Henry Hawkins, defined the meaning of a wager in English law as ‘a contract by which two persons, professing to hold opposite views touching the issue of a future uncertain event, mutually agree that dependent on the determination of that event one shall win from the other’.13 Insurance is different.

 

pages: 322 words: 77,341

I.O.U.: Why Everyone Owes Everyone and No One Can Pay by John Lanchester

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asset-backed security, bank run, banking crisis, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black-Scholes formula, Celtic Tiger, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversified portfolio, double entry bookkeeping, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial innovation, fixed income, George Akerlof, greed is good, hindsight bias, housing crisis, Hyman Minsky, interest rate swap, invisible hand, Jane Jacobs, John Maynard Keynes: Economic Possibilities for our Grandchildren, laissez-faire capitalism, liquidity trap, Long Term Capital Management, loss aversion, Martin Wolf, mortgage debt, mortgage tax deduction, mutually assured destruction, new economy, Nick Leeson, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative easing, reserve currency, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, South Sea Bubble, statistical model, The Great Moderation, the payments system, too big to fail, tulip mania, value at risk

The irony is that he wasn’t even talking here about the category of derivative which turned out to be the most destructive of all, the credit default swap, or CDS. I am going to arraign a number of culprits for the crash: derivatives are one of the main ones, but among derivatives, it was CDS which were the chief baddy, the gang leader, the Mafia don, the most destructive of the WMDs. As with some other culprits in the crisis, credit default swaps were a new thing, invented by bankers seeking newer, sexier ways of making newer, sexier profits. When I first began to study the world of the City, I found it hard to come to grips with the idea that financial instruments are “invented,” cooked up in the same way as works of art or scientific theories—but the fact is that they are. Credit default swaps are complicated, but they’re based on an old idea, that of a more straightforward kind of swap.

But the deal had been laborious and time-consuming, and the bank wouldn’t be able to make real money out of credit default swaps until the process became streamlined and industrialized. In the above personal finance example, the personal nature of the deal is part of the point: you know your neighbors and can make a decision about how likely they are to pay you back and therefore how safe your investment is. To make real money out of these deals, however, it would be so much more lucrative if one could just skip past that stage—if there were a way of bypassing all the tedious, case-by-case, look-them-in-the-eye stage of assessing the risk of default. The invention which allowed all this to happen was securitization. The issue with credit default swaps was the underlying issue with all banking, everywhere and always: the risk that the person to whom you’re lending money won’t be able to pay you back.

Customers would be able to buy exactly the degree of risk they wanted, tailor-made to their needs. All these ideas were knocking around the banking world. William Demchak at J.P. Morgan put them together to create securitized bundles of credit default swaps—bundles of insurance against default—and selling them to investors. The investors would get the streams of revenue, according to the level of risk and reward they chose; the bank would get insurance against its loans and fees for setting up the deal. There was one final component of the J.P. Morgan team’s invention. It set up an offshore shell company, called a special purpose vehicle, or SPV, to fulfill the role supplied by the EBRD in the first credit default swap. The shell company would assume $9.7 billion of J.P. Morgan’s risk; then it would sell off that risk to investors in the form of securities paying differing rates of interest.

 

pages: 460 words: 122,556

The End of Wall Street by Roger Lowenstein

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Asian financial crisis, asset-backed security, bank run, banking crisis, Berlin Wall, Bernie Madoff, Black Swan, Brownian motion, Carmen Reinhart, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, fear of failure, financial deregulation, fixed income, high net worth, Hyman Minsky, interest rate derivative, invisible hand, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, Martin Wolf, moral hazard, mortgage debt, Northern Rock, Ponzi scheme, profit motive, race to the bottom, risk tolerance, Ronald Reagan, savings glut, short selling, sovereign wealth fund, statistical model, the payments system, too big to fail, tulip mania, Y2K

Russo was apoplectic, but Lehman’s stock, now down to the midteens, held its own through August. Equally distressing to the banks, Wall Street had constructed an alternative way of speculating against troubled corporations, via derivatives, and this wholly unregulated market doubled back on its Wall Street creators with a vengeance. Credit default swaps had been invented by financial engineers at Bankers Trust as a form of insurance on corporate defaults.af The initial purpose was supposedly as a hedging vehicle. A bank that had lent money to General Motors could hedge its risk by purchasing a credit default swap from another party who believed that the loan would be repaid. Thus, if GM defaulted on the loan, the bank would recoup its investment via the swap. Unfortunately, such hedges dulled the bank’s incentive to perform the one function for which society depended on it: thoughtfully rationing credit to worthy borrowers.

INDEX Adelson, Mark adjustable rate mortgages option ARMs rate freeze on proposed affordable housing Age of Markets American International Group (AIG) accounting scandals assets bailouts. See AIG bailouts Ben Bernanke and board of Warren Buffett and CDOs and collateral calls on compensation at corporate structure of credit default swaps and credit rating agencies and Jamie Dimon and diversity of holdings employees, number of Financial Products subsidiary Timothy Geithner and Goldman Sachs and insurance (credit default swap) premiums of JPMorgan Chase and lack of reserve for losses leadership changes Lehman Brothers and losses Moody’s and Morgan Stanley and New York Federal Reserve Bank and Hank Paulson and rescue of. See AIG bailouts revenue of shareholders statistical modeling of stock price of struggles of risk of systemic effects of failure of Texas and AIG bailouts amount of Ben Bernanke and board’s role in credit rating agencies and Federal Reserve and Timothy Geithner and Goldman Sachs and JPMorgan Chase and Lehman Brothers’ bankruptcy and New York state and Hank Paulson and reasons for harm to shareholders in Akers, John Alexander, Richard Allison, Herbert Ambac American Home Mortgages Andrukonis, David appraisers, real estate Archstone-Smith Trust Associates First Capital Atteberry, Thomas auto industry Bagehot, Walter bailouts.

See home foreclosure(s) foreign investors France Frank, Barney Freddie Mac and Fannie Mae accounting problems of affordable housing and Alternative-A loans bailout of Ben Bernanke and capital raised by competitive threats to Congress and Countrywide Financial and Democrats and Federal Reserve and foreign investment in Alan Greenspan and as guarantor history of lack of regulation of leadership changes leverage losses mortgage bubble and as mortgage traders Hank Paulson and politics and predatory lending and reasons for failures of relocation to private sector Robert Rodriguez and shareholders solving financial crisis through statistical models of stock price of Treasury Department and free market Freidheim, Scott Friedman, Milton Fuld, Richard compensation of failure to pull back from mortgage-backed securities identification with Lehman Brothers Lehman Brothers’ bankruptcy and Lehman Brothers’ last days and long tenure of Hank Paulson and personality and character of Gamble, James (Jamie) GDP Geithner, Timothy AIG and bank debt guarantees and Bear Stearns bailout and career of China and Citigroup and financial crisis, response to Lehman Brothers and money markets and Morgan Stanley and in Obama administration Hank Paulson and TARP and Gelband, Michael General Electric General Motors Germany Glass-Steagall Act Glauber, Robert Golden West Savings and Loan Goldman Sachs AIG and as bank holding company Warren Buffett investment in capital raised by capital sought by compensation at credit default swaps and hedge funds and insurance (credit default swap) premiums of job losses at leverage of Merrill Lynch and Stanley O’Neal’s obsession with Hank Paulson and pull back from mortgage-backed securities short selling against stock price of Wachovia and Gorton, Gary government, U.S. See also specific agencies as absent from Wall Street bailouts by. See TARP banking regulation by. See banking regulators/ regulation deficit of help for homeowners housing market, role in international loans by intervention by, suspicion of lack of tools available to market busts, intervention in policy formulation, Bernanke’s urge for policy of, effect on banking tactics recoupment of relief funds rescue plan of.

 

Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America by Matt Taibbi

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affirmative action, Affordable Care Act / Obamacare, Bernie Sanders, Bretton Woods, carried interest, clean water, collateralized debt obligation, collective bargaining, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, David Brooks, desegregation, diversification, diversified portfolio, Donald Trump, financial innovation, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, illegal immigration, interest rate swap, laissez-faire capitalism, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, medical malpractice, moral hazard, mortgage debt, obamacare, passive investing, Ponzi scheme, prediction markets, quantitative easing, reserve currency, Ronald Reagan, Sergey Aleynikov, short selling, sovereign wealth fund, too big to fail, trickle-down economics, Y2K, Yom Kippur War

“Then I turn around and I call up AIG and I’m like, ‘Hey, where would you credit default swap this bond?’ And they’re like, ‘Oh, we’ll do that for LIBOR plus ten.’ ” Miklos pauses and laughs, recalling the pregnant pause on his end of the phone line as he heard this offer from AIG. He couldn’t believe what he’d just heard: it was either a mistake, or they had just handed him a mountain of money, free of charge. “I hear this,” he says, “and I’m like, ‘Uh … okay. Sure, guys.’ ” Here we need another digression. The credit default swap was a kind of insurance policy originally designed to get around those same regulatory capital charges. Ironically, Miklos had once been part of a famed team at JPMorgan that helped design the modern credit default swap, although the bank envisioned a much different use for them back then. A credit default swap is just a bet on an outcome.

None of this fazed Greenspan, who apparently never understood what derivatives are or how they work. He saw derivatives like credit default swaps—insurance-like contracts that allow a lender to buy “protection” from a third party in the event his debtor defaults—as brilliant innovations that not only weren’t risky, but reduced risk. “Greenspan saw credit derivatives as a device that enhanced a risk-free economic environment,” says Greenberger. “And the theory was as follows: he’s looking at credit derivatives, and he’s saying everyone is going to have insurance against breakdowns … But what he didn’t understand was that the insurance wasn’t going to be capitalized.” In other words, credit default swaps and the like allowed companies to sell something like insurance protection without actually having the money to pay that insurance—a situation that allowed lenders to feel that they were covered and free to take more risks, when in fact they were not.

The unit originally dealt in the little-known world of interest rate swaps (which would later become notorious for their role in the collapse of countries like Greece and localities like Jefferson County, Alabama). But in the early part of this decade it moved into the credit default swap world, selling protection to the Mikloses and Goldman Sachses of the world, mainly for supersenior AAA-rated tranches of the tiered, structured deals of the type Andy put together. How you view Cassano’s business plan largely depends on whether you think he was hugely amoral or just really stupid. Again, thanks largely to the fact that credit default swaps existed in a totally unregulated area of the financial universe—this was the result of that 2000 law, the Commodity Futures Modernization Act, sponsored by then-senator Phil Gramm and supported by then–Treasury chief Larry Summers and his predecessor Bob Rubin—Cassano could sell as much credit protection as he wanted without having to post any real money at all.

 

pages: 305 words: 69,216

A Failure of Capitalism: The Crisis of '08 and the Descent Into Depression by Richard A. Posner

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Andrei Shleifer, banking crisis, Bernie Madoff, collateralized debt obligation, collective bargaining, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, diversified portfolio, equity premium, financial deregulation, financial intermediation, Home mortgage interest deduction, illegal immigration, laissez-faire capitalism, Long Term Capital Management, market bubble, moral hazard, mortgage debt, oil shock, Ponzi scheme, price stability, profit maximization, race to the bottom, reserve currency, risk tolerance, risk/return, Robert Shiller, Robert Shiller, savings glut, shareholder value, short selling, statistical model, too big to fail, transaction costs, very high income

But they also could, and many did, buy a form of insurance, issued in great quantity by, among many other firms, the American International Group, against declines in the value of mortgage-backed securities, as well as of other investments. This form of insurance, called "credit-default swaps," had originally been intended as insurance against bond defaults, of which there was a long history on the basis of which premiums could be computed with reasonable confidence. But AIG and other financial firms (not limited to insurance companies and commercial banks, the traditional issuers of credit insurance, such as conventional mortgage insurance, as distinct from insurance of securitized debt) began issuing credit-default swaps to insure against losses in the value of mortgage-backed securities, which lacked such a history. One beauty of swaps was that they reduced the amount of collateral that a lender needed in order to protect itself from the consequence of the borrower's default.

Because the banking industry was highly leveraged, and because much of its capital consisted of securities that were very difficult to value, the bursting of the housing bubble shrank the banks' capital —but by an unknown amount because of the valuation problem. The banks didn't know how meager their equity cushion had become and therefore how much they could lend without incurring a high risk of bankruptcy, since as we know lending is increasingly risky the more leverage the lender has in its capital structure. A further complication was that banks that had bought the insurance side of credit-default swaps did not know their exposure. When Lehman Brothers collapsed, issuers of credit-default swaps all over the world were on the hook because Lehman had purchased many swaps. It had issued many swaps as well, and its equity, devoured by the collapse of the mortgagebacked securities, which it had held in great quantity, was insufficient to enable it to pay the debts that it had insured. Suppose bank A had insured Lehman against a loss of $X, and bank B was insured by Lehman against a loss of $X.

The trends toward easy credit and deregulated and therefore risky lending were mutually reinforcing. Banks realized this and tried to reduce the riskiness of their loan portfolios without reducing profit by devices such as securitized debt (notably securities backed by residential mortgages) and credit-default swaps (insurance against defaults), which dispersed risk and therefore reduced the risks borne by a particular bank. These instruments did reduce risk, but also increased it, making the net effect on the banking industry's risk unclear; for example, banks both issued and bought credit-default swaps —they were insurers of defaults as well as being insured against them. The riskiness of secnritized debt was hard to assess because of the complexity of the securities, a single one of which might be backed by hundreds or even thousands of mortgages on houses scattered all over the country.

 

pages: 468 words: 145,998

On the Brink: Inside the Race to Stop the Collapse of the Global Financial System by Henry M. Paulson

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asset-backed security, bank run, banking crisis, Bretton Woods, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Doha Development Round, fear of failure, financial innovation, housing crisis, income inequality, London Interbank Offered Rate, Long Term Capital Management, margin call, moral hazard, Northern Rock, price discovery process, price mechanism, regulatory arbitrage, Ronald Reagan, Saturday Night Live, short selling, sovereign wealth fund, technology bubble, too big to fail, trade liberalization, young professional

He seemed much more comfortable after the meeting. The market stayed strong through the day, with the Dow closing up 290 points, or 2.6 percent, at 11,511. But Lehman’s shares dropped $2.05, to $14.15, while its credit default swaps edged up to a worrisome 328 basis points. And the markets still did not know that Lehman’s talks with KDB were collapsing. I had hoped that the GSE takeovers would give Lehman a bit of breathing room, but I was wrong. Tuesday, September 9, 2008 I arrived at the office shortly after 6:00 a.m. and headed straight to the Markets Room. Lehman’s shares were headed toward single digits, and its credit default swaps were under pressure. I went to Ken Wilson’s office to get the latest on Dick Fuld. The KDB deal, Ken told me, was dead. “Does he know how serious the problem is?” I asked. “He’s still clinging to the view that somehow or other the Fed has the power to inject capital,” Ken answered.

AIG’s problems had been exacerbated by the crumbling financial markets; since the deal had been made, the global insurance business had slumped. Now the company’s credit default swaps had neared 2,400 basis points. That meant that it cost almost $24 to insure $100 of AIG credit—an extraordinarily high amount. The market could see that AIG’s capital structure was unsustainable. The Federal Reserve’s loan had saved it, but the company still had too much debt. The loan’s high cost strained interest coverage, and its short, two-year duration created pressure to sell assets quickly in a soft market. Meantime, the company was still weighed down by substantial market and credit risks from its holdings of residential mortgage-backed securities and the credit default swaps it had written on residential MBS. It had even used its securities lending program to purchase residential MBS.

We need regulation and capital requirements that lead to greater simplicity, standardization, and consistency. Contrary to popular belief, credit default swaps and other derivatives provide a useful function in making the capital markets more efficient and were not the cause of the crisis. But these financial instruments do introduce embedded and hidden leverage into financial institutions’ balance sheets, complicating due diligence for counterparties and making effective supervision more difficult. The resulting opacity, which should be unacceptable even in normal markets, only intensified and magnified the crisis. This system needs to be reformed so that these innovative instruments can play their important role as mitigators, not transmitters, of risk. Standardized credit default swaps, which make up the vast majority of CDS contracts, should be traded on a public exchange, and nonstandardized contracts should be centrally cleared, subject to more regulatory scrutiny and greater capital charges.

 

pages: 342 words: 99,390

The greatest trade ever: the behind-the-scenes story of how John Paulson defied Wall Street and made financial history by Gregory Zuckerman

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1960s counterculture, banking crisis, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, financial innovation, fixed income, index fund, Isaac Newton, Long Term Capital Management, margin call, Mark Zuckerberg, Menlo Park, merger arbitrage, mortgage debt, mortgage tax deduction, Ponzi scheme, Renaissance Technologies, rent control, Robert Shiller, Robert Shiller, rolodex, short selling, Silicon Valley, statistical arbitrage, Steve Ballmer, Steve Wozniak, technology bubble

Paulson had examined shorting shares of some financial-service companies, but some companies in that business recently had received takeover offers, sending the stocks racing higher, burning those who shorted them with deep losses. Was there any better insurance? One day in October 2004, Pellegrini, still nervous about his standing at the firm, got up the nerve to approach Paulson in the hallway to tell his boss that there might be a better way to protect the firm’'s portfolio. Why not buy credit-default swaps? Paulson and his team weren’'t very familiar with the world of credit-default swaps, beyond a vague understanding that these instruments provided insurance against losses from debt investments. Though trading of CDS contracts had soared in volume in recent years, it was a complicated, esoteric world. Paulson was one of many investors who shied away from using these “"derivative”" investments, described as such because their value derives from the change in some underlying asset.

But Paulson liked to encourage his staff to develop novel approaches to problems, and he seemed intrigued, a small smile forming on his face. He asked Pellegrini to research how the firm could buy CDS contracts on financial companies, which Paulson was especially worried about due to all their borrowed money. In truth, Pellegrini didn’'t know that much about how credit-default swaps were traded, other than watching others do it at Tricadia. So he arranged for tutorials by various brokerage firms on the ins and outs of credit-default swaps. The fund made its first purchase of CDS protection on a company called MBIA, Inc., which insured all those mortgage bonds backed by aggressive loans. The annual cost of insuring $100 million of MBIA’'s debt was a puny $500,000. In other words, if MBIA ran into problems and its debt became worthless, Paulson would get paid $100 million thanks to CDS protection that cost just $500,000 annually.

Finally, a pro could weigh in on his moves and tell him if he was missing anything. I’'m just a beginner figuring it all out. He’'s the expert! Dimon bounded over, a warm smile on his face. This was Greene’'s chance. He could hardly contain himself. “"Hey, Jamie. My biggest position is shorting subprime credit through credit-default swaps. I’'ve done four hundred million with you guys.”" Dimon had a blank look on his face. “"What’'s that?”" he asked. Greene was taken aback. Dimon was among the most important players in the financial markets. But he didn’'t seem to know much about credit-default swaps. Even the $400 million figure didn’'t grab his attention. Dimon kept glancing at the tennis match below, where Roger Federer was fending off Novak ÐDjokovićc in the finals. Then Dimon looked around the suite, smiling at his other guests. Greene thought maybe he just needed to explain it better.

 

pages: 1,073 words: 302,361

Money and Power: How Goldman Sachs Came to Rule the World by William D. Cohan

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asset-backed security, Bernie Madoff, buttonwood tree, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, fear of failure, financial innovation, fixed income, Ford paid five dollars a day, Goldman Sachs: Vampire Squid, Gordon Gekko, high net worth, hiring and firing, hive mind, Hyman Minsky, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, merger arbitrage, moral hazard, mortgage debt, paper trading, passive investing, Ponzi scheme, price stability, profit maximization, risk tolerance, Ronald Reagan, Saturday Night Live, South Sea Bubble, time value of money, too big to fail, traveling salesman, value at risk, yield curve, Yogi Berra

At this moment, Greenberg said, Sullivan should have pretty much shut down the credit-default swap operation at AIGFP: “When the AAA credit rating disappeared in spring 2005, it would have been logical for AIG’s new management to have exited or reduced its business of writing credit-default swaps,” he explained. With little effort, Greenberg ticked off in rapid fire the litany of mistakes then made by Sullivan, Cassano, and company: Rather than curtailing the selling of credit-default swaps, AIGFP ratcheted up exponentially its issuance of them, and no longer just on corporate debt but on a whole new explosion of risk that Wall Street was madly underwriting through the issuance of increasingly risky mortgage-backed securities tied to so-called subprime and Alt-A mortgages. Then there were the credit-default swaps written on collateralized debt obligations, or CDOs, with huge exposures to subprime mortgages.

One of the more intriguing opportunities that Birnbaum spied in the market by the end of 2005 was the increasing use of credit-default swaps, or CDS—a form of insurance that could be bought on whether a debt would in fact be paid—in the mortgage or any other debt market. Increasingly, insurance companies, such as AIG, or other Wall Street firms were willing to sell protection on whether the mortgages that went into mortgage-backed securities would in fact be paid. To get the insurance, buyers had to pay premiums to the issuers, as they did to obtain any other form of insurance. Instead of buying life insurance, or fire insurance on your house, or auto insurance on your car, buying a credit-default swap allowed investors to make bets on whether people ended up paying their mortgages. There were a number of reasons that the markets for mortgages and for credit-default swaps started to intersect in the summer of 2005.

The supposed genius of the synthetic CDO was that instead of having to accumulate mortgages in a warehouse until you had enough to build and then sell a CDO, Goldman could create the CDO virtually overnight using credit-default swaps, those insurance contracts offering a holder protection on whether a debt security would fail or not. It would be as if you could buy and sell the idea of selling cakes without actually having to buy the ingredients for the cakes, make them, and then sell them. Warren Buffett might consider this one of the eureka moments in the creation of financial weapons of mass destruction, as he referred to derivatives and credit-default swaps. “This was the trade, basically,” Sparks said. “CDOs were writing protection on CDS and doing synthetic CDOs. Most of the guys that bought the protection were hedge funds and then we, or others, might be in the middle of that trade.

 

Global Financial Crisis by Noah Berlatsky

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accounting loophole / creative accounting, asset-backed security, banking crisis, Bretton Woods, capital controls, Celtic Tiger, centre right, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, deindustrialization, Doha Development Round, energy security, eurozone crisis, financial innovation, Food sovereignty, George Akerlof, Gordon Gekko, housing crisis, illegal immigration, income inequality, market bubble, market fundamentalism, moral hazard, new economy, Northern Rock, purchasing power parity, quantitative easing, race to the bottom, regulatory arbitrage, reserve currency, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, South China Sea, structural adjustment programs, too big to fail, trade liberalization, transfer pricing, working poor

Based on this theory, banks repackaged and sold these mortgages as investments, or mortgagebased securities. Thus, an investor could buy a bunch of mortgages (or a small piece of a bunch of mortgages) which were guaranteed to pay back a certain return. The banks were so sure that these mortgage-based securities would always pay that they even sold insurance on the investments. These insurance contracts were called credit default swaps. A credit default swap (CDS) means an investor in mortgage-based securities would pay a certain amount of money to the bank on a regular basis as long as the securities made money. If the securities ever stopped making money, though, the bank would have to pay the investor a large sum. CDSs were very popular because they made investors feel safer, and banks were certain they would never have to pay on them; investments would never default because housing prices would go up forever, or so they believed.

As a result, as Janet Morrissey reported in TIME in 2009, “The CDS market exploded over the past decade to more than $45 trillion in mid-2007. . . . This is roughly twice the size of the U.S. stock market.” When the bubble burst and housing prices did start to go down, banks found themselves in a precarious position. Much of the banks’ money was invested in mortgages that were now shown to be bad debts. To make matters worse, the banks had in many cases promised to pay other investors through credit default swaps if these loans went bad. The resulting strain caused a series of catastrophic failures of large banks in the United States. Bear Stearns, a large investment bank, first noted publicly that it was having trouble because of subprime 17 The Global Financial Crisis loans in July 2007. On September 7, 2008, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), the two largest mortgage lenders in the United States, had to be bailed out by the U.S. government.

Derivatives are contracts that allow companies to trade risks that derive from some other underlying assets. For example, a currency futures contract lets you . . . lock into a specific foreign exchange rate. It’s a sensible move if you trade abroad and do not wish to carry the risk of a sudden change in exchange rates. Recent decades brought much trickier—and riskier—derivatives, such as “over-the-counter credit default swaps (CDS).” Sound complex? It is. Derivatives could . . . be used to circumvent regulations that protect investors and the public. Credit derivatives permit lenders to transfer their credit risks (mortgage defaults) to third parties, such as hedge funds. Thus banks can do more business. In the 1990s and 2000s, credit derivatives became a massive global gamble. If used properly, derivatives are useful and ethically unobjectionable.

 

pages: 545 words: 137,789

How Markets Fail: The Logic of Economic Calamities by John Cassidy

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Albert Einstein, Andrei Shleifer, anti-communist, asset allocation, asset-backed security, availability heuristic, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black-Scholes formula, Bretton Woods, British Empire, capital asset pricing model, centralized clearinghouse, collateralized debt obligation, Columbine, conceptual framework, Corn Laws, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Daniel Kahneman / Amos Tversky, debt deflation, diversification, Elliott wave, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, global supply chain, Haight Ashbury, hiring and firing, Hyman Minsky, income per capita, incomplete markets, index fund, invisible hand, John Nash: game theory, John von Neumann, Joseph Schumpeter, laissez-faire capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, Mikhail Gorbachev, Mont Pelerin Society, moral hazard, mortgage debt, Naomi Klein, Network effects, Nick Leeson, Northern Rock, paradox of thrift, Ponzi scheme, price discrimination, price stability, principal–agent problem, profit maximization, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, RAND corporation, random walk, Renaissance Technologies, rent control, Richard Thaler, risk tolerance, risk-adjusted returns, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, technology bubble, The Chicago School, The Great Moderation, The Market for Lemons, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, unorthodox policies, value at risk, Vanguard fund

Greenspan later acknowledged that the fall of Long-Term Capital, which prior to its troubles had been lionized in the media, was “a major failure of counterparty surveillance.” However, it didn’t prevent him, in the period after 1998, from repeating his previous arguments to head off efforts to regulate derivatives trading. Brooksley E. Born, the then-head of the Commodity Futures Trading Commission (CFTC), tried to bring credit default swaps, which offered investors protection against the possibility of a bond defaulting, under the regulatory jurisdiction of the CFTC. Such a move would have involved establishing some minimal capital requirements for Wall Street firms that bought and sold credit default swaps, and forcing them to disclose more information. “Recognizing the dangers . . . was not rocket science, but it was contrary to the conventional wisdom and certainly contrary to the economic interests of Wall Street at the moment,” Born told Stanford Magazine in early 2009.

In addition to placing their trust in rating agencies and risk models, the men who ran the big Wall Street firms took comfort from the fact that at least some of the dubious assets on their balance sheets were insured. Which brings us to the final ingredient of the subprime alphabet soup. J.P. Morgan has much to answer for—the firm, not the man. As well as unleashing VAR models on an unsuspecting public, it played a key role in developing credit insurance in the form of credit default swaps (CDSs). The word “swaps” is used in the derivatives business, and it has caused a lot of unnecessary confusion. Credit default swaps aren’t really swaps at all; they should be called credit insurance contracts. As with VAR, Morgan didn’t invent the concept of credit insurance—the late Bankers Trust also has claims to that honor—but it turned it into a major industry. In 1997, a group of math whizzes in Morgan’s derivatives department took $9.7 billion in loans that it had issued to about three hundred corporations, placed them in a special-purpose vehicle, and distributed tranches of the SPV to investors.

Once Morgan had demonstrated how to do this with bank loans, the obvious next step was to apply the same technique to different types of credit products, such as mortgage-backed securities. This didn’t prove too difficult, and between 1998 and 2004, the issuance of credit default swaps increased exponentially. The two most popular products were “single-name CDSs,” which provided their holders with protection against the default of a particular loan or bond, and “basket CDSs,” which insured a basket of loans or bonds. Since credit default swaps weren’t regulated, there was plenty of scope for creativity. An important development was the creation of CDSs that didn’t have anything to do with the issuer of the underlying debts. For example, Citigroup could agree to provide protection to Goldman Sachs on some mortgage bonds issued by Merrill Lynch: in this case, Goldman would pay premiums to Citigroup, and if the Merrill bonds got downgraded, say, Citigroup would pay Goldman an agreed sum of money.

 

pages: 206 words: 70,924

The Rise of the Quants: Marschak, Sharpe, Black, Scholes and Merton by Colin Read

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Albert Einstein, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John von Neumann, Joseph Schumpeter, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, naked short selling, price stability, principal–agent problem, quantitative trading / quantitative finance, RAND corporation, random walk, risk tolerance, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve

A commonly traded type of derivatives contract insures against default of promises to pay. For instance, we may wish to insure against the default of a portfolio of subprime mortgages with an insured value of $50,000,000. The seller of a credit default swap written for $40,000,000 on this $50,000,000 receives the equivalent of a put price as a premium and is obliged to pay the purchaser of the swap the difference, or $10,000,000, if the portfolio value falls to less than $40,000,000. The insurance role for such credit default swaps is obvious. The investor can purchase a policy that limits the downside risk. However, these credit default swaps can also be purchased by an investor who does not own the underlying portfolios. Such a purchase is a speculation on another’s misfortune, but also provides an opportunity for liquidity and more efficient valuations through a very broad insurance market, with low transaction costs and relatively simple contracting.

While we see that four scholars worked independently to develop the link between the mean return and the variance of a security and its market price, we will forever associate this new methodology of the Capital Asset Pricing Model (CAPM) with the great mind William Sharpe. 4 A Roadmap to Resolve the Big Questions 5 However, while Sharpe’s insights helped us better understand how an individual security is priced, the greatest need for the rapid pricing of securities was in the derivatives market. This new financial market, once the sleepy domain of farmers and food processors concerned about price stability for the future delivery of agricultural commodities, now represents an annual market value that rivals the combined size of the world’s economies. There is now a much greater volume of trading in these derivatives, in commodities futures and in options markets, in credit default swaps and mortgage-backed securities, in foreign exchange futures and bond futures than in the traditional market for corporate securities. Yet, before the publication of the theory from the great minds Fischer Black and Myron Scholes, we knew little about how to price such financial derivatives. Meanwhile, Robert Merton, a disciple of the great mind Paul Samuelson, was rapidly extending the relatively static models of finance to a dynamic context that more effectively included time.

In 1973, on the cusp of the publication of the Black-Scholes formula and the creation of the CBOE, no one could have reasonably imagined that derivatives markets could come to affect us all in incredibly profound ways, both positively and negatively. Derivatives markets are more esoteric than the underlying securities from which they derive their value. These are instruments that allow us the option to buy a stock at a future date, or a contract to deliver or accept a commodity at some future date. They could be the credit default swaps that are bets, according to some, or insurance hedges, according to others, that other instruments will default. In every case, the derivative can serve some useful purpose as a hedge or insurance for those who must hold or market the underlying security. However, just as we can sell short a stock we do not own and have not borrowed (a naked short), derivatives traders may not have to own the underlying security, and most likely will have little or no interest in the underlying security.

 

pages: 566 words: 155,428

After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead by Alan S. Blinder

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Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, banks create money, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, conceptual framework, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Detroit bankruptcy, diversification, double entry bookkeeping, eurozone crisis, facts on the ground, financial innovation, fixed income, friendly fire, full employment, hiring and firing, housing crisis, Hyman Minsky, illegal immigration, inflation targeting, interest rate swap, Isaac Newton, Kenneth Rogoff, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, market clearing, market fundamentalism, McMansion, moral hazard, naked short selling, new economy, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, price mechanism, quantitative easing, Ralph Waldo Emerson, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, statistical model, the payments system, time value of money, too big to fail, working-age population, yield curve, Yogi Berra

.), 224 Keynesian view, 210–12 Stimulus package, 223–36 amount requested, 225, 228 effectiveness of, 233–34 and federal budget deficit, 234–36 Republicans against, 225–28, 351 shortcomings of, 229–32 as timely/targeted/temporary, 224–26, 229, 232–34 Stock market S & P losses (2007–2008), 114, 193 S & P losses (2009), 256–57 Stock options call option, 53–54 as derivative, 53–54, 61 option premium, 52–53 potential losses from, 54 strike price, 52–53 as synthetic leverage, 53–54 Stock value, determinants of, 29 Stress tests on American banks, 257–60 on European banks, 420 Strike price, 52–53 Structured investment vehicles (SIVs), 50–52 features of, 50–52 leverage ratio of, 50–51 in shadow banking system, 60 Subprime mortgages, 68–72 borrowing balance (2005), 58 collapse of market, 88–90 and credit default swaps (CDS), 68 default as design of, 57, 70–71, 84 and Fannie Mae/Freddie Mac, 71–72, 116–17 and financial crisis, 71–72 liar loans, 69, 70 as low-doc/no-doc loans, 69, 70 negative amortization loans, 71 NINJA loans, 70 nonbank lenders, 59 originations (1994–2005), 70 rationale for product, 69–70 regulatory failure related to, 58–59 securitization of, 72–79 unregulated lenders of, 59 warnings about, 58 Sullivan, Martin, 133–34 Summers, Lawrence on AIG bailout, 138 derivatives regulation failure, 63 on effective stimulus, 224–25 as Obama national economic adviser, 214–16, 259 Suskind, Ron, 215 Suspensions of specie payments, 90 Swagel, Phillip, 178–79, 197–98, 202, 328 Synthetic leverage credit default swaps (CDS) as, 66–67 and derivatives, 53–55, 62, 281 stock options example, 53–54 Systemically important financial institutions (SIFIs), regulatory needs for, 269–70, 294–95, 298, 302 Systemic risk Dodd-Frank provisions, 307 regulatory needs for, 270–71, 293 Systemic risk exception, by FDIC, 162–63 TARP (Troubled Assets Relief Program), 126, 159, 177–209 and AIG bailout, 137 amount requested, 184–85, 228 bait and switch tactics, 193, 197, 200, 205, 208 Bernanke/Paulson conflicts, 180–81 Break-the-Glass Memo, 178–80, 184 and capital injections, 179–81, 192, 193, 195–99 Capital Purchase Program (CPP) flaws, 202–3 Citigroup bailout, 163 congressional leaders briefing about, 181–84 effectiveness of, 178, 203, 207–9 evaluation of, 191, 207–9 executive pay issue, 183, 188–91, 202 final disbursements, types/amount of, 205 and foreclosure mitigation, 179, 332–33 initial draft, flaws of, 185–87, 195, 207 investment banks, funds forced on, 200–203, 208 oversight of, 192 passage of, 161, 192–93, 200 political issues, 181, 187–88, 190–91, 193 profitability, 203, 206, 209 purposes/necessity of, 179–80 redesign by Congress, 187–93 stigma avoidance, 189–91, 202 troubled asset purchase, 181, 192, 194–95, 205 troubled asset purchase canceled, 179, 208 Tax cuts by Bush (G.W.), 97–98, 224, 360, 389, 391 by Obama, 360 Tax reform, and deficit reduction, 405–6, 430 Taylor, John, 349, 351 Taylor Bean & Whitaker, 354–56 Taylor rule, 352 Tea Party, 7, 339, 344, 349, 362, 397 Tech bubble, 39 TED spread, 114 Temporary Liquidity Guarantee Program (TLGP), 161–62, 208, 242–43 Term Asset-Backed Securities Loan Facilities (TALF), 206–7, 223 Term Auction Facility (TAF), 96 Term Securities Lending Facility (TSLF), 98–99 Thain, John, 150, 152–53.

Never Again: Legacies of the Crisis Notes Sources Index LIST OF ACRONYMS AND ABBREVIATIONS ABCP: asset-backed commercial paper ABS: asset-backed securities AIG: American International Group AIG FP: AIG Financial Products AMLF: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility ANPR: Advance Notice of Proposed Rulemaking ARM: adjustable-rate mortgage ARRA: American Reinvestment and Recovery Act (2009) BofA: Bank of America CBO: Congressional Budget Office CDO: collateralized debt obligation CDS: credit default swaps CEA: Council of Economic Advisers CEO: Chief Executive Officer CFMA: Commodity Futures Modernization Act (2000) CFPA: Consumer Financial Protection Agency CFPB: Consumer Financial Protection Bureau CFTC: Commodity Futures Trading Commission CME: Chicago Mercantile Exchange CP: commercial paper CPFF: Commercial Paper Funding Facility CPI: Consumer Price Index CPP: Capital Purchase Program DTI: debt (service)-to-income ratio ECB: European Central Bank EMH: efficient markets hypothesis ESF: Exchange Stabilization Fund FCIC: Financial Crisis Inquiry Commission FDIC: Federal Deposit Insurance Corporation FHA: Federal Housing Administration FHFA: Federal Housing Finance Agency FICO: Fair Isaac Company FOMC: Federal Open Market Committee FSA: Financial Services Authority (UK) FSLIC: Federal Savings and Loan Insurance Corporation FSOC: Financial Stability Oversight Council G7: Group of Seven (nations) GAAP: generally accepted accounting principles GAO: Government Accountability Office GDP: gross domestic product GLB: Gramm-Leach-Bliley Act (1999) GSE: government-sponsored enterprise H4H: Hope for Homeowners HAFA: Home Affordable Foreclosure Alternatives Program HAMP: Home Affordable Modification Program HARP: Home Affordable Refinancing Program HAUP: Home Affordable Unemployment Program HHF: Hardest Hit Fund HOLC: Home Owners’ Loan Corporation HUD: Department of Housing and Urban Development IMF: International Monetary Fund ISDA: International Swaps and Derivatives Association LIBOR: London Interbank Offer Rate LTCM: Long-Term Capital Management LTRO: Longer-Term Refinancing Operations LTV: loan-to-value (ratio) MBS: mortgage-backed securities MOM: my own money NBER: National Bureau of Economic Research NEC: National Economic Council NINJA (loans): no income, no jobs, and no assets NJTC: new jobs tax credit OCC: Office of the Comptroller of the Currency OFHEO: Office of Federal Housing Enterprise Oversight OMB: Office of Management and Budget OMT: Outright Monetary Transactions OPM: other people’s money OTC: over the counter OTS: Office of Thrift Supervision PDCF: Primary Dealer Credit Facility PIIGS: Portugal, Ireland, Italy, Greece, and Spain QE: quantitative easing Repo: repurchase agreement S&L: savings and loan association S&P: Standard and Poor’s SEC: Securities and Exchange Commission Section 13(3): of Federal Reserve Act SIFI: systemically important financial institution SIV: structured investment vehicle SPV: special purpose vehicle TAF: Term Auction Facility TALF: Term Asset-Backed Securities Loan Facility TARP: Troubled Assets Relief Program TBTF: too big to fail TED (spread): spread between LIBOR and Treasuries TIPS: Treasury Inflation-Protected Securities TLGP: Temporary Liquidity Guarantee Program TSLF: Term Securities Lending Facility UMP: unconventional monetary policy WaMu: Washington Mutual PREFACE When the music stops . . . things will be complicated.

There is no agreed-upon definition of the shadow banking system, but the institutions involved on the eve of the crisis included nonbank loan originators; the two government-sponsored housing agencies, Fannie Mae and Freddie Mac; other so-called private-label securitizers; the giant investment banks (who were often securitizers, too); the aforementioned SIVs; a variety of finance companies (some of which specialized in housing finance); hedge funds, private equity funds, and other asset managers; and thousands of mutual, pension, and other sorts of investment funds. The markets involved included those for mortgage-backed securities (MBS), other asset-backed securities (ABS), commercial paper (CP), repurchase agreements (“repos”), and a bewildering variety of derivatives, including the notorious collateralized debt obligations (CDOs) and the ill-fated credit default swaps (CDS). (Sorry about the alphabet soup—explanations to come.) By most estimates, the shadow banking system was far larger than the conventional banking system. Imagine leaving all that financial activity almost totally unregulated—like a bunch of wild animals running around without zookeepers. Well, actually, you don’t have to imagine it. We did it. In the case of derivatives, a little history is instructive.

 

pages: 422 words: 113,830

Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism by Kevin Phillips

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algorithmic trading, asset-backed security, bank run, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, collateralized debt obligation, computer age, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency peg, diversification, Doha Development Round, energy security, financial deregulation, financial innovation, fixed income, Francis Fukuyama: the end of history, George Gilder, housing crisis, Hyman Minsky, imperial preference, income inequality, index arbitrage, index fund, interest rate derivative, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, large denomination, Long Term Capital Management, market bubble, Martin Wolf, Menlo Park, mobile money, Monroe Doctrine, moral hazard, mortgage debt, new economy, oil shale / tar sands, oil shock, peak oil, Plutocrats, plutocrats, Ponzi scheme, profit maximization, Renaissance Technologies, reserve currency, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, sovereign wealth fund, The Chicago School, Thomas Malthus, too big to fail, trade route

Using 2007 data, the Bank for International Settlements first broke out the notional values: a total of $596 trillion split between interest rate derivatives ($393 trillion), credit default swaps ($58 trillion), and currency derivatives ($56 trillion) with the remainder put into an unallocated category. Then, to assess real-world vulnerability, the BIS set what they called net risk at $14.5 trillion, and put a plausible gross credit exposure at $3.256 trillion.14 Abstract as these trillion-dollar references may seem to laypeople, global fears of a second wave of exotic financial implosions took shape during 2008. In 2007, mortgage-backed securities and mortgage-linked packages of collateralized debt obligations (CDOs), contaminated by subprime mortgage ingredients, had been the top sources of heartburn. By autumn 2008, financial institutions had already written off some $700 billion of these products. In the meantime, credit default swaps (CDSs), as well as the so-called Synthetic CDOS in which credit swaps also figured, had become the new front burner of crisis management.

The outstanding notional value of credit derivatives contracts has doubled every year since the start of this decade to reach $26 [trillion] in the middle of last year [2006].”7 By October 2007, the newly merged Chicago Mercantile Exchange reported that the notional value of credit derivatives had climbed to $45.5 trillion. By year’s end, as bank and investment bank losses began to pile up, some exporters began to fear that problems might spread into the corporate credit markets, principally through credit default swaps with their purpose of allowing risk managers and speculators to bet on a company’s ability to repay debt. The New York Times half-joked that if 2007 was the year readers and reporters learned about CDOs and SIVs, 2008 might be the year of credit default swaps. Unfortunately, it is entirely relevant to note the greed factor: the amount of money the financial sector was making out of these hot new products and huge volumes, at least until mid-2007. Between 2002 and 2006, volume in these financial sector bestsellers swelled enormously, creating a cumulative total of roughly $2.3 trillion in residential mortgage-backed securities and $1.7 trillion in CDOs.

With regulation all but suspended, competition to innovate, experiment, and return to the collusions of the 1920s became intense. And before the wax attaching their wings melted Icarus-like in 2007-2008, most of the top fifteen to twenty institutions had bet their fortunes on a host of new financial vehicles and instruments—structured investment vehicles (SIVs), special purpose acquisition companies (SPACs), mortgage securitization, collateralized debt obligations (CDOs), credit default swaps (CDSs), and the like. Although bountiful in their own right, fees for mergers and acquisitions soon paled alongside the larger benefits of bull markets, assets bubbles, and the uber-profitability of exotic financial instruments. Back in the late 1980s, Goldman Sachs estimated that a major portion of that decade’s stock market upsurge had come from anticipation of takeover bids or buyouts, and other analysts would make the same point about the later M&A floodtides in 2000 and 2006 (see p. 77).

 

pages: 701 words: 199,010

The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini

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affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bernie Madoff, Black-Scholes formula, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, labour mobility, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, systematic trading, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

It eliminated the SEC and CFTC’s oversight of the OTC derivative market. It is difficult to determine the consequences of this decision. It may have been the reason AIG Financial Products became so heavily involved in credit default swap transactions. AIG sold CDS that effectively insured every mortgage pool against defaults. Unlike traditional insurance contracts, the CDS didn’t force AIG to set aside a large amount of capital against potential future losses, nor did the company have to post collateral. AIG’s CDS protection let other banks continue betting on the housing market. AIG’s position in credit default swaps rose to $500 billion. The entire market jumped from $6.4 trillion in 2004 to $58 trillion by 2007. In 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act extended collateral rights in repo transactions to include securities other than GSE debt or Treasuries, if the counterparty went bankrupt.

They need to know how risks and values should change. They need to understand when a report doesn’t make sense. A rule to add a risk officer to report directly to the board per se won’t do this. He will just tick a box and mistakes will go on as usual. —Robert Merton interview, Nobel prizewinner in economics, July 9, 2011 Large insurance companies’ use of credit-default swaps is another example of misusing derivatives. AIG and other insurers sold credit protection on mortgage pools using a derivative known as the credit-default swap (CDS). Traditional insurance is based on pooling many independent risks, but AIG was insuring the interlinked housing market. Given the probability of losses, AIG should have put many reserves aside, but it did not. With equities and other liquid securities, traders essentially vote on an asset’s proper price every time they buy or short it, and the price eventually reflects these votes.

That is, if a counterparty does not pay, then what is the real cost of reestablishing the hedge? Finally, many of the customized OTC derivatives are nonliquid contracts that were accumulated on a large scale by one large institution without hedging them. AIG engaged in this activity with credit default swaps. What They Propose The new legislation requires the creating of a centralized platform for the clearing of all swap transactions, which includes interest rate swaps, foreign-exchange swaps, credit default swaps, security-based swaps, and many other transactions. The SEC will regulate security-based swaps and mixed swaps, while the CFTC will regulate all other swaps. The CFTC and SEC must review all swap contracts in the marketplace and will determine which swaps in the marketplace should be cleared on the exchange.

 

pages: 311 words: 99,699

Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett

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accounting loophole / creative accounting, asset-backed security, bank run, banking crisis, Black-Scholes formula, Bretton Woods, business climate, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, easy for humans, difficult for computers, financial innovation, fixed income, housing crisis, interest rate derivative, interest rate swap, locking in a profit, Long Term Capital Management, McMansion, mortgage debt, North Sea oil, Northern Rock, Renaissance Technologies, risk tolerance, Robert Shiller, Robert Shiller, short selling, sovereign wealth fund, statistical model, The Great Moderation, too big to fail, value at risk, yield curve

After all, for every buyer in a market there must be a seller; a market in any commodity—be it equities, art, or synthetic CDOs—can operate only if there are parties on both sides of the trade. Feldstein and some others putting their money on the contrarian view helped to make a lively new business of trading in default swaps take off. By 2005 there were more tools available to conduct such trading, too. In the early years, bankers who wanted to trade credit default swaps generally used only contracts that related to single names. From 2004 onward, though, indices of credit default swaps sprang up, known as “CDX” in the US and “iTraxx” in Europe. They tracked the cost of insuring against default on a basket of companies, offering a handy way for investors to evaluate trends in pricing, in the same way that the S&P 500 shows how the whole equity market is moving. They could also be traded as contracts in their own right.

Correlation: The degree to which asset prices, events, or risks move in the same manner. Credit Default Swap (CDS): A contract between two parties, where the buyer pays a regular fee to the seller in exchange for a guarantee that he will be compensated in the case of any default on a stipulated piece of debt. CDS contracts are similar to insurance in some senses, but they are not regulated in the same manner, can be freely traded, and can be struck even if the buyer does not own the debt he wishes to “insure.” Credit Derivatives (CD): A bilateral contract between a buyer and seller whose value derives from the credit risk attached to an underlying bond, loan, or other financial asset. Typically, they are designed to compensate one party if that underlying asset goes into default. CDS (credit default swaps) are one form of credit derivatives, but not the only one.

Why did the bankers, regulators, and ratings agencies collaborate to build and run a system that was doomed to self-destruct? Did they fail to see the flaws, or did they fail to care? This book explores the answer to the central question of how the catastrophe happened by beginning with the tale of a small group of bankers formerly linked to J.P. Morgan, the iconic, century-old pillar of banking. In the 1990s, they developed an innovative set of products with names such as “credit default swaps” and “synthetic collateralized debt obligations” (of which more later) that fall under the rubric of credit derivatives. The Morgan team’s concepts were diffused and mutated all around the global economy and collided with separate innovations in mortgage finance. These then played a critical role in both the great credit bubble and its subsequent terrible bursting. The J.P. Morgan team were not the true inventors of credit derivatives.

 

pages: 430 words: 140,405

A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers by Lawrence G. Mcdonald, Patrick Robinson

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asset-backed security, bank run, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, diversification, fixed income, high net worth, hiring and firing, if you build it, they will come, London Interbank Offered Rate, Long Term Capital Management, margin call, moral hazard, mortgage debt, naked short selling, new economy, Ronald Reagan, short selling, sovereign wealth fund, value at risk

Anand did not, of course, know the future ramifications of the act. But he knew it mattered terribly, and he was aware that deregulation in this instance might or might not be in our best interest. As a matter of fact, he was not all that crazy about the repeal of Glass-Steagall either. Let me just recap the significance of the CFMA, which would not be passed until the end of the year. A major purpose was to deregulate the entire business of trading a credit default swap (CDS). This is nothing more than a bet—for instance, that a mortgage company will go broke and its bond value will sink to, say, 4 cents on the dollar. We’re talking about a bet that would allow a big bondholder to go to an investment bank and say, “I hold $1 billion worth of bonds in Countrywide. The coupon is 5 percent, which is 1 percent more than a similar Treasury bond. I’ll give you 90 percent of that 1 percent if you’ll insure me for the present value of the bond all the way to zero, in case the corporation goes broke and my bond becomes valueless.”

And as the years went by, Dick Fuld had tightened his circle, shutting out more and more key people from the downstairs floors where the daily action seethed, where the trading battles ebbed and flowed, where more critical information flew around than anywhere else in the city. That was the place from which he had, to all intents and purposes, removed himself. In the process, he had become separated from the most modern technology and the ultramodern trading of credit derivatives—CDO (collateralized debt obligations), RMBS (residential mortgage-backed securities), CLO (collateralized loan obligations), CDS (credit default swaps), and CMBS (commercial mortgage-backed securities). Stories about long-departed commanders were legion. There were mind-blowing tales of the Fuld temper, secondhand accounts of his rages, threats, and vengeance. It was like hearing the life story of some caged lion. Tell the truth, I ended up feeling pretty darn glad I wasn’t meeting him. There was something of the night about this guy, and it all dated back to the early part of the 1980s, when he and his chief cohort had not quite covered themselves in glory.

We, however, whose entire expertise was in the distressed-debt market, could see the signs, and Larry McCarthy was all set to throw a barrel at them, because Beazer was the one company that fitted all of our criteria. We decided to deploy 100,000 shares at $75 each and wait for the property market to cave in, which we thought it surely must. The only problem was, when? Larry McCarthy took out $500 million worth of protection in the form of a five-year credit default swap. That meant he agreed to pay a 1.8 percent* carry on the $500 million, which was $9 million annually. However, if Beazer filed for bankruptcy, Lehman would be paid the $500 million,† provided the counterparty on the other side of the trade had the ability to pay. In addition, we all bought equity options—another bet that Beazer would crash, but in this case in the form of puts, which came into play if the stock went down.

 

pages: 543 words: 147,357

Them And Us: Politics, Greed And Inequality - Why We Need A Fair Society by Will Hutton

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Andrei Shleifer, asset-backed security, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bretton Woods, capital controls, carbon footprint, Carmen Reinhart, Cass Sunstein, centre right, choice architecture, cloud computing, collective bargaining, conceptual framework, Corn Laws, corporate governance, credit crunch, Credit Default Swap, debt deflation, decarbonisation, Deng Xiaoping, discovery of DNA, discovery of the americas, discrete time, diversification, double helix, Edward Glaeser, financial deregulation, financial innovation, financial intermediation, first-past-the-post, floating exchange rates, Francis Fukuyama: the end of history, Frank Levy and Richard Murnane: The New Division of Labor, full employment, George Akerlof, Gini coefficient, global supply chain, Growth in a Time of Debt, Hyman Minsky, I think there is a world market for maybe five computers, income inequality, inflation targeting, interest rate swap, invisible hand, Isaac Newton, James Dyson, James Watt: steam engine, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, knowledge worker, labour market flexibility, Long Term Capital Management, Louis Pasteur, low-wage service sector, mandelbrot fractal, margin call, market fundamentalism, Martin Wolf, means of production, Mikhail Gorbachev, millennium bug, moral hazard, mortgage debt, new economy, Northern Rock, offshore financial centre, open economy, Plutocrats, plutocrats, price discrimination, private sector deleveraging, purchasing power parity, quantitative easing, race to the bottom, railway mania, random walk, rent-seeking, reserve currency, Richard Thaler, rising living standards, Robert Shiller, Robert Shiller, Ronald Reagan, Rory Sutherland, shareholder value, short selling, Silicon Valley, Skype, South Sea Bubble, Steve Jobs, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, the scientific method, The Wealth of Nations by Adam Smith, too big to fail, unpaid internship, value at risk, Washington Consensus, working poor, éminence grise

Over the same period, bank assets jumped from twice to five times British GDP, with bankers resisting demands for more self-insurance of deposits.14 Bankers believed that they were containing possible negative consequences through diversifying risk in bundles of disparate income-earning assets where the chance of default was not corelated in so-called ‘structured investment vehicles’; that the assets were carefully valued through new mathematical models; that the likelihood of default had been insured against via credit default swaps; and, as a bonus, that important tax savings had been secured by placing the investments off shore. In effect, they thought they had created a new alchemy – the lead of poorly rated bonds and assets was turned into the gold of ‘Triple A’ ratings.15 As just 1 per cent of corporate bonds received a Triple A rating, compared to an astonishing 60 per cent of structured investment vehicles, evidently the world’s credit-rating agencies agreed.16 However, the business model in which the agencies were paid by the investment banks issuing the securities, rather than the investors who were buying them, was profoundly flawed.

But failure was never more likely because their belief that they held less risk was delusional, a fundamental error compounded by vastly expanding their balance sheets but underwriting them with ever less capital. It turned out that financial randomness was a fairy tale. The risk of default was co-related when general economic conditions turned adverse, despite the confident assertions by bankers that there was no such correlation. Credit default swaps turned out not to be proper insurance contracts, and the mathematical models which predicted that calamitous events were outside any normal distribution of risk proved to be bunk. The entire edifice – intellectual and business – was riddled with mistakes. The IMF has estimated that the aggregate support its member states were forced to offer their financial systems was around $9 trillion in recapitalisation, guarantees and special liquidity provision.

As everybody was individually guarding against risk, luminaries like Alan Greenspan claimed that the system as a whole was not risky, even as it created a growing mountain of credit and debt. Moreover, inflation targeting would ensure that there was no consequent inflation. All of these assumptions exploded to devastating effect in 2008. If the 1980s were the decade of interest and currency swaps, the 1990s were the decade of securitisation, and the 2000s the decade of credit default swaps. The great investment banks vied with each other to find the most innovative diversification and hedging techniques. Hedging risk has always had a dual character. Insurance has had the socially useful purpose of allowing protection against the chance of loss, but also the chance to make money on what is essentially gambling. London underwriters in the eighteenth century offered insurance on the loss of a vessel and took bets on who was likely to be Louis XV’s next mistress.

 

pages: 475 words: 155,554

The Default Line: The Inside Story of People, Banks and Entire Nations on the Edge by Faisal Islam

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Asian financial crisis, asset-backed security, balance sheet recession, bank run, banking crisis, Basel III, Ben Bernanke: helicopter money, Berlin Wall, Big bang: deregulation of the City of London, British Empire, capital controls, carbon footprint, Celtic Tiger, central bank independence, centre right, collapse of Lehman Brothers, credit crunch, Credit Default Swap, crony capitalism, dark matter, deindustrialization, Deng Xiaoping, disintermediation, energy security, Eugene Fama: efficient market hypothesis, eurozone crisis, financial deregulation, financial innovation, financial repression, floating exchange rates, forensic accounting, forward guidance, full employment, ghettoisation, global rebalancing, global reserve currency, hiring and firing, inflation targeting, Irish property bubble, Just-in-time delivery, labour market flexibility, London Whale, Long Term Capital Management, margin call, market clearing, megacity, Mikhail Gorbachev, mini-job, mittelstand, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, North Sea oil, Northern Rock, offshore financial centre, open economy, paradox of thrift, pension reform, price mechanism, price stability, profit motive, quantitative easing, quantitative trading / quantitative finance, race to the bottom, regulatory arbitrage, reserve currency, reshoring, rising living standards, Ronald Reagan, savings glut, shareholder value, sovereign wealth fund, The Chicago School, the payments system, too big to fail, trade route, transaction costs, two tier labour market, unorthodox policies, uranium enrichment, urban planning, value at risk, working-age population

Specifically, Li’s formula based these correlations on trading movements for the two corporations in the growing credit default swap (CDS) market. KMV’s historic data points on corporate asset prices weren’t required. An appreciation of historic defaults was not required. And even if this measure of default risk was not deeply flawed, the data underpinning it stretched back for, at most, only a few years. Did the equations include data, patterns and correlations during periods of time when there were actually lots of defaults? For corporate debt, not really. When it was to come to mortgages, the answer was ‘not at all’. A fanatical supporter of the model might suggest that all of that information was contained within the wisdom of the crowd – the efficient market price – of the credit default swap. Obviously that was nonsense. Never mind, the fully fledged Gaussian copula helped the market for corporate Collateralised Debt Obligations (CDOs) explode.

In real terms, over the lifetime of the debt, this amounted to a cut of 74 per cent. The Greek government’s debts shrunk by €107 billion, one-third of the total. Most bondholders did agree voluntarily to this offer. It was, after all, an offer that they could not really refuse. But the Greek government also invoked special clauses that forced some otherwise unwilling debtors to take a hit. This triggered credit default swaps (see here) – bets or insurance on a country going bust. This had been a ‘red line’ that Brussels officials vowed not to cross in the first deal. By early 2012 Greece was not just officially in default – it was the world’s biggest sovereign defaulter. Greece’s national debt had been heading for a completely unsustainable 160 per cent of its GDP at the end of the decade. After PSI and default that total had come down to a still lofty target for 2020 of 120 per cent.

A clue was to be provided nine months later, not so far away – in Cyprus (see here). 2 Of Fiscal Criminals and Bond Vigilantes Dramatis personae Nick Clegg, UK Liberal Democrat leader Sir Mervyn King, governor of the Bank of England (2003–13) David Cameron, then leader of the UK Opposition James Carville, adviser to President Clinton Brian Edmonds, bond trader, Cantor Fitzgerald Anonymous hedge fund credit default swap trader George Soros, financier and philanthropist Jim Rickards, ex-Long-Term Capital Management (LTCM), lawyer, economist, trader Gordon Brown, British prime minister (2007–10) Jesse Norman, Conservative MP, member of the Treasury Select Committee Rachel Lomax, deputy governor of the Bank of England (2003–08) Dick Moore, mayor of Elkhart, Indiana, USA Robert Lucas, Nobel Prize in Economics.

 

pages: 309 words: 95,495

Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe by Greg Ip

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Affordable Care Act / Obamacare, Air France Flight 447, air freight, airport security, Asian financial crisis, asset-backed security, bank run, banking crisis, Bretton Woods, capital controls, central bank independence, cloud computing, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, Daniel Kahneman / Amos Tversky, diversified portfolio, double helix, endowment effect, Exxon Valdez, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, global supply chain, hindsight bias, Hyman Minsky, Joseph Schumpeter, Kenneth Rogoff, London Whale, Long Term Capital Management, market bubble, moral hazard, Network effects, new economy, offshore financial centre, paradox of thrift, pets.com, Ponzi scheme, quantitative easing, Ralph Nader, Richard Thaler, risk tolerance, Ronald Reagan, savings glut, technology bubble, The Great Moderation, too big to fail, transaction costs, union organizing, Unsafe at Any Speed, value at risk

Nonetheless, the crash taught an important lesson about insurance against financial catastrophes. It works when only a few people buy it; when everyone does, it not only makes the catastrophe more likely, it threatens the survival of the system. This became apparent when, twenty years later, an almost identical problem erupted over the use of another financial innovation: credit default swaps, or CDSs. J.P. Morgan hit upon the idea of the credit default swap in 1994. As Gillian Tett recounts in her book Fool’s Gold, Exxon (now Exxon Mobil) had asked for a $4.8 billion credit line to handle an expected fine for the Exxon Valdez oil spill. This was more than J.P. Morgan was comfortable committing to a single client, but it didn’t want to say no, so it asked the European Bank for Reconstruction and Development to take on the credit risk of the loan in exchange for a fee.

Nassim Nicholas Taleb, a former derivatives trader, philosopher, and author, has argued that we should strive to be “antifragile,” a word he came up with to describe people or things that “thrive and grow when exposed to volatility, randomness, disorder, and stressors.” Many financial contracts “are antifragile: they are explicitly designed to benefit from market volatility.” Options and credit default swaps, for example, go up in value when the underlying market becomes more volatile or default becomes more likely. The catch, of course, is that the gain to the holder of the option, or the credit default swap, or the insurance policy, is a loss to the seller. If enough people buy such policies, a catastrophic loss will wipe out the insurers. And the more people who buy such insurance, the fewer will actually be protected in the event of a catastrophe. Idiosyncratic, or “micro,” risks, are insurable, Taleb told me; systemic, “macro” risks are not: “As you go from micro to macro, you have the problem of having to buy insurance on the Titanic from someone on the Titanic.”

Numerous other central banks, and the International Monetary Fund, had been regularly publishing “financial stability reports” to highlight potential crisis threats. All suffered from the same problem: ignorance of the risks then propagating in the shadows of the financial system. The Fed knew that subprime mortgages and more exotic instruments such as collateralized debt obligations and credit default swaps existed, but as one study later found, rarely did any of these seem important enough to be mentioned in monetary policy makers’ regular meetings. So, by 2007, there was widespread awareness that homes were probably overvalued but little concern that this would produce a systemic crisis. Twenty-five years of experience and reform had moved most of the risks out of the banking system, provided new tools such as secured repo loans to contain risks, and slain inflation, the single biggest threat to financial stability anyone alive had ever known.

 

pages: 280 words: 73,420

Crapshoot Investing: How Tech-Savvy Traders and Clueless Regulators Turned the Stock Market Into a Casino by Jim McTague

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algorithmic trading, automated trading system, Bernie Madoff, Bernie Sanders, Bretton Woods, buttonwood tree, credit crunch, Credit Default Swap, financial innovation, Flash crash, High speed trading, housing crisis, index arbitrage, locking in a profit, Long Term Capital Management, margin call, market bubble, market fragmentation, market fundamentalism, naked short selling, pattern recognition, Ponzi scheme, quantitative trading / quantitative finance, Renaissance Technologies, Ronald Reagan, Sergey Aleynikov, short selling, Small Order Execution System, statistical arbitrage, technology bubble, transaction costs, Vanguard fund, Y2K

Goldman Sachs was a badly tarnished institution in 2009 in the aftermath of the taxpayer bailout of Wall Street, and its reputation would sink even lower in 2010 with revelations that it had bet against the success of investments it had sold to its clients. The public was steamed in March 2009 when it learned that Goldman Sachs had finagled the government into bailing out counterparties involved in credit default swap deals with troubled insurance giant AIG, which was the recipient of more than $80 billion in taxpayer funds. The public was in an anti-Wall Street mood owing to the financial cataclysm caused by its investment bankers. It felt that Goldman Sachs should take a financial hit as a consequence of its high-risk investments and viewed it as a manipulative scheming firm with too much power in Washington, DC.

The world’s financial markets reflected the uncertainty. In the United States, both the equities and futures markets spent the morning and early afternoon of May 6 in negative territory. The S&P Volatility Index (VIX) was up 31.7%, the fourth largest, single-day increase ever. Gold prices were up and Treasury yields were down, indicating a flight to quality.8 The cost of buying protection in the credit default swaps market against the possible collapse of Greek bonds became progressively more expensive. Big institutional investors were bidding up the cost of such insurance. The increase in pricing coincided with a press conference by officials of the European Central Bank at 8:30 a.m. in which they failed to mention a possible purchase of Greek bonds to prop up that nation, which news investors were hoping to hear.9 Between 9:30 a.m., when the U.S. market opened, and 2:00 p.m., the DJIA already had fallen 161 points to 10,712 or 1.5%, and the S&P had fallen 33 points to 1,145, or down 2.9%.

A renaissance man with degrees in science and law, Hu in 1993 had written a forward-looking piece for the Yale Law Review predicting that big financial institutions would make significant mistakes employing relatively new products called derivatives. This was 5 years before the blowup of Long Term Capital Management, a hedge fund that had made interest rate bets using the exotic products and 15 years before insurer AIG would blow itself up dealing in the exotic products. Part of Hu’s thinking was that credit default swaps, which decoupled loans from the actual lender, led to “empty creditor” situations, undermining what it meant to be a debt holder. The SEC had been dominated by lawyers who were more interested in writing regulations than actually riding herd on the markets. Economists had been second-class citizens—dishwashers as opposed to cooks. The new division housed virtually every economist at the SEC and placed them on equal footing with the lawyers.

 

pages: 261 words: 64,977

Pity the Billionaire: The Unexpected Resurgence of the American Right by Thomas Frank

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Affordable Care Act / Obamacare, bank run, big-box store, bonus culture, collateralized debt obligation, collective bargaining, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Deng Xiaoping, financial innovation, housing crisis, invisible hand, Naomi Klein, obamacare, payday loans, profit maximization, profit motive, road to serfdom, Ronald Reagan, shareholder value, strikebreaker, The Chicago School, The Myth of the Rational Market, Thorstein Veblen, too big to fail, union organizing, Washington Consensus, white flight, Works Progress Administration

Then there were the geniuses at the next few steps of the process, who bundled those subprime mortgages into bonds and those bonds into collateralized debt obligations—and then sold credit default swaps to insure against the possibility of their failure.2 The gospel of deregulation, meanwhile, had become such an irresistible ideological juggernaut that no amount of real-world failure could call it into question. Under the guidance of this doctrine, our leaders removed certain derivatives from regulatory oversight; they watered down requirements that banks balance their risk with safe assets; they exempted credit default swaps from regulation as insurance products; they dialed back the Federal Reserve’s regulatory powers; and they struck down a rule that required hedge-fund advisers to register with the Securities and Exchange Commission.

And although nearly everything in high finance is related to everything else, Fannie and Freddie are not the same as AIG, which is an insurance company that acted like a hedge fund, investing in mortgage-related securities and issuing credit default swaps. These were the businesses that got AIG into trouble. It is true that AIG owned a subsidiary that originated subprime mortgages—all the Wall Street playaz did—but to my knowledge no one has ever thought to blame AIG’s travails on that subsidiary. Government regulations, for their part, never required anyone to make risky mortgage loans and they certainly never forced anyone to invest in securities based on risky mortgage loans. The credit-default-swaps business was almost completely unregulated. * One of the photos of himself that Beck includes in his first book, The Real America, shows the right-wing showman directing a radio drama while striking virtually the same pose as Welles in one of the photos taken of the latter during his Mars-invasion broadcast

.* This is not to say that the Right proceeds about its work while renouncing confusion or mystification. Just the opposite: in defending “capitalism,” the leaders of the latest conservative uprising don’t really bother with the actually existing capitalism of the last few years, even though capitalism’s particulars have made for scary headlines on the front pages of every newspaper in the land. They generally do not discuss credit default swaps or the deregulatory triumphs that made them so destructive. They do not have much to say about the massive oil spill in the Gulf of Mexico—the news story that shared the front pages with conservative primary victories all through the summer of 2010—nor about “foreclosuregate,” the revelation a few months later that banks had cut all sorts of legal corners in order to hustle borrowers in default out of their houses as quickly as possible.

 

pages: 320 words: 87,853

The Black Box Society: The Secret Algorithms That Control Money and Information by Frank Pasquale

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Affordable Care Act / Obamacare, algorithmic trading, Amazon Mechanical Turk, asset-backed security, Atul Gawande, bank run, barriers to entry, Berlin Wall, Bernie Madoff, Black Swan, bonus culture, Brian Krebs, call centre, Capital in the Twenty-First Century by Thomas Piketty, Chelsea Manning, cloud computing, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, cryptocurrency, Debian, don't be evil, Edward Snowden, en.wikipedia.org, Fall of the Berlin Wall, Filter Bubble, financial innovation, Flash crash, full employment, Goldman Sachs: Vampire Squid, Google Earth, Hernando de Soto, High speed trading, hiring and firing, housing crisis, informal economy, information retrieval, interest rate swap, Internet of things, invisible hand, Jaron Lanier, Jeff Bezos, job automation, Julian Assange, Kevin Kelly, knowledge worker, Kodak vs Instagram, kremlinology, late fees, London Interbank Offered Rate, London Whale, Mark Zuckerberg, mobile money, moral hazard, new economy, Nicholas Carr, offshore financial centre, PageRank, pattern recognition, precariat, profit maximization, profit motive, quantitative easing, race to the bottom, recommendation engine, regulatory arbitrage, risk-adjusted returns, search engine result page, shareholder value, Silicon Valley, Snapchat, Spread Networks laid a new fibre optics cable between New York and Chicago, statistical arbitrage, statistical model, Steven Levy, the scientific method, too big to fail, transaction costs, two-sided market, universal basic income, Upton Sinclair, value at risk, WikiLeaks

That’s the Holy Grail of today’s Wall Street: guaranteed returns.60 The problem is that as this experiment got under way, a key insurer started doing the same thing— assuming it had a “sure thing” going. Recall that, in the 1990s, it was big news for AIG to lose less than a tenth of a billion dollars on swaps. By 2008, AIG had amassed a credit default swap portfolio of tens of billions of dollars and was happily collecting premiums from fi rms who wanted to insure their shaky securities.61 It had nowhere near that amount of money at hand.62 Those who had bought insurance from AIG confidently registered on their own balance sheets a guarantee that any lost revenue would be made up by AIG’s credit default swaps.63 The fantasy here was that a private entity like AIG could take on the essentially public function of an agency like the FDIC: to make the insured whole even after catastrophic failures of their counterparties.

Sometimes the buyer may be desperate, and sometimes the seller might be. In the aggregate, this “noise” should cancel out as a clear price signal emerges. The inventors of credit default swaps hoped that their derivative could achieve in debt markets what stock exchanges were (theoretically) realizing in equity markets.109 The ultimate goal was to set exact prices on a wide array of financial risks. The financial engineers saw this as a great triumph of human ingenuity, a technology of risk commodification that would vastly expand societal capabilities to plan and invest. In the giddy days of the real estate bubble, investors who bought both a CDO and a credit default swap likely felt like Midas, guaranteed gains no matter how the future turned out. As we now know, the price discovery function failed miserably. Complexity, malfeasance, and sometimes outright fraud made a FINANCE’S ALGORITHMS 127 mockery of the fi nely engineered fi nancial future promised by quants.

You would think that after repeated crises, from the S&L crimes of the late 1980s to the accounting scandals of the early 2000s, the finance sector would have cleaned house by 2008. But rather than improving internal processes at companies they could not fully understand (let alone control), financiers started insuring against bad outcomes. “Financial engineers” crafted “swaps” of risk,55 encouraging quants (and regulators) to try to estimate it in ever more precise ways.56 A credit default swap (CDS), for instance, transfers the risk of nonpayment to a third party, which promises to pay you (the first party) in case the debtor (the second party) does not.57 This innovation was celebrated as a landmark of “price discovery,” a day-by-day (or even second-by-second) tracking of exactly how likely an entity was to default.58 114 THE BLACK BOX SOCIETY As with credit scores, the risk modeling here was deeply fallible, another misapplication of natural science methods to an essentially social science of finance.

 

pages: 435 words: 127,403

Panderer to Power by Frederick Sheehan

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Asian financial crisis, asset-backed security, bank run, banking crisis, Bretton Woods, British Empire, call centre, central bank independence, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, deindustrialization, diversification, financial deregulation, financial innovation, full employment, inflation targeting, interest rate swap, inventory management, Isaac Newton, Long Term Capital Management, margin call, market bubble, McMansion, Menlo Park, mortgage debt, new economy, Northern Rock, oil shock, place-making, Ponzi scheme, price stability, reserve currency, rising living standards, rolodex, Ronald Reagan, Sand Hill Road, savings glut, shareholder value, Silicon Valley, Silicon Valley startup, South Sea Bubble, supply-chain management, supply-chain management software, The Great Moderation, too big to fail, transaction costs, trickle-down economics, VA Linux, Y2K, Yom Kippur War

It included 7,212 first-and second-lien mortgages when it was issued.23 Some of these CDOs owned pieces of millions of mortgages, sometimes owning the same mortgage three or four times, since one layer of a CDO might be owned by another layer and so on. One other growing class of derivatives deserves mention, especially since Alan Greenspan sang its praises into 2008: credit default swaps (CDS). These were originally designed to hedge against losses should a company enter bankruptcy. The purchaser pays a premium for bankruptcy protection. Credit default swaps would appeal to General Motors bondholders who wanted to hedge—hold an “insurance” policy— against General Motors declaring bankruptcy. The original intention expanded. Credit default swaps were written for other derivatives, such as CDOs. The complications of credit default swaps written on CDOs that combined several CDOs (CDOs squared) were recreational mathematics played with other people’s money. 21 Gillian Tett, “The Unease Bubbling in Today’s Brave New Financial World,” Financial Times (London edition), January 19, 2007, p. 36.

He told the Bond Market Association that “credit default swaps are becoming the most important instrument I’ve seen in decades. … For 1 Margaret Mitchell, Gone with the Wind (New York: Scribner, 1936), pp. 241–242. 2 Roddy Boyd and Niles Lathem, “Want Alan Greenspan to Come to Dinner? That’ll Be $250,000 …” New York Post, February 9, 2006. 315 decades we used to have monetary crises because banks” could “freeze up.” Credit default swaps “lay off all these loans.”3 Greenspan could not have been more wrong if he tried, but he was speaking to the bond industry, so his listeners enjoyed the quotable endorsement. The failure of Lehman Brothers in 2008 would show the degree to which financial institutions froze up from exposure to credit default swaps. The Bond Market Association announced that it was creating the annual “Alan Greenspan Award for Market Leadership.”4 In October, speaking in Canada, Greenspan claimed that the housing boom was due to global integration, but the system “ran out of steam because no one could afford houses anymore.”5 Two weeks later, Greenspan claimed: “Most of the negatives in housing are probably behind us.

., 247, 278, 308, 339 BusinessWeek, 52–53, 54, 55, 60, 81, 209–210, 233 Butz, Earl, 56 C California real estate, 63, 86–87, 88–91, 165, 273, 274, 279, 289, 292, 293, 295, 331 Campbell, Kirsten, 233 Capital, 364 Capitalism, 362–364 Carlyle Group, 323 Carry trade, 125–126, 128, 162 in 2006, 313 in late 1990s, 166 Carter, Jimmy, 62–63, 67, 77 Casey, William, 69 CDOs (collateralized debt obligations), 313–314 CDS (credit default swaps), 314–316 CEA (see Council of Economic Advisers) Central banks, 126 1998 rate cuts by, 195 and bubbles, 203, 204 currencies degraded by, 305–306 and price stability, 287, 298 (See also specific banks) Centrust Savings Bank (Miami, Florida), 89 CEOs (see Chief executive officers) Chambers, John, 235 Chase Manhattan Bank, 112 Chemical Bank, 35 Chicago, Ill, 45, 295 Cheney, Richard “Dick,” 54, 300 Chief executive officers (CEOs), 128, 235, 318 Chinese central bank, 308–310 Chrysler, 62, 246 Churning, in mortgage markets, 262 Cisco Systems, 177, 207, 216, 235, 237, 238, 243, 248 Citicorp (Citigroup), 78, 79, 114–115, 275, 276, 347n.48, 354 Clark, Jim, 141 Clinton, Bill, 136–138, 142, 143, 216–217, 323, 339 Clinton, Hillary, 339 CMBS (commercial mortgagebacked security) market, 273–274 CMOs (collateralized mortgage obligations), 130 CNBC, ix, 55n.33, 64, 104, 119, 193, 198, 212–213, 297, 322, 342 Cohen, Abby Joseph, 174–175, 208, 232, 248–249 Cohen, Steve, 324 Collateral, LTCM failure and, 185 Collateralized debt obligations (CDOs), 313–314 Collateralized mortgage obligations (CMOs), 130 The Collective, 14–15 Columbia Savings and Loan (Beverly Hills, California), 89, 90, 93 Columbia University, 12, 27, 28, 333 Commercial banks: bailouts of, 72, 78–79 derivative contracts held by, 312 in early 1990s, 125 mortgages held by, 312 Commercial mortgagebacked security (CMBS) market, 273–274 Commercial paper 90, 117, 306 Community Reinvestment Act (1995), 273, 277 Computer industry: in 1997–1998, 197–198 in 1999, 207 profit losses in, 218 Computer prices, adjustment of, 153, 230 Conference Board, 13 Conglomerates, 33–36, 349 Consumer debt, 251–258 in early 2000s, 271 in mid–1990s, 134 renewing economic growth through, 311 (See also Mortgages) Consumer Price Index (CPI): in 1960s, 39 calculation of, 147–152 changes to, 50 and inflation of asset prices, 170–171 Consumer spending, economic growth and, 291, 292, 311 Consumerism, 22, 51, 52, 63 Continental Illinois National Bank and Trust, 78–79, 306 Cooper, Sherry, 344 Coraine, Richard, 355 Corporate bonds, yields on, 72 Corporate (business) debt, 99, 134 Corporate executives, priorities of, 209–210 Corporate growth, 77 Corporate profits: as measure of productivity, 197 and price of stocks, 175, 177–178, 194, 216 Council of Economic Advisers (CEA): under Carter, 61 under Ford, 5, 47, 50, 52–57, 97 under Kennedy, 26 Counterparty risk, 182 Countrywide Bank, 334 Countrywide Credit, 165, 279 Countrywide Financial, 271, 273, 277, 347n.48 CPI (see Consumer Price Index) Cramer, Jim, 208 Cranston, Alan, 85 Credit: in 1960s, 34, 37 in 1970s, 48 in 1980s, 77 in 1990s, 166 in 1999, 209 in 2001, 245 from 2005–2007, 312 consumer, 252–257 expanded access to, 296 and Great Depression, 352 and house prices, 290 inflation in, 173 from investment banks, 125 as liquidity, 363 at mid-century, 21, 22 and recession of early 1990s, 124 and rise in corporate/consumer debt, 134 worldwide bubble in, 302, 319 Credit default swaps (CDS), 314–316 Credit-rating agencies, 270, 271, 314 Crime, inflation of 1970s and, 44–45 Crime, appraisal fraud, 280 Crocker, Donald, 86, 87 D Dallas Federal Reserve Bank, 288 The Darwin Awards, 236 Daily Telegraph (London), 341, 344 Davis Polk & Wardwell, 116 Day trading, 169, 211 D.E. Shaw & Company, 323 DeConcini, Dennis, 85 Deflation, 287–288, 359 de la Renta, Françoise, 75 de la Renta, Oscar, 75 Dell Computer Corporation, 130, 207, 216 Depression, deflation and, 285–286 Deregulation of banking, 99–100, 102 Derivatives, 111, 190 in 2007, 303 Congressional hearings on, 131 credit default swaps, 314 and fed funds rate, 130 Greenspan’s understanding of, 189–190, 343 held by commercial banks, 312 in late 1990s, 164–165 and LTCM failure, 183 mortgage securities, 273 and recession of early 1990s, 124–125 risk of, 131 synthetic CDOs, 313 Deutsche Bank, 300, 345 Dillon, Douglas, 26, 77 Dingell, John, 115 Discount rate, 1987 stock market crash and, 112–113 DJIA (see Dow Jones Industrial Average) Dollar(s): in 1980s, 72 and Asian financial crisis, 172–173 and gold standard, 22, 38, 41 and positive inflation, 288 recycled into Treasury securities, 309 shorting, 316–317 value of, 1–2, 5 as world’s reserve currency, 49 Dow 36,000 (James K.

 

pages: 504 words: 139,137

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

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algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, mortgage debt, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond

While the equity hedge partially protects against the risk of default, this hedge often does not fully cover the loss on the convertible bond in case of default. Each bond’s default risk can be hedged by buying credit default swap (CDS) protection (if CDSs are traded for that firm) or by selling straight corporate bonds. However, buying protection on all convertible bonds in a portfolio is expensive and associated with large transaction costs. Alternatively, a convertible arbitrage trader can make sure that her portfolio is well diversified, largely diversifying away idiosyncratic credit risk. Changes in marketwide credit risk can then be hedged with a credit default swap index such as CDX or iTraxx. Convertible bonds also face risks in connection with takeovers and other corporate events. Such event risk is difficult to hedge, but it can be diversified away to some extent.

See also event-driven investment corporate hedging activity, in line with trends, 212 correlations across assets: liquidity spirals and, 82; in portfolio construction, 55, 57; portfolio volatility and, 58 costs of implementing a strategy, 63–64. See also funding costs; transaction costs coupons: bond prices and, 242; bond returns and, 180, 243; of convertible bonds, 269, 270, 271, 277, 283, 287, 288; inflation and, 179; reinvestment of, 179n crash risk, 31–32; implied volatility and, 239; liquidity spiral and, 82; volatility and, 58 credit carry trades, 188 credit cycles, 7t, 16 credit default swap index, 283 credit default swaps (CDSs), 241; capital structure arbitrage with, 312; credit return and, 180; fixed income arbitrage involving, 13, 260–61; to hedge convertible bond default risk, 283; in overheated economy, 191 credit returns, 180–81 credit risk, 260; of convertible bonds, 283; of credit carry strategy, 188; in event-driven investment, 292; Scholes on, 264 credit risk premium, 168, 260 credit spread, 180–81, 260; of distressed firms, 311; in overheated economy, 191 crises.

The biggest risk in convergence trades is that the trader is forced to unwind the trade when the price gap widens and the trade loses money. The economist (and trader!) John Maynard Keynes expressed this risk well: The markets can remain irrational longer than you can remain solvent. Typical examples of fixed-income arbitrage trades include on-the-run versus off-the-run Treasury bonds, yield curve trading, betting on swap spreads, mortgage trades, futures-bond basis trades, and trades on the basis between bonds and credit default swaps (CDS). Another classic arbitrage trade is convertible bond arbitrage. Convertible bonds are corporate bonds that can be converted into stock at a prespecified conversion ratio. A convertible bond can be viewed as a package of a straight corporate bond and a call option on the company’s stock. Using option pricing techniques, the convertible bond value can be computed as a function of the company’s stock price and volatility.

 

pages: 459 words: 103,153

Adapt: Why Success Always Starts With Failure by Tim Harford

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Andrew Wiles, banking crisis, Basel III, Berlin Wall, Bernie Madoff, Black Swan, car-free, carbon footprint, Cass Sunstein, charter city, Clayton Christensen, clean water, cloud computing, cognitive dissonance, complexity theory, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, crowdsourcing, cuban missile crisis, Daniel Kahneman / Amos Tversky, Dava Sobel, Deep Water Horizon, Deng Xiaoping, double entry bookkeeping, Edmond Halley, en.wikipedia.org, Erik Brynjolfsson, experimental subject, Fall of the Berlin Wall, Fermat's Last Theorem, Firefox, food miles, Gerolamo Cardano, global supply chain, Isaac Newton, Jane Jacobs, Jarndyce and Jarndyce, Jarndyce and Jarndyce, John Harrison: Longitude, knowledge worker, loose coupling, Martin Wolf, Menlo Park, Mikhail Gorbachev, mutually assured destruction, Netflix Prize, New Urbanism, Nick Leeson, PageRank, Piper Alpha, profit motive, Richard Florida, Richard Thaler, rolodex, Shenzhen was a fishing village, Silicon Valley, Silicon Valley startup, South China Sea, special economic zone, spectrum auction, Steve Jobs, supply-chain management, the market place, The Wisdom of Crowds, too big to fail, trade route, Tyler Cowen: Great Stagnation, web application, X Prize

The filter had been installed at the last moment for safety reasons, at the express request of the Nuclear Regulatory Commission. The problem in all of these cases is that the safety system introduced what an engineer would call a new ‘failure mode’ – a new way for things to go wrong. And that was precisely the problem in the financial crisis: not that it had no safety systems, but that the safety systems it did have made the problems worse. Consider the credit default swap, or CDS – a three-letter acronym with a starring role in the crisis. Credit default swaps are a kind of insurance against a loan not being repaid. The first CDS was agreed between JP Morgan and a government-sponsored development bank, the European Bank for Reconstruction and Development, in 1994. JP Morgan paid fees to the EBRD, and in exchange the EBRD agreed to make good any losses in the almost unimaginable event that the oil giant Exxon defaulted on a possible $4.8 billion loan.

As with safety belts and dangerous drivers, innocent bystanders were among the casualties. The subtler way in which credit default swaps helped cause the crisis was by introducing new and unexpected ways for things to go wrong – just as with Galileo’s columns or the zirconium filter at the Fermi reactor. The CDS contracts increased both the complexity and the tight coupling of the financial system. Institutions that hadn’t previously been connected turned out to be bound together, and new chains of cause and effect emerged that nobody had anticipated. The bond insurance business is a case in point.* As the banks cranked out complex new mortgage-related bonds, they turned to insurance companies called ‘monolines’, and huge general insurers such as AIG, to provide insurance using credit default swaps. This seemed to make sense for both sides: for the insurers, it was profitable and seemed extremely safe, while investors enjoyed the security of being backed by rock-solid insurance companies.

The insurance company itself would get into trouble because it had insured subprime mortgage products, and the bank’s portfolio would have its credit rating downgraded not because the quality of the portfolio changed, but because its insurer was in trouble. The bank would be legally obliged to sell its assets at the same time as other banks were doing the same. It was like a mountaineer, cautiously scaling a cliff while roped to a reckless team, and suddenly finding himself pulled into the abyss by his own safety harness. The insurance companies and their web of credit default swaps acted as the rope. Rather than reducing risk, credit default swaps instead contrived to magnify it and make it pop up in an unexpected place. The same thing was true of other financial safety systems – for instance the infamous collateralised debt obligations, or CDOs, which repackaged financial flows from risky ‘subprime’ mortgages. The aim was to parcel out the risk into well-understood slices, some extremely risky and some extremely safe.

 

pages: 368 words: 32,950

How the City Really Works: The Definitive Guide to Money and Investing in London's Square Mile by Alexander Davidson

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accounting loophole / creative accounting, algorithmic trading, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, Big bang: deregulation of the City of London, capital asset pricing model, central bank independence, corporate governance, Credit Default Swap, dematerialisation, discounted cash flows, diversified portfolio, double entry bookkeeping, Edward Lloyd's coffeehouse, Elliott wave, Exxon Valdez, forensic accounting, global reserve currency, high net worth, index fund, inflation targeting, interest rate derivative, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, Nick Leeson, North Sea oil, Northern Rock, pension reform, Piper Alpha, price stability, purchasing power parity, Real Time Gross Settlement, reserve currency, shareholder value, short selling, The Wealth of Nations by Adam Smith, transaction costs, value at risk, yield curve, zero-coupon bond

They will pay quarterly premiums to the bank selling protection. If there is a default, the buyer will give his or her bonds to the seller of protection and will receive their full value. A credit default swap index is a standardised credit security and so may be more liquid than credit default swaps, which are traded over the counter. It can be cheaper to use an index for hedging bonds than it would be to use a variety of CDSs for the purpose. Unfortunately, like any free-ranging financial instrument, the CDS is not always a reliable hedge. In the two Bear Stearns hedge funds that came close to collapse in mid-2007, as discussed earlier, credit default swaps, mainly through an index, were used as a hedge, and should have provided some protection against a decline in the value of bonds held, but in March of that year, both the bonds and hedges deteriorated at the same time, according to a Bear Stearns note to investors.

The global market size of credit derivatives has grown from US $180 billion in 1996 to US $5 trillion in 2004 and an estimated US $20.2 trillion in 2006, and will reach an estimated US $33 trillion by 2008, according to the British Bankers’ Association’s (BBA) Credit Derivatives Report 2006. The London market share had dipped from 45 per cent to below 40 per cent over the period. But this level of market share shows that London remains attractive as a key centre for trading in credit derivatives, according to the BBA. Credit default swap The single-name credit default swap (CDS) was the first credit derivative. It is a bilateral over-the-counter contract in which the seller agrees to make a payment to the buyer in the event of a specified credit event on a reference entity, in exchange for a fixed payment or series of fixed payments. Credit events will be specified in the contract and may include restructuring, default or bankruptcy. The basket CDS is a group of CDS contracts where the reference entity is more than one name and the credit event will be a default of some combination of the credits in the basket.

The swaps market has developed from nothing in 1982 to a level that dwarfs the bonds and equities markets together. The notional global amount outstanding of interest rate swaps and options and cross-currency swaps grew by 18 per cent to US $250.8 trillion during the first six months of 2006, according to a 2006 mid-year market survey by the International Swaps and Derivatives Association. The notional amount of credit default swaps grew by 52 per cent to US $26.0 trillion. On-exchange versus OTC derivatives An exchange-traded contract has the advantage of being standardised, which makes it much cheaper and means that you can move a large deal quickly, with very little price impact. There is no counterparty risk when you are dealing with the exchange. An OTC contract, unlike its exchange-traded counterpart, is negotiated between both parties to the contract.

 

pages: 180 words: 61,340

Boomerang: Travels in the New Third World by Michael Lewis

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Berlin Wall, Bernie Madoff, Carmen Reinhart, Celtic Tiger, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, fiat currency, full employment, German hyperinflation, Irish property bubble, Kenneth Rogoff, offshore financial centre, pension reform, Ponzi scheme, Ronald Reagan, Ronald Reagan: Tear down this wall, South Sea Bubble, tulip mania, women in the workforce

I’d become interested in a tiny handful of investors who had made their fortunes from the collapse of the subprime mortgage market. Back in 2004, the biggest Wall Street investment banks had created the instrument of their own destruction, the credit default swap on the subprime mortgage bond. The credit default swap enabled investors to bet against the price of any given bond—to “short” it. It was an insurance policy, but with a twist: the buyer didn’t need to own the insured asset. No insurance company can legally sell you fire protection on another person’s house, but the financial markets can and will sell you default insurance on another person’s investments. Hundreds of investors had dabbled in the credit default swap market—a lot of people had thought, at least in passing, that the debt-fueled U.S. housing boom was unsustainable—but only fifteen or so had gone all in, and placed enormous bets that vast tracts of American finance would go up in flames.

“Let’s say it takes five years and not two,” he said. “Let’s say it takes seven years. Should I wait until I see the whites of their eyes before I position myself, or should I position myself now? The answer is now. Because the moment people think it [national default] is a possibility, it’s expensive. If you wait, you have to pay up for the risk.” When we met, he had just bought his first credit default swaps on the countries he and his team of analysts viewed as the most likely to be unable to pay off their debts: Greece, Ireland, Italy, Switzerland, Portugal, and Spain. He made these bets directly with the few big Wall Street firms that he felt were least likely to be allowed to fail—Goldman Sachs, J.P. Morgan, and Morgan Stanley—but, doubting their capacity to withstand a more serious crisis, he demanded that they post collateral on the trades every day.

I wrote the book about the U.S. subprime mortgage crisis and the people who had made a fortune from it, but began to travel to these other places, just to see what was up. But I traveled with a nagging question: how did a hedge fund manager in Dallas even think to imagine these strange events? Two and a half years later, in the summer of 2011, I returned to Dallas to ask Kyle Bass that question. Greek credit default swaps were up from 11 basis points to 2300; Greece was just about to default on its national debt. Ireland and Portugal had required massive bailouts; and Spain and Italy had gone from being viewed as essentially riskless to nations on the brink of financial collapse. On top of it all, the Japanese Ministry of Finance was about to send a delegation to the United States to tour the big bond investment funds such as Pimco and BlackRock—to see if they could find someone, anyone, willing to buy half a trillion dollars’ worth of ten-year Japanese government bonds.

 

pages: 351 words: 102,379

Too big to fail: the inside story of how Wall Street and Washington fought to save the financial system from crisis--and themselves by Andrew Ross Sorkin

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affirmative action, Asian financial crisis, Berlin Wall, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Fall of the Berlin Wall, fear of failure, fixed income, Goldman Sachs: Vampire Squid, housing crisis, indoor plumbing, invisible hand, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, Mikhail Gorbachev, moral hazard, NetJets, Northern Rock, oil shock, paper trading, risk tolerance, rolodex, Ronald Reagan, savings glut, shareholder value, short selling, sovereign wealth fund, supply-chain management, too big to fail, value at risk, éminence grise

Ultimately, Cassano passed on buying BISTROs from JP Morgan, but he was intrigued enough that he ordered his own quants to dissect it. Building computer models based on years of historical data on corporate bonds, they concluded that this new device—a credit default swap—seemed foolproof. The odds of a wave of defaults occurring simultaneously were remote, short of another Great Depression. So, absent a catastrophe of that magnitude, the holders of the swap could expect to receive millions of dollars in premiums a year. It was like free money. Cassano, who became head of the unit in 2001, pushed AIG into the business of writing credit default swaps. By early 2005, it was such a big player in the area that even Cassano had begun to wonder how it had happened so quickly. “How could we possibly be doing so many deals?” he asked his top marketing executive, Alan Frost, during a conference call with the unit’s office in Wilton, Connecticut.

Under European banking regulations, financial institutions had been allowed to meet capital requirements by entering into credit default swap agreements with AIG’s financial products unit. Using the swaps, the banks had essentially wrapped AIG’s triple-A credit rating around riskier assets, such as corporate loans and residential mortgages, allowing the banks to take on more leverage. If AIG were to fail, however, those protective wrappers would vanish, forcing the banks to mark down assets and raise billions of dollars—a frightening prospect in the current markets. And the numbers were staggering: Halfway though 2008, AIG had reported more than $300 billion in credit default swaps involved in this wrapping procedure, which it politely called “regulatory capital relief.” Then, of course, there was the matter of AIG’s vast insurance empire, which included about 81 million life insurance policies around the world with a face value of $1.9 trillion.

A professorial sixty-five-year-old, he was one of Fuld’s few other confidants in the firm besides Gregory. On this morning, however, he was fanning the flames, telling Fuld the latest rumor swirling around the trading floor: A bunch of “hedgies,” Wall Street’s disparaging nickname for hedge fund managers, had systematically taken down Bear Stearns by pulling their brokerage accounts, buying insurance against the bank—an instrument called a credit default swap, or CDS—and then shorting its stock. According to Russo’s sources, a story making the rounds was that the group of short-sellers who had destroyed Bear had then assembled for a breakfast at the Four Seasons Hotel in Manhattan on Sunday morning, clinking glasses of mimosas made with $350 bottles of Cristal to celebrate their achievement. Was it true? Who knew? The three executives huddled and planned their counterattack, starting with their morning meeting with nerve-wracked senior managers.

 

pages: 302 words: 86,614

The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds by Maneet Ahuja, Myron Scholes, Mohamed El-Erian

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Asian financial crisis, asset allocation, asset-backed security, backtesting, Bernie Madoff, Bretton Woods, business process, call centre, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, en.wikipedia.org, family office, fixed income, high net worth, interest rate derivative, Isaac Newton, Long Term Capital Management, Mark Zuckerberg, merger arbitrage, NetJets, oil shock, pattern recognition, Ponzi scheme, quantitative easing, quantitative trading / quantitative finance, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, short selling, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, systematic trading

Weinstein joined Deutsche Bank in January 1998, when the market for credit derivatives—financial contracts for hedging (or speculating) against a company’s default—was in its infancy. “Not only was it brand new, but few people understood the mechanics of how to price a credit default swap,” says Weinstein. A CDS is the most common credit derivative. “Foreign exchange derivatives, interest rate derivatives, equity derivatives—those instruments had been around for 25 years before J. P. Morgan and Deutsche began figuring out how to structure and trade credit default swaps.” This was an ideal situation for young Weinstein. For years, while his peers had all followed equities, Weinstein had been fascinated by the complexity of credit. “If you analyze a company and decide you like the stock, all you can really do is buy the stock or a call option on the stock.

He then explained how it happened that his firm managed to pull off a $15 billion trade. He explained that, in 2005, he and his team had become concerned about weak credit underwriting standards and excessive leverage among financial institutions believing that credit was fundamentally mispriced. “To protect our investors against the risk in the financial markets, we purchased protection through credit default swaps on debt securities we thought would decline in value due to weak credit underwriting. As credit spreads widened and the value of these securities fell, we realized substantial gains for our investors.” Paulson explained this as if it were just that simple. The funny thing is, to Paulson, it was that simple. He concluded his testimony with some recommendations for steps the government could take to relieve the credit crisis.

Paulson began to suspect that shorting credit could be the strategy that could give him the outsized performance he was looking for without taking excessive risk. Slowly, Paulson and his team were able to piece together how housing prices, and the trillion-dollar market built around them, were doomed to collapse like a house of cards. This gave Paulson the green light to begin purchasing protection through credit default swaps on debt securities he felt would decline in value due to weak credit underwriting. The subprime mortgage securitization market was uniquely suited to buying credit protection. The typical subprime securitization was divided into 18 tranches, ranging from “AAA” to “BB,” with each lower tranche subordinate to the one above. The “BBB” tranche traded at par with a yield of about 100 basis points more than U.S.

 

pages: 593 words: 189,857

Stress Test: Reflections on Financial Crises by Timothy F. Geithner

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Affordable Care Act / Obamacare, asset-backed security, Atul Gawande, bank run, banking crisis, Basel III, Bernie Madoff, Bernie Sanders, Buckminster Fuller, Carmen Reinhart, central bank independence, collateralized debt obligation, correlation does not imply causation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, David Brooks, Doomsday Book, eurozone crisis, financial innovation, Flash crash, Goldman Sachs: Vampire Squid, housing crisis, Hyman Minsky, illegal immigration, implied volatility, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, Martin Wolf, McMansion, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, Nate Silver, Northern Rock, obamacare, paradox of thrift, pets.com, price stability, profit maximization, pushing on a string, quantitative easing, race to the bottom, RAND corporation, regulatory arbitrage, reserve currency, Saturday Night Live, savings glut, short selling, sovereign wealth fund, The Great Moderation, The Signal and the Noise by Nate Silver, Tobin tax, too big to fail, working poor

We sought improvements in risk management, but we couldn’t compel change beyond the banks we regulated, and we missed major weaknesses in some of those banks, too. One of the best examples of our accomplishments, but also of the limits of our accomplishments, was in the realm of derivatives. BY 2005, the market in over-the-counter derivatives had quadrupled since Brooksley Born had started warning about them seven years earlier. Investors were gobbling up an array of new products, from “credit default swaps” to “synthetic CDOs.” But there was still no single authority over derivatives, or over the banks and securities firms that manufactured and sold them. All this worried me. In some ways, derivatives were just another form of risk taking, like simple bank loans or any other financial transactions. They could be useful tools for companies that needed to hedge risks, helping importers and exporters protect themselves against changes in exchange rates, or helping banks protect themselves against the bankruptcy of a counterparty.

There was more fear, more urgency, more direct appeals for the Fed to do more. Every morning, the New York Fed’s market room sent around a dashboard of about fifty economic and financial indicators. Most were heading the wrong way. Mortgage-backed securities were still bleeding. Rating agencies were belatedly downgrading them, leading to margin calls, forced asset sales, and more bleeding. Prices for credit default swaps—derivative contracts insuring against the failure of a firm or default of a security—were rising. Ambac, MBIA, and other large monoline insurers that stood behind many mortgage securities faced downgrades as well; even the dull municipal bonds they backed were starting to wobble. The New York state insurance commissioner, Eric Dinallo, had tracked me down in Davos, frantically informing me that the monolines were in trouble and that Charlie Gasparino was criticizing him on CNBC for not doing something about it.

We were especially worried about the risks in tri-party repo, so we persuaded the clearing banks, BoNY and JPMorgan, to push the market toward less short-term financing of less risky securities. We hoped that would reduce the danger of an uncontrolled run. We were also concerned that the spaghetti-like tangle of overlapping positions in derivatives markets could create uncertainty if another major firm failed. To shrink the plate and untangle some of the spaghetti, we encouraged the Fourteen Families to “tear up” offsetting trades of credit default swaps, getting dealers who had bought and sold the same insurance contract to step out of the offsetting trades and match up the counterparties. That way, if the dealer in the middle failed, the other firms wouldn’t be exposed. We ended up eliminating about one-third of the outstanding contracts. I was still painfully aware of our limited ability to contain the crisis. The ad hoc Bear intervention had worked out, because JPMorgan was willing and able to take on risks the Fed couldn’t.

 

pages: 402 words: 110,972

Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber

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AI winter, algorithmic trading, asset allocation, banking crisis, barriers to entry, Big bang: deregulation of the City of London, butterfly effect, buttonwood tree, buy low sell high, capital asset pricing model, citizen journalism, collateralized debt obligation, corporate governance, Craig Reynolds: boids flock, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, en.wikipedia.org, experimental economics, financial innovation, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, Internet Archive, John Nash: game theory, Khan Academy, load shedding, Long Term Capital Management, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, moral hazard, mutually assured destruction, natural language processing, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, quantitative hedge fund, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Renaissance Technologies, Richard Stallman, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, semantic web, Sharpe ratio, short selling, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, too big to fail, transaction costs, Turing machine, Upton Sinclair, value at risk, Vernor Vinge, yield curve, Yogi Berra

On November 14, 2008, the President’s Working Group (PWG) on Financial Markets said its “top near-term OTC derivatives priority” is to oversee the successful implementation of central counterparty services for credit default swaps: A well-regulated and prudently managed CDS central counterparty can provide immediate benefits to the market by 286 Nerds on Wall Str eet reducing the systemic risk associated with counterparty credit exposures. . . . It also can help facilitate greater market transparency and be a catalyst for a more competitive trading environment that includes exchange trading of CDSs. In light of recent developments, the PWG is issuing broader objectives than those that motivated the PWG’s previous OTC derivatives recommendations in the March 13 PWG Policy Statement on Financial Market Developments. The PWG has established the following policy objectives: 1. improve the transparency and integrity of the credit default swaps market; 2. enhance risk management of OTC derivatives; 3. further strengthen the OTC derivatives market infrastructure; 4. strengthen cooperation among regulatory authorities.8 The President’s Working Group brings together the scattered agencies that can make this happen.

The NABI proposal this paper advocates is actually much closer to the RTC since it advocates preserving the systemic value of banks’ operational and human assets while punishing those who made inappropriate decisions. It goes one step further by quickly placing the assets in the hands of multiple private managers (who would be accountable to the American people, the shareholders) rather than a small cadre of government officials. What about the $60⫹ trillion in credit default swaps? Many people fear that if major insolvent institutions are allowed to fail and potentially default on their derivative contracts insuring bonds Structural Ideas for the Economic Rescue 323 (credit default swaps), that it would create a chain reaction of derivative defaults, asset write-downs, and further bank failures. This is a valid concern, but existing bailout plans only defer the problem. This could be the subject of another paper, but the government should create a clearinghouse for these contracts as quickly as possible so that we can begin to unwind offsetting claims and have a clearer picture of the net liability.

There is tremendous transparency in the stock market. Look at the bottom of any business television channel or web site. You can see the details of every trade in every stock, within seconds. Regulators can track down parties involved in suspicious trades via automated clearing systems. In marked contrast, we see absolutely nothing at all about trading in the collateralized debt obligations (CDOs), credit default swaps (CDSs), and mortgage-backed securities (MBSs) that created this mess, even though the total size of those markets is a multiple of the size of the stock market. Trades and quotes in these securities, holdings, and holders are all unknown and largely unknowable, even in today’s electronic markets. If the level of regulation, reporting, and transparency we have in the equity markets were in effect for the toxic garbage that is being laid off on the U.S. taxpayers, we wouldn’t be in the bind we are in.

 

pages: 393 words: 115,263

Planet Ponzi by Mitch Feierstein

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Affordable Care Act / Obamacare, Albert Einstein, Asian financial crisis, asset-backed security, bank run, banking crisis, barriers to entry, Bernie Madoff, centre right, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, disintermediation, diversification, Donald Trump, energy security, eurozone crisis, financial innovation, financial intermediation, Flash crash, floating exchange rates, frictionless, frictionless market, high net worth, High speed trading, illegal immigration, income inequality, interest rate swap, invention of agriculture, Long Term Capital Management, moral hazard, mortgage debt, Northern Rock, obamacare, offshore financial centre, oil shock, pensions crisis, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, purchasing power parity, quantitative easing, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, too big to fail, trickle-down economics, value at risk, yield curve

As the mortgage market boomed to a peak of something over $10 trillion, there were investors starting to get anxious about the scale of their exposures. Some of these were motivated by ordinary credit-driven concerns. Others were bullish on the mortgage market but simply had to cap the total volume of their exposures. And so on. There was a huge variety of different motivations. But there was one common solution for their needs: the credit default swap or CDS. Forget about the intricacies of the terminology. Credit default swaps operate exactly like regular insurance‌—‌in this case, insurance against credit risk and default. You pay your premium year after year. If the asset you’ve insured goes bad, then the insurance pays out. So if, for example, you bought a mortgage-backed security full of subprime mortgage assets, you might (when you came to your senses) decide to insure yourself against the possibility of default.

In addition, as we’ll see in due course, I think there are solid reasons for optimism in the medium to longer term. Nevertheless, I want to keep my personal view strictly to one side, so we’ll focus here instead on what the financial markets themselves expect, using the most recent data available. The data we’ll use rely on credit default swaps, which as we’ve already seen are essentially a way to buy insurance against the risk of default. Because these swap prices are publicly displayed, it’s possible to see what insurance premiums are being demanded and paid. Clearly, the higher the premiums charged, the higher is the implicit risk of default. Indeed, it’s possible to use credit default swap pricing to estimate the ‘cumulative probability of default’ for all sovereign debt markets. The cumulative probability of default (CPD) is exactly what it sounds like. It’s the chance that a default happens at some point within a given period‌—‌in our case, we’re looking at the next five years.

Some smart guys on the Street noticed that the pattern of payouts on insurance schemes (a chain of small regular premiums followed by a potentially large one-off insurance payout) looked very like the pattern of payments on a CDO (a chain of small regular interest payments followed by a large final repayment of principal). Using a little financial magic it proved to be possible to turn those credit default swaps into a ‘synthetic’ CDO. In plain language, all those people taking out insurance against defaults were making bets on one side of the mortgage market, while the synthetic CDO enabled investors to bet on the other side of the market. In effect, that synthetic CDO created mortgage risk out of nowhere. That $10 trillion of mortgage risk was apparently not enough; Wall Street had to artificially create more from thin air.

 

pages: 289 words: 77,532

The Secret Club That Runs the World: Inside the Fraternity of Commodity Traders by Kate Kelly

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Bakken shale, bank run, Credit Default Swap, diversification, fixed income, Gordon Gekko, index fund, locking in a profit, London Interbank Offered Rate, Long Term Capital Management, margin call, paper trading, peak oil, Ponzi scheme, risk tolerance, Ronald Reagan, side project, Silicon Valley, sovereign wealth fund, supply-chain management, the market place

It was the fall of 2008, the period during which Andurand made so much money as the oil market sunk toward its low point, and financial firms were all under scrutiny as the U.S. banks flailed. Nobody in the financial markets wanted to take any risk. But Glencore, an infamous trading firm known equally for its opacity and its high tolerance for risk, was now especially vulnerable. By October, the price of a standard credit default swap, or CDS, on its debt—an insurance-like policy that would pay the holder if Glencore couldn’t pay its creditors—had zoomed past its already heightened levels, fueling the increasingly widespread belief that it was about to go under. Like any trading company, Glencore borrowed heavily to finance its operations, and depended on a steady flow of credit to keep the lights on. But now Glencore’s seventy-odd oil traders, who, like their counterparts at Vitol, bought and sold physical barrels everywhere from Asia to West Africa and used futures contracts to hedge their short-term exposure, were fielding concerned calls from the banks and other oil companies with which they normally did business almost daily.

Nobody knew how long the carnage might last, but they were all bracing for a sustained move down in the markets. As he left the meeting, Beard called his office in London. Above and beyond the commodity contract trading they were doing to hedge their exposure to price swings in physical energy trades, he wanted his team to put on a massive speculative bet that the price of oil would fall further. Glencore credit default swaps at that time had been trading at the relatively calm level of about €150,000. By contrast, the swap prices attached to the major U.S. investment banks—the cost of purchasing an insurance policy that would pay its keeper if the banks defaulted and couldn’t pay their debts—were growing vastly more expensive. Around the time of the September partner meeting in Baar, Beard’s team received an unusual request from Morgan Stanley, long a friendly rival in the trading of commodities and their correspondent contracts.

In January 2001, after an intense lobbying campaign handled partly by his former wife Denise, Rich received a presidential pardon on the last day Bill Clinton was in office. He never revisited the United States. His reputation remained stained even upon his death from a stroke, in 2013, as did those of Clinton and the lobbyists who had helped secure his pardon. The commodity rout of 2008 was probably Glencore’s toughest period since Rich’s ill-fated zinc gamble in 1992. The company’s credit default swap, or insurance-against-default, prices had retreated from their stratospheric levels, and Glencore was bringing in nearly $5 billion in net income, an amount just shy of 2007’s. But its publicly traded bonds were still only barely above investment grade. The landscape had also changed. Commodity prices were still at their lows, credit to help finance transactions was much harder to secure as banks grew more parsimonious about sharing their resources, and the troubles with BP and other companies had left the company more vulnerable to rivals.

 

pages: 246 words: 74,341

Financial Fiasco: How America's Infatuation With Homeownership and Easy Money Created the Economic Crisis by Johan Norberg

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accounting loophole / creative accounting, bank run, banking crisis, Bernie Madoff, Black Swan, capital controls, central bank independence, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Brooks, diversification, financial deregulation, financial innovation, helicopter parent, Home mortgage interest deduction, housing crisis, Howard Zinn, Hyman Minsky, Isaac Newton, Joseph Schumpeter, Long Term Capital Management, market bubble, Martin Wolf, Mexican peso crisis / tequila crisis, millennium bug, moral hazard, mortgage tax deduction, Naomi Klein, new economy, Northern Rock, Own Your Own Home, price stability, Ronald Reagan, savings glut, short selling, Silicon Valley, South Sea Bubble, The Wealth of Nations by Adam Smith, too big to fail

Considering the scale of the earthquake that shook the world when one Wall Street giant went down, we can only speculate about what would have happened if Lehman Brothers had been joined by the other four on its way down. But investment banks were not the only ones to collapse during this fateful week. A huge stash of new financial weapons of mass destruction had just been discovered, and something was now going very wrong with them, potentially causing a series of explosions throughout the financial system. They were "credit-default swaps" (CDSs), a kind of insurance policy that you can take out against the risk of a company or a security collapsing. The history of the CDS begins at the Boca Raton, a pink luxury hotel in Florida where about 80 people from J. P. Morgan & Co. took part in a conference in 1994. Legend has it that the young, successful bankers partied so wildly that they ended up throwing each other into the pool fully dressed.

What if only a tiny proportion of default swaps were to default, and the related losses were to cause a bank to collapse, which would trigger more CDSs, creating new losses and triggering new CDSs, and so on in a long series of explosions that might end up knocking out the entire financial system? That is why dark glances were now being cast at AIG, the American International Group. It was not only the world's largest insurer, with 116,000 employees and operations in 116 countries, but also a leading seller of credit-default swaps. On the same day that Lehman went down-Monday, September 15-the rating agencies downgraded AIG. Since it had been able to apply tiny margins to its insurance agreements only on the strength of its earlier grade, AIG was now forced to raise new collateral to the tune of many billions of dollars in short order, and its stock fell by 60 percent as soon as the stock market opened. One of those participating in talks with the administration and the Fed about AIG was Lloyd Blankfein, who was CEO of Goldman Sachs-the job Hank Paulson had had before he became Treasury secretary.

Blankfein was particularly worried, because if AIG collapsed, his bank would lose around $20 billion worth of insurance policies, according to reports in the New York Times. But it never came to that. Instead, there was yet another large-scale government intervention. On that Tuesday, the Fed made $85 billion available to AIG in exchange for the departure of its CEO and an opportunity to buy a majority share of the company stock.37 Credit-default swaps have been characterized as engines of doom, but if you take a closer look at them, you find that, if correctly used, they may in fact be a good insurance solution. Blaming them for, say, the poor quality of the mortgages they insured is a bit like being against fire insurance because houses lack smoke detectors. The possibility of taking out insurance against the collapse of an investment or a counterparty is obviously very valuable to those who want to avoid being pulled along down.

 

pages: 350 words: 109,220

In FED We Trust: Ben Bernanke's War on the Great Panic by David Wessel

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Asian financial crisis, asset-backed security, bank run, banking crisis, banks create money, Berlin Wall, Black Swan, central bank independence, credit crunch, Credit Default Swap, crony capitalism, debt deflation, Fall of the Berlin Wall, financial innovation, financial intermediation, full employment, George Akerlof, housing crisis, inflation targeting, London Interbank Offered Rate, Long Term Capital Management, market bubble, moral hazard, mortgage debt, new economy, Northern Rock, price stability, quantitative easing, Robert Shiller, Robert Shiller, Ronald Reagan, Saturday Night Live, savings glut, Socratic dialogue, too big to fail

“In the case of Lehman Brothers,” he said, reading from prepared testimony, “the Federal Reserve and the Treasury declined to commit public funds to support the institution. The failure of Lehman posed risks. But the troubles at Lehman had been well known for some time, and investors clearly recognized — as evidenced, for example, by the high cost of insuring Lehman’s debt in the market for credit default swaps — that the failure of the firm was a significant possibility. Thus, we judged that investors and counterparties had had time to take precautionary measures.” Paulson and Bernanke’s statements were more than after-the-fact window dressing. Although Lehman was already dead, the cause of death wasn’t a secondary issue. Lehman’s collapse caused — or coincided with — so much financial turmoil in large part because of the lack of a consistent story.

But to the officials overseeing the economy and many others, a crisis as big and broad as the Great Panic simply wasn’t considered a plausible scenario — and they weren’t preparing for anything this large. Geithner did muse, occasionally, that the evolution of financial markets might produce fewer crises, but bigger ones. (The “bigger” so far has proven dead-on. “Fewer” remains an open question.) And he did help clean up one mess: an alarming backlog of paperwork in a rapidly growing corner of the markets, the securities called credit default swaps, which allow banks and other lenders to buy insurance against borrowers going bust. The buyers and sellers used sophisticated twenty-first-century finance; but the back office was more circa the late nineteenth century. One firm confessed in June 2006 that it had 18,000 undocumented trades, several thousand of which had been languishing in the back office for more than ninety days. The risk was that in a crisis, no one would be sure who owed what to whom — and everyone would stop doing business.

With the help of his predecessor, Gerald Corrigan, then at Goldman Sachs, Geithner summoned representatives of fourteen big Wall Street firms — “the Fourteen Families,” they called themselves — and prodded them to automate the process before a crisis hit. It worked. On September 30, 2006, the firms counted 97,000 unconfirmed trades outstanding for more than thirty days. By October 2008, the backlog had been reduced by 75 percent. And in all the turmoil of the Great Panic, the failure to process credit default swaps was one problem that didn’t occur. Big players on Wall Street knew who their counterparties were — even if they didn’t completely trust them. No one at the Fed, however, rang the gong and warned investors, lenders, business executives, and consumers that years of easy credit even for risky borrowers, placid markets, and shared optimism were unsustainable. There was no analog to Alan Greenspan’s famous — and unheeded — admonition about “irrational exuberance” in the stock market in 1996.

 

pages: 353 words: 88,376

The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett by Jack (edited By) Guinan

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Albert Einstein, asset allocation, asset-backed security, Brownian motion, business process, capital asset pricing model, clean water, collateralized debt obligation, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, equity premium, fixed income, implied volatility, index fund, interest rate swap, inventory management, London Interbank Offered Rate, margin call, market fundamentalism, mortgage debt, passive investing, performance metric, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, statistical model, time value of money, transaction costs, yield curve, zero-coupon bond

A credit crunch makes it nearly impossible for companies to borrow money because lenders are scared of bankruptcies or defaults and charge higher interest rates because of that fear. The result is a slowdown in growth that leads to a prolonged recession (or slower recovery), which is compounded as banks hold tight to the banking reserves. Related Terms: • Bankruptcy • Debt • Subprime Meltdown • Bear Market • Recession Credit Default Swap (CDS) What Does Credit Default Swap (CDS) Mean? A swap designed to transfer the credit exposure of fixed-income products between parties. Investopedia explains Credit Default Swap (CDS) The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the creditworthiness of the product. When this is done, the risk of default is transferred from the holder of the fixed-income security to the seller of the swap. For example, the buyer of a credit swap still is entitled to the par value of the bond from the seller of the swap if the bond defaults in its coupon payments. 58 The Investopedia Guide to Wall Speak Related Terms: • Bond • Fixed Income Security • Swap • Credit Derivative • Interest Rate Swap Credit Derivative What Does Credit Derivative Mean?

Credit derivatives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments). Investopedia explains Credit Derivative As an example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss from default by transferring the credit risk to another party while keeping the loan on its books. Related Terms: • Credit Default Swap • Derivative • Yield • Credit Rating • Securitization Credit Rating What Does Credit Rating Mean? An assessment of the creditworthiness of individuals and corporations. It is based on the history of borrowing and repayment as well as the availability of assets and the extent of liabilities. Investopedia explains Credit Rating Credit is important because individuals and corporations with poor credit will have difficulty finding financing and most likely will have to pay more because of the risk of default.

Swaps include currency swaps and interest rate swaps. Investopedia explains Swap If companies in different countries have regional advantages on interest rates, a swap will benefit both firms. For example, one firm may have a lower fixed interest rate while another has access to a lower floating interest rate. To take advantage of this situation, the companies would do an interest rate swap. Related Terms: • Arbitrage • Credit Default Swap • Interest Rate Swap • Commodity • Currency Swap Swing Trading What Does Swing Trading Mean? A style of trading that is used to capture quick gains in a stock over a one- to four-day trading period. It is done to capitalize on the shortterm swings in the market. Investopedia explains Swing Trading Traders must make quick trading decisions to exploit these shortterm price swings in the stock market.

 

pages: 386 words: 122,595

Naked Economics: Undressing the Dismal Science (Fully Revised and Updated) by Charles Wheelan

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affirmative action, Albert Einstein, Andrei Shleifer, barriers to entry, Berlin Wall, Bernie Madoff, Bretton Woods, capital controls, Cass Sunstein, central bank independence, clean water, collapse of Lehman Brothers, congestion charging, Credit Default Swap, crony capitalism, currency manipulation / currency intervention, Daniel Kahneman / Amos Tversky, David Brooks, demographic transition, diversified portfolio, Doha Development Round, Exxon Valdez, financial innovation, floating exchange rates, George Akerlof, Gini coefficient, Gordon Gekko, greed is good, happiness index / gross national happiness, Hernando de Soto, income inequality, index fund, interest rate swap, invisible hand, job automation, Joseph Schumpeter, Kenneth Rogoff, libertarian paternalism, low skilled workers, lump of labour, Malacca Straits, market bubble, microcredit, money: store of value / unit of account / medium of exchange, Network effects, new economy, open economy, presumed consent, price discrimination, price stability, principal–agent problem, profit maximization, profit motive, purchasing power parity, race to the bottom, RAND corporation, random walk, rent control, Richard Thaler, rising living standards, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, school vouchers, Silicon Valley, Silicon Valley startup, South China Sea, Steve Jobs, The Market for Lemons, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, transaction costs, transcontinental railway, trickle-down economics, urban sprawl, Washington Consensus, Yogi Berra, young professional

One attraction of catastrophe bonds for investors is that their payout is determined by the frequency of natural disasters, which is not correlated with the performance of stocks, bonds, real estate, or other traditional investments. Even the much-maligned credit default swaps have a legitimate investment purpose. A credit default swap is really just an insurance policy on whether or not some third party will pay back its debts. Suppose your husband pressures you to loan $25,000 to your ne’er-do-well brother-in-law so that he can finally complete his court-man-dated anger management program and turn his life around. You have grave concerns about whether you will ever see any of this money again. What you need is a credit default swap. You can pay some other party (presumably with a more favorable view of your brother-in-law’s creditworthiness) to enter into a contract with you that promises to pay you $25,000 in the event that your brother-in-law does not pay back the cash.

One can use the stock market to invest in companies and share their future profits—or one can buy a stock at 10:00 a.m. in hopes of making a few bucks by noon. Financial products are to speculation what sporting events are to gambling. They facilitate it, even if that is not their primary purpose. This is what went wrong with credit default swaps. The curious thing about these contracts is that anyone can get into the action, regardless of whether or not they are a party to the debt that is being guaranteed. Let’s stick with the example of your loser brother-in-law. It makes sense for you to use a credit default swap to protect yourself against loss. However, that same market also allows the rest of us to bet on whether or not your brother-in-law will pay back the loan. That’s not hedging a bet; that’s speculation. So for any single debt, there may be hundreds or thousands of contracts tied to whether or not it gets repaid.

The demise of the investment bank Lehman Brothers, which declared bankruptcy on September 15, 2008, ushered in “the financial crisis,” which deserves its frequent description as the worst economic downturn since the Great Depression. How did it happen? How did so many consumers, who are supposed to have a rational understanding of their own well-being, end up crushed by a housing “bubble”? Who were the knuckleheads who loaned them all that money? Why did Wall Street create things like “CDOs” and credit-default swaps, and why did they prove so devastating to the financial system? Chapter 2 makes the case that most of the reckless behavior that led to the financial crisis was predictable, given the incentives built into the system. Why did mortgage brokers originate so many reckless loans? Because it wasn’t their money! They were paid on commission by the banks that made the loans. More mortgages meant more commissions, and bigger mortgages meant bigger commissions.

 

pages: 726 words: 172,988

The Bankers' New Clothes: What's Wrong With Banking and What to Do About It by Anat Admati, Martin Hellwig

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Andrei Shleifer, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bonus culture, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, diversified portfolio, en.wikipedia.org, Exxon Valdez, financial deregulation, financial innovation, financial intermediation, George Akerlof, Growth in a Time of Debt, income inequality, invisible hand, Jean Tirole, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, margin call, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, Nick Leeson, Northern Rock, open economy, peer-to-peer lending, regulatory arbitrage, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, sovereign wealth fund, technology bubble, The Market for Lemons, the payments system, too big to fail, Upton Sinclair, Yogi Berra

These debt promises are sold to different investors, although sometimes the investment bank itself might buy some.32 The desire to shift risk away from the original mortgage lender thus lengthens the chain of transactions and increases the scope for defaults to trigger domino effects. If the banks or other institutions that buy the mortgage securities borrow from money market funds, the chain of transactions is even longer.33 The use of so-called credit default swaps is another example of how attempts to manage risk can create additional complexity and fragility. A credit default swap (CDS) is a kind of insurance contract. The buyer of a CDS pays a periodic premium to the seller. In return, the seller promises to reimburse the buyer if the loan or portfolio of loans on which the CDS is written does not perform as it had promised. By buying a CDS, the bank shifts the default risk on the loans that are protected to the seller of the CDS, just as a buyer of home insurance shifts the risk of fire to the insurance company.

See Community Reinvestment Act Cranston, Alan, 252n35 credibility: of ban on bailouts, 139; of threat of allowing bank failures, 75–76, 139, 264n65; of threat of closing banks for capital violations, 189 credit cards: interest rates on, 104, 276n11; payments through, 49, 150 credit crunches: causes of, 5, 301n54; fears of, in delay of regulation, 171–72; in financial crisis of 2007-2009, 5, 211, 301n54 credit default swaps (CDSs): at AIG, 69, 73–74, 255n1, 259n34, 334n44; definition of, 68, 255n1; and interconnectedness, 68–69; origins of term, 259n34; regulation of, 259n34; risks of, 73–74; in risk-weighting approach, 185 Crédit Immobilier de France, bailout of, 74 credit insurance, risks of, 73–74. See also AIG; credit default swaps credit limits, regulations on, 88, 268n24 Crédit Lyonnais: cost of bailout of, 318n7; failure of, 55–56, 252n37 creditors: benefits of guarantees to, 129, 142; collateral used by, 164, 301n57; covenants of, 141; default as problem of, 36, 244n3; deposit insurance and, 62, 163; lending through repo (repurchase) agreements, 164; motivations for short-term lending by, 163–65; response to default, 35–36 credit ratings: guarantees in, role of, 9, 143, 235nn31–32, 290n28; for mortgage-related securities, 156–57, 185; risks hidden in, 124–25, 156–57, 222, 296n29; in securitization of mortgages, 259n33 credit risks: AIG and, 74, 161; definition of, 313n64; in financial crisis of 2007-2009, 157, 185; in risk-weighted approach, 183, 313n64, 313n66 creditworthiness assessments, 50; careless-ness in, 56, 277n12; challenges of, 50; economizing on, 249n13; hard versus soft information in, 50, 248n9; for mortgages, 56, 58, 248n9, 277n12 criminal proceedings, 208, 215, 228, 321n27 crony capitalism, 331n19 culture of banking: complacency in, 206; greed in, 208–9, 328n6; lying in, 328n5; return on equity in, 115, 125–28, 284–85nn29–30; unethical behavior in, 209, 328n6, 329n8 Cumming, Christine, 262n60, 263n62 currency, and risk of sovereign default, 276n6 currency boards, 294n15, 333n39 currency swaps, 260n37 Curry, Timothy, 252n34, 289n20, 293n3 Das, Satyajit, 230n9, 253n42, 259n34, 260nn37–38, 260n41, 261n43, 261n46, 261n50, 262nn52–53, 284n24, 284n29, 285n37, 286n40, 308n41, 323n38, 328n5, 329n6, 329n8 Dattel, Danny, 252n36 Davies, Richard, 270n31, 290n29, 291n34 Davydenko, Sergei A., 245n13 debit cards, 49, 150 debt, treated as equity, 187–88.

Basel II, concluded in 2004, was considered to be doing it properly, but the financial crisis showed that Basel II was flawed.61 Basel III attempts to correct some of the flaws in Basel II, but it has not changed the overall approach.62 The risk-weighting approach is extremely complex and has many unintended consequences that harm the financial system. It allows banks to reduce their equity by concentrating on investments that the regulation treats as safe. Banks might also use derivatives to shift the risks of their investments to others, and this can increase interconnectedness. An example would be a bank’s purchase of credit default swaps in order to insure against the credit risk of debt securities held by the bank. As we saw in Chapter 5, such credit insurance served to justify treating mortgage-related securities as perfectly safe; it was also a source of systemic risk and played an important role in the government’s decision to bail out AIG. Banks have developed various techniques for “risk-weight optimization” that allow them to choose investments that are in fact riskier than the supervisors believe and have return prospects reflecting these risks so that, on average, returns are higher than the returns on investments that are in fact safer.63 In theory, risk weights are meant to adapt equity requirements to the risks of the banks’ investments; in practice, the weights are determined by a mixture of politics, tradition, genuine and make-believe science, and the banks’ self-interest.

 

pages: 662 words: 180,546

Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown by Philip Mirowski

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Andrei Shleifer, asset-backed security, bank run, barriers to entry, Basel III, Berlin Wall, Bernie Madoff, Bernie Sanders, Black Swan, blue-collar work, Bretton Woods, Brownian motion, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, constrained optimization, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, dark matter, David Brooks, David Graeber, debt deflation, deindustrialization, Edward Glaeser, Eugene Fama: efficient market hypothesis, experimental economics, facts on the ground, Fall of the Berlin Wall, financial deregulation, financial innovation, Flash crash, full employment, George Akerlof, Goldman Sachs: Vampire Squid, Hernando de Soto, housing crisis, Hyman Minsky, illegal immigration, income inequality, incomplete markets, invisible hand, Jean Tirole, joint-stock company, Kenneth Rogoff, knowledge economy, l'esprit de l'escalier, labor-force participation, liquidity trap, loose coupling, manufacturing employment, market clearing, market design, market fundamentalism, Martin Wolf, Mont Pelerin Society, moral hazard, mortgage debt, Naomi Klein, Nash equilibrium, night-watchman state, Northern Rock, Occupy movement, offshore financial centre, oil shock, payday loans, Ponzi scheme, precariat, prediction markets, price mechanism, profit motive, quantitative easing, race to the bottom, random walk, rent-seeking, Richard Thaler, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, savings glut, school choice, sealed-bid auction, Silicon Valley, South Sea Bubble, Steven Levy, technoutopianism, The Chicago School, The Great Moderation, the map is not the territory, The Myth of the Rational Market, the scientific method, The Wisdom of Crowds, theory of mind, Thomas Kuhn: the structure of scientific revolutions, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, War on Poverty, Washington Consensus, We are the 99%, working poor

Matt Taibbi had some fun pointing out that even wives of the rich and famous were bestowed enormous opportunities to enrich themselves off TALF, a program nominally instituted to support the rancid securities the Fed had permitted to proliferate over the previous decade.56 But few have acknowledged that this was precisely the Depression remedy promoted by Milton Friedman: keep the rich from suffering writedowns or defaulting on their debts so the so-called money supply does not contract inordinately, and everything else will just work itself out fine. Yves Smith has made the important point that Bernanke tends to justify the sites and instances where the Fed has intervened largely by insisting that private contracts have to be respected; but this is yet another Big Lie from Foggy Bottom. If the contracts favored the banks, such as the credit default swaps written by AIG, then it was permissible to stretch the Fed legal charter by essentially nationalizing an insurance company, or purchasing mortgage-backed securities. (Saving AIG reveals the Bernanke excuse that “we had no legal authority” to save Lehman to be bootless.) However, whenever it was the banks themselves that violated sanctity of contract, from the total travesty of riding roughshod over the chain of title in mortgage securitization, to the defrauding of clients and investors, to reverse long-established principles of creditor hierarchy, then the Fed looked the other way.

When he filed his “Executive Branch Financial Disclosure Report” on January 20, 2009, listing a net worth of $17–$39 million, he prompted a flurry of newspaper and blog accounts of his outsized speaker fees and favors done for the financial sector from the late 1990s onward.93 Summers has enjoyed an extremely checkered career in many respects, dating from his controversial tenure as chief economist at the World Bank in 1990, but had nonetheless risen to political prominence due to the long-term patronage of Robert Rubin, formerly co-chair of Goldman Sachs, secretary of the Treasury, and later gray eminence at Citigroup and other Wall Street institutions. During the Clinton administration, Rubin and Summers played a now-infamous role in quashing Brooksley Born at the CFTC in 1998 when she proposed reining in the proliferating markets in credit default swaps. Indeed, many of the most significant neoliberal bank deregulations that led up to the crisis happened during the joint watch of Rubin, Summers, and Greenspan. When Rubin left the Treasury in 1999 for Citigroup, he persuaded Clinton to name Summers as his replacement. Rubin lobbied for Summers to be appointed president of Harvard, a term that ended rather inauspiciously in 2006 with accusations of economics faculty fraud from the federal government.94 Summers did not suffer from these contretemps, however; he was taken on board at Taconic Capital Advisors, a Goldman alumni hedge fund,95 and began earning $5 million a year working one day a week at the hedge fund D.

Take another illustrious Harvard economist, Martin Feldstein. Among other ties to the key crisis institutions, he had been on the board of AIG for twenty-two years, only to conveniently resign from his duties on June 30, 2009. He had also been chair of its finance committee and risk management, and therefore was formally directly responsible for the disastrous AIG Financial Products division, whose credit default swaps and other unsustainable derivatives brought down the company. For his services there he accrued more than $6 million, and has apparently never suffered any ostracism for saddling the Treasury with a shell of a remnant of an insurance behemoth that is still hemorrhaging money. Indeed, none of this seemed an obstacle to President Obama appointing him to his Presidential Economic Recovery Advisory Board in 2009, and his Tax Policy task force thereafter.

 

pages: 225 words: 11,355

Financial Market Meltdown: Everything You Need to Know to Understand and Survive the Global Credit Crisis by Kevin Mellyn

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asset-backed security, bank run, banking crisis, Bernie Madoff, bonus culture, Bretton Woods, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, disintermediation, diversification, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Francis Fukuyama: the end of history, global reserve currency, Home mortgage interest deduction, Isaac Newton, joint-stock company, liquidity trap, London Interbank Offered Rate, margin call, market clearing, moral hazard, mortgage tax deduction, Northern Rock, offshore financial centre, paradox of thrift, pattern recognition, pension reform, pets.com, Plutocrats, plutocrats, Ponzi scheme, profit maximization, pushing on a string, reserve currency, risk tolerance, risk-adjusted returns, road to serfdom, Ronald Reagan, shareholder value, Silicon Valley, South Sea Bubble, statistical model, The Great Moderation, the payments system, too big to fail, value at risk, very high income, War on Poverty, Y2K, yield curve

DERIVATIVES PILED ON DERIVATIVES All this would be bad enough, but it gets worse. Banks used derivatives to hedge their bets on many of these structured credit deals. At the extreme end of this complexity within complexity were so-called synthetic CDOs. These structures did not even own a pool of real assets like bonds or loans. Instead, they used something called a credit default swap or CDS to gain ‘‘credit exposure’’ to pools of assets. ‘‘Credit exposure’’ is finance-speak for getting paid to take risk. Without going into detail, a credit default swap is a derivative in which the seller of protection on a loan or bond gets paid a fee and ongoing premium by the owner of the instrument. If a pre-defined event of default happens, the swap is triggered. The seller takes the bond, and the buyer gets paid its full value. The credit default market is the largest single derivatives market in the financial world, with contracts outstanding amounting to $45 trillion on the eve of the financial crisis.

This process, called ‘‘asset securitization,’’ made the reckless expansion of consumer debt not only possible but almost irresistible because of buy-side demand. The investment banking wiz kids even invented whole new classes of securities called ‘‘derivatives.’’ Derivatives have no value in themselves but allow investors to ‘‘bet’’ on the value of an asset or contract linked to them. For example, a credit default swap allows investors to make money if a company or country cannot pay its bond holders. The rapid fire invention and roll out of new, untested securities has been central both to the explosive growth of the global financial markets and the shocking meltdown we are now living through. Hedge Funds New providers—often called ‘‘alternative investment vehicles’’— have also sprung up to meet the ‘‘buy-side’’ demand for higher returns on invested money.

The man the press dubbed the ‘‘Sheriff of Wall Street’’ did nothing to head off the excesses behind the bubble in asset-backed securities that brought down Wall Street in 2008. In fact, by vindictively driving the one man from power who really understood AIG and who essentially managed its risk, its founder Hank Greenburg, Spitzer bears at least some responsibility for destabilizing a critical cog in the credit default swap market on the eve of the crisis. AIG’s default book may have proved fatal in any case but Spitzer weakened the company by arbitrarily using an arcane state law to undermine other key parts of its global business model such as finite risk contracts, a key product in the global reinsurance market. He has nonetheless set a useful example for state attorney generals everywhere, including in Massachusetts, which got a big settlement from Goldman in 2009 without even bothering to bring a complaint.

 

pages: 252 words: 72,473

Weapons of Math Destruction: How Big Data Increases Inequality and Threatens Democracy by Cathy O'Neil

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Affordable Care Act / Obamacare, Bernie Madoff, big data - Walmart - Pop Tarts, call centre, carried interest, cloud computing, collateralized debt obligation, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, Emanuel Derman, housing crisis, illegal immigration, Internet of things, late fees, medical bankruptcy, Moneyball by Michael Lewis explains big data, new economy, obamacare, Occupy movement, offshore financial centre, payday loans, peer-to-peer lending, Peter Thiel, Ponzi scheme, prediction markets, price discrimination, quantitative hedge fund, Ralph Nader, RAND corporation, recommendation engine, Sharpe ratio, statistical model, Tim Cook: Apple, too big to fail, Unsafe at Any Speed, Upton Sinclair, Watson beat the top human players on Jeopardy!, working poor

But this time the power of modern computing fueled fraud at a scale unequaled in history. The damage was compounded by other vast markets that had grown up around the mortgage-backed securities: credit default swaps and synthetic collateralized debt obligations, or CDOs. Credit default swaps were small insurance policies that transferred the risk on a bond. The swaps gave banks and hedge funds alike a sense of security, since they could supposedly use them to balance risk. But if the entities holding these insurance policies go belly up, as many did, the chain reaction blows holes through the global economy. Synthetic CDOs went one step further: they were contracts whose value depended on the performance of credit default swaps and mortgage-backed securities. They allowed financial engineers to leverage up their bets even more. The overheated (and then collapsing) market featured $3 trillion of subprime mortgages by 2007, and the market around it—including the credit default swaps and synthetic CDOs, which magnified the risks—was twenty times as big.

The overheated (and then collapsing) market featured $3 trillion of subprime mortgages by 2007, and the market around it—including the credit default swaps and synthetic CDOs, which magnified the risks—was twenty times as big. No national economy could compare. Paradoxically, the supposedly powerful algorithms that created the market, the ones that analyzed the risk in tranches of debt and sorted them into securities, turned out to be useless when it came time to clean up the mess and calculate what all the paper was actually worth. The math could multiply the horseshit, but it could not decipher it. This was a job for human beings. Only people could sift through the mortgages, picking out the false promises and wishful thinking and putting real dollar values on the loans. It was a painstaking process, because people—unlike WMDs—cannot scale their work exponentially, and for much of the industry it was a low priority.

This is a result of the way we define a trader’s prowess, namely by his “Sharpe ratio,” which is calculated as the profits he generates divided by the risks in his portfolio. This ratio is crucial to a trader’s career, his annual bonus, his very sense of being. If you disembody those traders and consider them as a set of algorithms, those algorithms are relentlessly focused on optimizing the Sharpe ratio. Ideally, it will climb, or at least never fall too low. So if one of the risk reports on credit default swaps bumped up the risk calculation on one of a trader’s key holdings, his Sharpe ratio would tumble. This could cost him hundreds of thousands of dollars when it came time to calculate his year-end bonus. I soon realized that I was in the rubber-stamp business. In 2011 it was time to move again, and I saw a huge growth market for mathematicians like me. In the time it took me to type two words into my résumé, I was a newly proclaimed Data Scientist, and ready to plunge into the Internet economy.

 

Unhappy Union by The Economist, La Guardia, Anton, Peet, John

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bank run, banking crisis, Berlin Wall, Bretton Woods, capital controls, Celtic Tiger, central bank independence, centre right, collapse of Lehman Brothers, credit crunch, Credit Default Swap, debt deflation, Doha Development Round, eurozone crisis, Fall of the Berlin Wall, Flash crash, illegal immigration, labour market flexibility, labour mobility, market fundamentalism, moral hazard, Northern Rock, oil shock, open economy, pension reform, price stability, quantitative easing, special drawing rights, supply-chain management, The Great Moderation, too big to fail, transaction costs, éminence grise

Indeed, the ESM was made more flexible in other ways too. It was also allowed to lend money to governments to recapitalise banks and extend precautionary loans. The deal would prompt ratings agencies to declare a temporary “selective default” (the EFSF would have to offer the ECB alternative collateral), but its voluntary nature ensured it would not count as a “credit event” that triggered payments of credit-default swaps, a form of insurance against sovereign defaults. However, the deal proved to be the worst of both worlds: the haircut was too small to turn around Greece’s public finances, but big enough to spread fear that other bonds were at risk. Markets had other reasons to worry. The original banking crisis had never been satisfactorily resolved; it had only been masked by the Greek turmoil and, to a great extent, worsened by the sovereign-debt crisis.

They were in a muddle about whether Greece was solvent or bust, and thus vacillated over how to deal with its accumulated debt. They first chose a complete bail-out; then at Deauville suddenly flirted with the idea of across-the-board bail-in of creditors; and then backed away from the idea more or less entirely. By July, when they got around to cutting Greece’s debt, the haircut was too modest and came too late. Months were wasted seeking a “voluntary” contribution from private creditors that would not trigger credit-default swaps (CDS); in the end CDS contracts were paid out anyway. The same uncertainty affected their judgment about the pace of fiscal consolidation. To make the numbers fit within the money made available by the euro zone and the IMF, Greece was forced into excessively harsh deficit-cutting (and at first had to pay high rates of interest). In contrast with Latvia, which cut its budget as its main trading partners were still stimulating their economies, Greece was trying to consolidate its budget while others were reducing deficits as well.

Over the following weeks Draghi’s cash would ease the spasm. The euro zone breathed more easily. Bond yields for Italy and Spain dropped markedly, by about 250 and 90 basis points respectively between January and March. The long-drawn-out second Greek bailout, with its large haircut on privately held government bonds, was concluded in February and markets seemed unconcerned by the triggering of credit-default swaps that had once been so feared. Draghi quietly retired Trichet’s official bond-buying operation in February. Yet no sooner had he told Bild in March 2012 that “the worst is over” than the crisis entered another, more perilous phase. The LTRO drug was wearing off, and the euro zone had entered a double-dip recession at the end of 2011, caused in part by the previous year’s turmoil. Markets’ concern shifted from the deficit to shrinking output, that is, from the numerator to the denominator in the ratio of borrowing to GDP.

 

pages: 1,088 words: 228,743

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

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Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, Bretton Woods, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, New Journalism, oil shock, p-value, passive investing, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, systematic trading, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond

The reasons for such instability include the changing uses of swaps—reduced use in positive-carry trades, greater use in convexity hedging in the dollar market, occasional use by public debt managers, and asset–liability duration matching by pension funds. Evolving perceptions of the credit risk of swaps and government bonds over time have also played a role. Recently some observers have emphasized swaps’ off-balance-sheet nature, a factor that could justify swaps’ richness against government bonds that require capital outlays. Credit default swaps (CDS) Compared with buying a corporate bond, a credit default swap offers a purer and more efficient way of gaining exposure to the default risk of the bond’s issuer. In a CDS, the seller provides default protection in exchange for receiving a fee—in default the seller must pay the difference between the bond’s par value and, typically, its market value after the default event. Unlike interest rate swaps, the payoff profile is asymmetric.

Index AAA/AA/A-rated bonds absolute valuation academic investors active investing active risk puzzle (Litterman) active strategies adaptive markets hypothesis (Lo) advisors, CTAs agriculture alpha—beta barbell alpha—beta separation alphas CAPM currency carry hedge funds long horizon investors portable alpha alternative assets assets list commodities hedge funds liquidity momentum strategies PE funds premia real estate risk factors alternative betas AM see arithmetic mean ambiguity aversion Amihud, Yakov announcement days arbitrage behavioral finance CRP front-end trading equity value strategies term structure models Argentina arithmetic mean (AM) art investing asset classes 1990—2009 alternative assets “bad times” performance currency carry derivatives foreign exchange forward-looking indicators growth sensitivities historical returns inflation long history momentum strategies performance 1990—2009 profitable strategies risk factors style diversification traditional trend following understanding returns value strategies volatility selling world wealth assets 1968—2007 asset richening AUM Berk—Green management model cyclical variation empirical “horse races” ERPC feedback loops forward-looking measures growth illiquidity liquidity long-horizon investors market relations multiple asset classes prices/pricing privately held real assets risky assets seasonal regularities survey-based returns tactical forecasting tail risks time-varying illiquidity premia volatility see also asset classes assets under management (AUM) asymmetric information asymmetric returns asymmetric risk at-the-money (ATM) options seasonal regularities tail risks volatility selling attention bias AUM see assets under management BAB see betting against beta backfill bias backwardation “bad times” carry strategies catastrophes crashes crises inflation rare disasters bank credibility Bank of England Barcap Index BBB-rated bonds behavioral finance applications arbitrage biases cross-sectional trading heuristics historical aspects macro-inefficiencies micro-inefficiencies momentum over/underreaction preferences prospect theory psychology rational learning reversal effects speculative bubbles value stocks BEI see break-even inflation benchmarks, view-based expected returns Berk—Green asset management model Bernstein, Peter betas alpha—beta barbell BAB currency carry equity hedge funds long-horizon investors risk time-varying betting against beta (BAB) biases attention behavioral finance confirmation conservatism currency carry downgrading extrapolation forward rate hedge funds heuristic simplifications high equity premium hindsight historical returns learning limits memory momentum overconfidence overfitting overoptimism reporting representativeness reversal tendencies self-attribution self-deception survey data terminology volatility selling binary timing model Black—Litterman optimizers Black—Scholes (BS) option-pricing formula Black—Scholes—Merton (BSM) world blind men and elephant poem (Saxe) bond risk premium (BRP) approximate identities bond yield business cycles covariance risk cyclical factors decomposed-year Treasury yield drivers ex ante measures historical returns inflation interpreting BRP IRP macro-finance models nominal bonds realized/excess return safe haven premium supply—demand survey-based returns tactical forecasting targets terminology theories YC bonds AAA/AA/A-rated balanced portfolios BBB-rated credit spreads ERPB government historical records HY bonds IG bonds inflation-linked long-term nominal non-government relative valuation stock—bond correlation top-rated yields see also bond risk premium; corporate bonds booms break-even inflation (BEI) Bretton Woods system BRIC countries BRP see bond risk premium BSM see Black—Scholes—Merton bubbles absolute valuation memory bias money illusion real estate Shiller’s four elements speculative Buffet, Warren building block approach business cycles asset returns economic regime analysis ex ante indicators realized returns buybacks B-S see Black—Scholes option-pricing formula C-P BRP see Cochrane—Piazzesi BRP forward rate curve calls seasonal regularities tail risks volatility selling Campbell, John Campbell—Cochrane habit formation model Capital Asset Pricing Model (CAPM) alphas carry strategies Consumption CAPM covariance with “bad times” disagreement models ERP Intertemporal CAPM liquidity-adjusted market frictions market price equation multiple risk factors risk factors risk-adjusted returns risk-based models skewness stock—bond correlation supply—demand volatility Capital Ideas (Bernstein) capitalism capitalization (cap) rate CAPM see Capital Asset Pricing Model carry strategies 1990—2009 active investing asset classes business cycles credit carry currency ERP financing rates foreign exchange forward-looking indicators forward-looking measures generic proxy role historical returns long-horizon investors non-zero yield spreads real asset investing roll Sharpe ratios 2008 slide tactical forecasting cash, ERPC cash flow catastrophes see also “bad times” CAY see consumption/wealth ratio CCW see covered call writing CDOs see collateralized debt obligations CDSs see credit default swaps central banks Chen three-factor stock returns model China Citi (Il—)Liquidity indices Cochrane—Piazzesi BRP (C-P BRP) forward rate curve see also Campbell—Cochrane collateral return collateralized debt obligations (CDOs) comfortable approaches commodities characteristics equity value strategies excess returns expected returns expected risk premia futures historical returns inflation momentum return decomposition returns 1984—2009 supply—demand seasonals term structure trading advisors value indicators commodity momentum performance rational stories simple strategies trend following tweaks when it works well why it works see also momentum strategies commodity trading advisors (CTAs) composite ranking cross-asset selection models compound returns conditioners confirmation bias conservatism constant expected returns constant relative risk aversion (CRRA) Consumption CAPM consumption/wealth ratio (CAY) contemporaneous correlation contrarian strategies blunders feedback loops forward indication approach see also reversal convenience yield corporate bonds credit spreads CRP forward-looking indicators front-end trading IG bonds liquidity sample-specific valuation tactical forecasting correlation asset returns correlation premium correlation risk default correlations equities implied risk factors tail risks costs control currency carry enhancing returns taxes trading costs country-specific vulnerability indices covariance with “bad times” covariance risk risk factors covered call writing (CCW) crashes markets see also “bad times” credit default swaps (CDSs) credit-pricing models credit risk credit risk premium (CRP) analytical models attractive opportunities business cycles credit default swaps credit spreads decomposing credit spread default correlations emerging markets debt front-end trading historical excess returns IG bonds low ex post premia mortgage-backed securities non-government debt portfolio risk reduced-form credit-pricing models reward—risk single-name risk swap—Treasury spreads tactical forecasting terminology theory credit spreads AAA/AA/A-rated bonds BBB-rated bonds business cycles CRP cyclical effects decomposition empirical “horse races” forward-looking indicators high-yield bonds rolling yield top-rated bonds volatility yield-level dependence credit and tactical forecasting creditworthiness crises 2007—2008 crisis currency carry liquidity money markets see also “bad times” cross-asset selection forecasting models cross-sectional market relations cross-sectional trading CRP see credit risk premium CRRA see constant relative risk aversion CTAs see commodity trading advisors currency base of returns carry empirical “horse races” equity value strategies inflation see also foreign exchange currency carry baseline variants combining carry conditioners costs diversification emerging markets ex ante opportunity financial crashes foreign exchange historical returns hyperinflation indicators interpreting evidence maturities pairwise carry trading portfolio construction ranking models regime indicators seasonals selection biases strategy improvements “timing” the strategy trading horizons unwind episodes why strategies work cyclical effects credit spreads growth seasonal regularities see also business cycles D/P see dividend yield data mining see also overfitting; selection bias data sources of time series data series construction day-of-the-week effect DDM see dividend discount model debt supercycle default correlations, CDOs default rates, HY bonds deflation delta hedging demand see supply—demand demographics derivatives Dimson, Elroy direct hedge funds disagreement models discount rates discounted cash flows discretionary managers disinflation disposition effect distress diversification currency carry drawdown control long-horizon investors return risk factors style diversification return (DR) dividend discount model (DDM) equities ERP forward-looking indicators growth rate debates dividend growth dividend yield (D/P) DJCS HF index dollars base of returns cost averaging currency carry foreign exchange downgrading bias downside beta DR see diversification return drawdown control duration risk duration timing dynamic strategies equity value strategies portfolio construction risk factors E/P see earnings/price ratio earnings E/P ratio EPS equity returns forecasts growth rates yield see also earnings/price ratio earnings-per-share (EPS) earnings/price (E/P) ratio absolute valuation drivers forward-looking indicators measures choices relative valuation value measures economic growth see also growth efficiency behavioral finance macro-inefficiencies market inefficiency micro-inefficiencies efficient markets hypothesis (EMH) elephant and blind men poem (Saxe) EMBI indices emerging markets carry strategies currency carry debt equity returns future trends growth EMH see efficient markets hypothesis empirical multi-factor finance models endogenous return and risk feedback loops market timing research endowments energy sector commodity momentum trend following volatility selling enhancing returns costs horizon investors risk management skill EPS see earnings per share equilibrium accounting equilibrium model equities 1990—2009 business cycles carry strategies correlation premium empirical “horse races” forward-looking indicators inflation long history momentum sample-specific valuation tactical forecasting ten-year rolling averages value strategies see also stock . . .

Antti Ilmanen Bad Homburg, November 2010 Abbreviations and acronyms AM Arithmetic Mean ATM At The Money (option) AUM Assets Under Management BEI Break-Even Inflation BF Behavioral Finance B/P Book/Price, book-to-market ratio BRP Bond Risk Premium, term premium B-S Black–Scholes C-P BRP Cochrane–Piazzesi Bond Risk Premium CAPM Capital Asset Pricing Model CAY Consumption wealth ratio CB Central Bank CCW Covered Call Writing CDO Collateralized Debt Obligation CDS Credit Default Swap CF Cash Flow CFNAI Chicago Fed National Activity Index CFO Chief Financial Officer CMD Commodity (futures) CPIyoy Consumer Price Inflation year on year CRB Commodity Research Bureau CRP Credit Risk Premium (over Treasury bond) CRRA Constant Relative Risk Aversion CTA Commodity Trading Advisor DDM Dividend Discount Model DJ CS Dow Jones Credit Suisse DMS Dimson–Marsh–Staunton D/P Dividend/Price (ratio), dividend yield DR Diversification Return E( ) Expected (conditional expectation) EMH Efficient Markets Hypothesis E/P Earnings/Price ratio, earnings yield EPS Earnings Per Share ERP Equity Risk Premium ERPB Equity Risk Premium over Bond (Treasury) ERPC Equity Risk Premium over Cash (Treasury bill) F Forward price or futures price FF Fama–French FI Fixed Income FoF Fund of Funds FX Foreign eXchange G Growth rate GARCH Generalized AutoRegressive Conditional Heteroskedasticity GC General Collateral repo rate (money market interest rate) GDP Gross Domestic Product GM Geometric Mean, also compound annual return GP General Partner GSCI Goldman Sachs Commodity Index H Holding-period return HF Hedge Fund HFR Hedge Fund Research HML High Minus Low, a value measure, also VMG HNWI High Net Worth Individual HPA House Price Appreciation (rate) HY High Yield, speculative-rated debt IG Investment Grade (rated debt) ILLIQ Measure of a stock’s illiquidity: average absolute daily return over a month divided by dollar volume IPO Initial Public Offering IR Information Ratio IRP Inflation Risk Premium ISM Business confidence index ITM In The Money (option) JGB Japanese Government Bond K-W BRP Kim–Wright Bond Risk Premium LIBOR London InterBank Offered Rate, a popular bank deposit rate LP Limited Partner LSV Lakonishok–Shleifer–Vishny LtA Limits to Arbitrage LTCM Long-Term Capital Management MA Moving Average MBS (fixed rate, residential) Mortgage-Backed Securities MIT-CRE MIT Center for Real Estate MOM Equity MOMentum proxy MSCI Morgan Stanley Capital International MU Marginal Utility NBER National Bureau of Economic Research NCREIF National Council of Real Estate Investment Fiduciaries OAS Option-Adjusted (credit) Spread OTM Out of The Money (option) P Price P/B Price/Book (valuation ratio) P/E Price/Earnings (valuation ratio) PE Private Equity PEH Pure Expectations Hypothesis PT Prospect Theory r Excess return R Real (rate) RE Real Estate REITs Real Estate Investment Trusts RWH Random Walk Hypothesis S Spot price, spot rate SBRP Survey-based Bond Risk Premium SDF Stochastic Discount Factor SMB Small Minus Big, size premium proxy SR Sharpe Ratio SWF Sovereign Wealth Fund TED Treasury–Eurodollar (deposit) rate spread in money markets TIPS Treasury Inflation-Protected Securities, real bonds UIP Uncovered Interest Parity (hypothesis) VaR Value at Risk VC Venture Capital VIX A popular measure of the implied volatility of S&P 500 index options VMG Value Minus Growth, equity value premium proxy WDRA Wealth-Dependent Risk Aversion X Cash flow Y Yield YC Yield Curve (steepness), term spread YTM Yield To Maturity YTW Yield To Worst Disclaimer Antti Ilmanen is a Senior Portfolio Manager at Brevan Howard, one of Europe’s largest hedge fund managers.

 

pages: 358 words: 106,729

Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan

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accounting loophole / creative accounting, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, barriers to entry, Bernie Madoff, Bretton Woods, business climate, Clayton Christensen, clean water, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, diversification, Edward Glaeser, financial innovation, floating exchange rates, full employment, global supply chain, Goldman Sachs: Vampire Squid, illegal immigration, implied volatility, income inequality, index fund, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, knowledge worker, labor-force participation, Long Term Capital Management, market bubble, Martin Wolf, medical malpractice, microcredit, moral hazard, new economy, Northern Rock, offshore financial centre, open economy, price stability, profit motive, Real Time Gross Settlement, Richard Florida, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, school vouchers, short selling, sovereign wealth fund, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, upwardly mobile, Vanguard fund, women in the workforce, World Values Survey

As the Wall Street Journal reported in 2009 in an article on my Jackson Hole presentation: Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products, with potentially big payoffs, which could on occasion fail spectacularly. He pointed to “credit default swaps” which act as insurance against bond defaults. He said insurers and others were generating big returns selling these swaps with the appearance of taking on little risk, even though the pain could be immense if defaults actually occurred. Mr. Rajan also argued that because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk.

Much like a financial Venus flytrap, though, AAA mortgage-backed securities masked their risk with their ratings, and their attractive returns drew in many an investor innocent about finance and many more who should have known better. Among the firms that should have understood the risk better was the American International Group (AIG). Its now-infamous financial products unit (AIGFP) sold insurance through credit-default swaps on billions of dollars of asset-backed securities, including senior (AAA-rated) tranches of the mortgage-backed securities described above. It promised buyers of the swaps that if the insured securities defaulted, AIGFP would make good on them. The unit was thus betting that defaults would be far rarer even than the market anticipated. Privately, AIGFP executives said the swaps contracts were like selling insurance for catastrophic events that would never happen: they brought in money for nothing!

It started attracting and recruiting the smartest students in class, people who thought they could price CDO squared and CDO cubed (particularly egregious forms of securitization involving collateralized debt obligations) and manage their risks. As Trillin writes: “When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.”11 The suggestion that bosses, recruited in a staid and regulated era, were of lower caliber than the employees they had recruited from the top of the class in a deregulated and high-paying era is not completely without foundation. An intriguing study of the U.S. financial sector indicates that the earnings of corporate employees in the financial sector relative to employees in other sectors started climbing around 1980, as the sector was deregulated.12 Moreover, jobs became more complex in the financial sector, requiring significantly more mathematical aptitude.

 

pages: 274 words: 93,758

Phishing for Phools: The Economics of Manipulation and Deception by George A. Akerlof, Robert J. Shiller, Stanley B Resor Professor Of Economics Robert J Shiller

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Andrei Shleifer, asset-backed security, Bernie Madoff, Capital in the Twenty-First Century by Thomas Piketty, collapse of Lehman Brothers, Credit Default Swap, Daniel Kahneman / Amos Tversky, dark matter, David Brooks, en.wikipedia.org, endowment effect, equity premium, financial intermediation, full employment, George Akerlof, greed is good, income per capita, invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, Kenneth Rogoff, late fees, loss aversion, Menlo Park, mental accounting, Milgram experiment, moral hazard, new economy, payday loans, Ponzi scheme, profit motive, Ralph Nader, randomized controlled trial, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, Silicon Valley, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, theory of mind, Thorstein Veblen, too big to fail, transaction costs, Unsafe at Any Speed, Upton Sinclair, Vanguard fund, wage slave

There, we will see two further examples, from US financial history, of similar distortions. We will introduce the concept of financial “looting” of firms; how it can occur for profit; and, furthermore, how relatively small opportunities to loot for profit can bring huge risks into the financial system. Appendix: The Credit Default Swap Sideshow If you go to the circus, you and your children may find that their favorite exhibits—the best magic shows, and so on—are not in the big tent, but rather at the sideshows. Let’s now go to the Credit Default Swap Tent. REPUTATION MINING AND FINANCIAL CRISIS Akerlof.indb 37 37 6/19/15 10:24 AM In the Big Tent, which we have described, the banks had dis­ covered that they had the ability to make mortgages, and then as a form of alchemy, with the help of the ratings agencies, they could turn these mortgages into gold: by creating assets that were sufficiently complicated that the ratings agencies could, out of real—or pretended—ignorance, rate them highly.

REPUTATION MINING AND FINANCIAL CRISIS Akerlof.indb 37 37 6/19/15 10:24 AM In the Big Tent, which we have described, the banks had dis­ covered that they had the ability to make mortgages, and then as a form of alchemy, with the help of the ratings agencies, they could turn these mortgages into gold: by creating assets that were sufficiently complicated that the ratings agencies could, out of real—or pretended—ignorance, rate them highly. If the overall value of the derivative assets was more than what the banks loaned out to make the collection of mortgages, there was money on the table. The creation of this magic was boosted by the presence of a new form of derivative contract: credit default swaps (CDSs). Such a derivative can be devised for any asset with fixed payments, such as a bond or any mortgage-backed asset. In the event of a default, the owner of the swap is paid the face value of the asset; but then he surrenders it (i.e., he “swaps” it) to the seller. It’s a form of insurance. It’s as if in the case of a fire (analogous to a payment default), you got paid the insurance value of your house; but then gave what might be left of the house to the insurer.

It is truly remarkable that so few economists foresaw what would happen.2 There are about 2¼ million article and book listings regarding finance and economics on Google Scholar.3 That may not indicate enough economist-monkeys to randomly type Hamlet, but it should have been enough to generate quite a few papers that would tell how Countrywide, WaMu, 164 Akerlof.indb 164 EPILOGUE 6/19/15 10:24 AM IndyMac, Lehman, and many, many others would in short order flame out and crash. We should have known that their positions in mortgage-backed securities and credit default swaps were fragile. At the time we should have also foreseen the future vulnerabilities of the euro. We believe this huge lacuna tells us that economists (including those in finance) systematically ignore or downplay the role of trickery and deception in the working of markets. We have already put our finger on a simple reason why they were so ignored: economists’ understanding of markets systematically excludes them.

 

pages: 394 words: 85,734

The Global Minotaur by Yanis Varoufakis, Paul Mason

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banking crisis, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, business climate, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, declining real wages, deindustrialization, eurozone crisis, financial innovation, first-past-the-post, full employment, Hyman Minsky, industrial robot, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, Mexican peso crisis / tequila crisis, mortgage debt, new economy, Northern Rock, paper trading, planetary scale, post-oil, price stability, quantitative easing, reserve currency, rising living standards, Ronald Reagan, special economic zone, Steve Jobs, structural adjustment programs, systematic trading, too big to fail, trickle-down economics, urban renewal, War on Poverty, Yom Kippur War

To address the Credit Crunch – i.e. the complete halt in inter-bank lending. 2008 – The main event January – The World Bank predicts a global recession, stock markets crash, the Fed drops interest rates to 3.5 per cent, and stock markets rebound in response. Before long, however, MBIA, an insurance company, announces that it has lost $2.3 billion from policies based on bonds containing sub-prime mortgages. These insurance policies suddenly become household names: they are known as credit default swaps, or CDSs. Box 6.1 Credit default swaps (CDS) If Mr Spock, of Star Trek fame, spotted a CDS and had to describe it to Captain Kirk, he would have said, in his usual expressionless way: ‘They are insurance policies, Captain, but not as we know them.’ CDSs pay out pre-specified amounts of money if someone else defaults. The difference between a CDS and a simple insurance policy is this: to insure your car against an accident, you must first own it.

., 149, 156, 157 Byrnes, James, 68 capital, and the human will, 18–19 capitalism: dynamic system, 139–40; free market, 68; generation of crises, 34; global, 58, 72, 114, 115, 133; Greenspan and, 11–12; Marxism, 17–18; static system, 139; supposed cure for poverty, 41–2; surplus recycling mechanisms, 64–5 capitalists, origin of, 31 car production, 70, 103, 116, 157–8 carry trade, 189–90 Carter, Jimmy, 99, 100 CDOs (collateralized debt obligations), 141–2, 147–8, 149, 150, 153; for crops, 163; eurozone, 205; explanation, 6–9; France, 203; function, 130–2; Greece, 206 see also EFSF; Geithner–Summers Plan CDSs (credit default swaps), 149, 150, 153, 154, 176, 177 CEOs (chief executive officers), 46, 48, 49 Chamber of Commerce, British, 152 cheapness, ideology of, 124 Chiang Kai-shek, 76 Chicago Commodities Exchange, 120 Chicago Futures Exchange, 163 China: aggregate demand, 245; Crash of 2008, 156, 162; currency, 194, 213, 214, 217, 218, 252; economic development, 106–7; effects of the Crash of 2008, 3; financial support for the US, 216; global capital, 116; Global Plan, 76; growth, 92; rise and impact, 212–18, 219–20 Chrysler, 117, 159 CIA (Central Intelligence Agency), 69 Citigroup, 149, 156, 158 City of London: Anglo-Celtic model, 12; Crash of 2008, 148, 152; debt in relation to GDP, 4–5; financialization, 118–19; under Thatcher, 138; wealth of merchants, 28 civilization, 27, 29–30, 128 Clinton, Hillary, 212, 215–16 Cold War, 71, 80, 81, 86 collateralized debt obligations see CDOs commodification: resistance to, 53–4; rise of, 30, 33, 54; of seeds, 175 commodities: global, 27–8; human nature not, 53; labour as, 45, 49, 54; money as, 45, 49; prices, 96, 98, 102, 125; trading, 31, 175 common market, European, 195 communism, collapse of, 22, 107–8 complexity, and economic models, 139–40 Condorcet, Nicholas de Caritat, marquis de, 29, 32 Congress (US): bail-outs, 77, 153–4, 155; import tariff bill, 45 Connally, John, 94–5 council houses, selling off, 137, 138 Crash of 1907, 40 Crash of 1929, 38–43, 44, 181 Crash of 2008, 146–68; aftermath, 158–60; chronicle, 2007, 147–9; chronicle, 2008, 149, 151–8; credit default swaps, 150; effects, 2–3; epilogue, 164–8; explanations, 4–19; in Italy, 237; review, 160–4; in Spain, 237; warnings, 144–5 credit crunch, 149, 151 credit default swaps (CDSs), 149, 150, 153, 154, 176, 177 credit facilities, 127–8 credit rating agencies, 6–7, 8, 9, 20, 130 crises: as laboratories of the future, 28; nature of, 141; pre-1929, 40; pre-2008, 2; proneness to, 30; redemptive, 33–5, 35 currency unions, 60–1, 61–2, 65, 251 Cyprus, Britain’s role in, 69, 79 Daimler-Benz, 117 DaimlerChrysler, 117 Darling, Alistair, 159 Darwinian process, 167 Das Kapital (Marx), 49 de Gaulle, Charles, 76, 93 Debenhams, takeover of, 119 debt: and GDP, 4–5; unsecured, 128; US government, 92; US households, 161–2 see also CDOs; leverage debt–deflation cycle, 63 deficits: in the EU, 196; US budget, 22–3, 25, 112, 136, 182–3, 215–16; US trade, 22–3, 25, 111, 182–3, 196, 227 Deng Xiao Ping, 92, 212 Depressions: US 1873–8, 40; US Great Depression, 55, 58, 59, 80 deregulations, 138, 143, 170 derivatives, 120, 131–2, 174, 178 Deutschmark, 74, 96, 195, 197 Dexia, 154 distribution, and production, 30, 31, 54, 64 dollar: devaluing, 188; flooding markets, 92–3; pegging, 190; reliance on, 57, 60, 102; value of, 96, 204; zone, 62, 78, 89, 164 dotcom bubble, 2, 5 Draghi, Mario, 239 East Asia, 79, 143, 144, 194 see also Asia; specific countries East Germany, 201, 202 see also Germany Eastern Europe, 108, 198, 203 ECB (European Central Bank): aftermath of Crash of 2008, 158; bank bail-outs, 203, 204; Crash of 2008, 148, 149, 155, 156, 157; European banking crisis, 208, 209–10; Greek crisis, 207; LTRO, 238; Maastricht Treaty, 199–200; toxic theory, 15 economic models, 139–42 Economic Recovery Advisory Board (ERAB), 180, 181 Economic Report of the President (1999), 116 ECSC (European Coal and Steel Community), 74, 75–6 Edison, Thomas, 38–9 Efficient Market Hypothesis (EMH), 15 EFSF (European Financial Stability Facility), 174, 175–7, 207, 208–9 EIB (European Investment Bank), 210 Eisenhower, Dwight D., 82 Elizabeth II, Queen, 4, 5 ERAB (Economic Recovery Advisory Board), 180, 181 ERM (European Exchange Rate Mechanism), 197 EU (European Union): economies within, 196; EFSF, 174; European Financial Stability Mechanism, 174; financial support for the US, 216; origins, 73, 74, 75; SPV, 174 euro see eurozone eurobonds, toxic, 175–7 Europa myth, 201 Europe: aftermath of Crash of 2008, 162; bank bail-outs, 203–5; Crash of 2008, 2–3, 12–13, 183; end of Bretton Woods system, 95; eurozone problems, 165; Geithner–Summers Plan, 174–7; oil price rises, 98; unemployment, 164 see also specific countries European Central Bank see ECB European Coal and Steel Community (ECSC), 74, 75–6 European Commission, 157, 203, 204 European Common Market, 195 European Exchange Rate Mechanism (ERM), 197 European Financial Stability Facility (EFSF), 174, 207, 208–9 European Financial Stability Mechanism, 174, 175–7 European Investment Bank (EIB), 210 European Recovery Progam see Marshall Plan European Union see EU eurozone, 61, 62, 156, 164; crisis, 165, 174, 204, 208–9, 209–11; European banks’ exposure to, 203; formation of, 198, 202; France and, 198; Germany and, 198–201; and Greek crisis, 207 exchange rate system, Bretton Woods, 60, 63, 67 falsifiability, empirical test of, 221 Fannie Mae, 152, 166 Fed, the (Federal Reserve): aftermath of Crash of 2008, 159; Crash of 2008, 148, 149, 151, 153, 155, 156, 157; creation, 40; current problems, 164; Geithner–Summers Plan, 171–2, 173, 230; Greenspan and, 3, 10; interest rate policy, 99; sub-prime crisis, 147, 149; and toxic theory, 15 feudalism, 30, 31, 64 Fiat, 159 finance: as a pillar of industry, 31; role of, 35–8 Financial Crisis Inquiry Commission, 166 financialization, 30, 190, 222 First World War, Gold Standard suspension, 44 food: markets, 215; prices, 163 Ford, Henry, 39 formalist economic model, 139–40 Forrestal, James, 68 Fortis, 153 franc, value against dollar, 96 France: aid for banks, 157; colonialism criticized, 79; EU membership, 196; and the euro, 198; gold request, 94; Plaza Accord, 188; reindustrialization of Germany, 74; support for Dexia, 154 Freddie Mac, 152, 166 free market fundamentalism, 181, 182 French Revolution, 29 G7 group, 151 G20 group, 159, 163–4 Galbraith, John Kenneth, 73 GATT (General Agreement on Tariffs and Trade), 78 GDP (Gross Domestic Product): Britain, 4–5, 88, 158; eurozone, 199, 204; France, 88; Germany, 88, 88; Japan, 88, 88; US, 4, 72, 73, 87, 88, 88, 161; world, 88 Geithner–Summers Plan, 159, 169–83; in Europe, 174–7; results, 178–81; in the US, 169–74, 170, 230 Geithner, Timothy, 170, 173, 230 General Motors (GM), 131–2, 157–8, 160 General Theory (Keynes), 37 geopolitical power, 106–8 Germany: aftermath of the Second World War, 68, 73–4; competition with US, 98, 103; current importance, 251; and Europe, 195–8; and the eurozone, 198–201, 211; global capital, 115–16; Global Plan, 69, 70; Greek crisis, 206; house prices, 129; Marshall Plan, 73; reunification, 201–3; support for Hypo Real Estate, 155; trade surplus, 251; trade surpluses, 158 Giscard d’Estaing, Valery, 93 Glass–Steagall Act (1933), 10, 180 global balance, 22 global imbalances, 251–2 Global Plan: appraisal, 85–9; architects, 68; end of, 100–1, 182; geopolitical ideology, 79–82; Germany, 75; Marshall Plan, 74; origins, 67–71; real GDP per capita, 87; unravelling of, 90–4; US domestic policies, 82–5 global surplus recycing mechanism see GSRM global warming, 163 globalization, 12, 28, 125 GM (General Motors), 131–2, 157–8, 160 gold: prices, 96; rushes, 40; US reserves, 92–3 Gold Exchange Standard, collapse, 43–5 Goodwin, Richard, 34 Great Depression, 55, 58, 59, 80 Greece: currency, 205; debt crisis, 206–8 greed, Crash of 2008, 9–12 Greek Civil War, 71, 72, 79 Greenspan, Alan, 3, 10–11 Greenwald, Robert, 125–6 Gross Domestic Product see GDP GSRM (global surplus recycling mechanism), 62, 66, 85, 90, 109–10, 222, 223, 224, 248, 252–6 HBOS, 153, 156 Heath, Edward, 94 hedge funds, 147, 204; LTCM, 2, 13; toxic theory, 15 hedging, 120–1 history: consent as driving force, 29; Marx on, 178; as undemocratic, 28 Ho Chi Minh, 92 Holland, 79, 120, 155, 196, 204 home ownership, 12, 127–8; reposessions, 161 Homeownership Preservation Foundation, 161 Hoover, Herbert, 42–3, 44–5, 230 House Committee on Un-American Activities, 73 house prices, 12, 128–9, 129, 138; falling, 151, 152 human nature, 10, 11–12 humanity, in the workforce, 50–2, 54 Hypo Real Estate, 155 Ibn Khaldun, 33 IBRD (International Bank for Reconstruction and Development) see World Bank Iceland, 154, 155, 156, 203 ICU (International Currency Union) proposal, 60–1, 66, 90, 251 IMF (International Monetary Fund): burst bubbles, 190; cost of the credit crunch, 151; Crash of 2008, 155–6, 156, 159; demise of social services, 163; on economic growth, 159; European banking crisis, 208; G20 support for, 163–4; Greek crisis, 207; origins, 59; South East Asia, 192, 193; Third World debt crisis, 108; as a transnational institution, 253, 254 income: distribution, 64; national, 42; US national, 43 India: Britain’s stance criticized, 79; Crash of 2008, 163; suicides of farmers, 163 Indochina, and colonization, 79 Indonesia, 79, 191 industrialization: Britain, 5; Germany, 74–5; Japan, 89, 185–6; roots of, 27–8; South East Asia, 86 infinite regress, 47 interest rates: CDOs, 7; post-Global Plan, 99; prophecy paradox, 48; rises in, 107 International Bank for Reconstruction and Development (IBRD) see World Bank International Currency Union (ICU) proposal, 60–1, 66, 90, 253 International Labour Organisation, 159 International Monetary Fund see IMF Iran, Shah of, 97 Ireland: bankruptcy, 154, 156; EFSF, 175; nationalization of Anglo Irish Bank, 158 Irwin, John, 97 Japan: aftermath of the Second World War, 68–9; competition with the US, 98, 103; in decline, 186–91; end of Bretton Woods system, 95; financial support for the US, 216; global capital, 115–16; Global Plan, 69, 70, 76–8, 85–6; house prices, 129; labour costs, 105; new Marshall Plan, 77; Plaza Accord, 188; post-war, 185–91; post-war growth, 185–6; relations with the US, 187–8, 189; South East Asia, 91, 191–2; trade surpluses, 158 joblessness see unemployment Johnson, Lyndon B.: Great Society programmes, 83, 84, 92; Vietnam War, 92 JPMorgan Chase, 151, 153 keiretsu system, Japan, 186, 187, 188, 189, 191 Kennan, George, 68, 71 Kennedy, John F., New Frontier social programmes, 83, 84 Keynes, John Maynard: Bretton Woods conference, 59, 60, 62, 109; General Theory, 37; ICU proposal, 60, 66, 90, 109, 254, 255; influence on New Dealers, 81; on investment decisions, 48; on liquidity, 160–1; trade imbalances, 62–6 Keynsianism, 157 Kim Il Sung, 77 Kissinger, Henry, 94, 98, 106 Kohl, Helmut, 201 Korea, 91, 191, 192 Korean War, 77, 86 labour: as a commodity, 28; costs, 104–5, 104, 105, 106, 137; hired, 31, 45, 46, 53, 64; scarcity of, 34–5; value of, 50–2 labour markets, 12, 202 Labour Party (British), 69 labourers, 32 land: as a commodity, 28; enclosure, 64 Landesbanken, 203 Latin America: effect of China on, 215, 218; European banks’ exposure to, 203; financial crisis, 190 see also specific countries lead, prices, 96 Lebensraum, 67 Left-Right divide, 167 Lehman Brothers, 150, 152–3 leverage, 121–2 leveraging, 37 Liberal Democratic Party (Japan), 187 liberation movements, 79, 107 LIBOR (London Interbank Offered Rate), 148 liquidity traps, 157, 190 Lloyds TSB, 153, 156 loans: and CDOs, 7–8, 129–31; defaults on, 37 London School of Economics, 4, 66 Long-Term Capital Management (LTCM) hedge fund collapse, 13 LTCM (Long-Term Capital Management) hedge fund collapse, 2, 13 Luxembourg, support for Dexia, 154 Maastricht Treaty, 199–200, 202 MacArthur, Douglas, 70–1, 76, 77 machines, and humans, 50–2 Malaysia, 91, 191 Mao, Chairman, 76, 86, 91 Maresca, John, 106–7 Marjolin, Robert, 73 Marshall, George, 72 Marshall Plan, 71–4 Marx, Karl: and capitalism, 17–18, 19, 34; Das Kapital, 49; on history, 178 Marxism, 181, 182 Matrix, The (film), 50–2 MBIA, 149, 150 McCarthy, Senator Joseph, 73 mercantilism, in Germany, 251 merchant class, 27–8 Merkel, Angela, 158, 206 Merrill Lynch, 149, 153, 157 Merton, Robert, 13 Mexico: effect of China on, 214; peso crisis, 190 Middle East, oil, 69 MIE (military-industrial establishment), 82–3 migration, Crash of 2008, 3 military-industrial complex mechanism, 65, 81, 182 Ministry for International Trade and Industry (Japan), 78 Ministry of Finance (Japan), 187 Minotaur legend, 24–5, 25 Minsky, Hyman, 37 money markets, 45–6, 53, 153 moneylenders, 31, 32 mortgage backed securities (MBS) 232, 233, 234 NAFTA (North American Free Trade Agreement), 214 National Bureau of Economic Research (US), 157 National Economic Council (US), 3 national income see GDP National Security Council (US), 94 National Security Study Memorandum 200 (US), 106 nationalization: Anglo Irish Bank, 158; Bradford and Bingley, 154; Fortis, 153; Geithner–Summers Plan, 179; General Motors, 160; Icelandic banks, 154, 155; Northern Rock, 151 NATO (North Atlantic Treaty Organization), 76, 253 negative engineering, 110 negative equity 234 neoliberalism, 139, 142; and greed, 10 New Century Financial, 147 New Deal: beginnings, 45; Bretton Woods conference, 57–9; China, 76; Global Plan, 67–71, 68; Japan, 77; President Kennedy, 84; support for the Deutschmark, 74; transfer union, 65 New Dealers: corporate power, 81; criticism of European colonizers, 79 ‘new economy’, 5–6 New York stock exchange, 40, 158 Nietzsche, Friedrich, 19 Nixon, Richard, 94, 95–6 Nobel Prize for Economics, 13 North American Free Trade Agreement (NAFTA), 214 North Atlantic Treaty Organization (NATO), 76 North Korea see Korea Northern Rock, 148, 151 Obama administration, 164, 178 Obama, Barack, 158, 159, 169, 180, 230, 231 OECD (Organisation for Economic Co-operation and Development), 73 OEEC (Organisation for European Economic Co-operation), 73, 74 oil: global consumption, 160; imports, 102–3; prices, 96, 97–9 OPEC (Organization of the Petroleum Exporting Countries), 96, 97 paradox of success, 249 parallax challenge, 20–1 Paulson, Henry, 152, 154, 170 Paulson Plan, 154, 173 Penn Bank, 40 Pentagon, the, 73 Plaza Accord (1985), 188, 192, 213 Pompidou, Georges, 94, 95–6 pound sterling, devaluing, 93 poverty: capitalism as a supposed cure for, 41–2; in China, 162; reduction in the US, 84; reports on global, 125 predatory governance, 181 prey–predator dynamic, 33–5 prices, flexible, 40–1 private money, 147, 177; Geithner–Summers Plan, 178; toxic, 132–3, 136, 179 privatization, of surpluses, 29 probability, estimating, 13–14 production: cars, 70, 103, 116, 157–8; coal, 73, 75; costs, 96, 104; cuts in, 41; in Japan, 185–6; processes, 30, 31, 64; steel, 70, 75 production–distribution cycle, 54 property see real estate prophecy paradox, 46, 47, 53 psychology, mass, 14 public debt crisis, 205 quantitative easing, 164, 231–6 railway bubbles, 40 Rational Expectations Hypothesis (REH), 15–16 RBS (Royal Bank of Scotland), 6, 151, 156; takeover of ABN-Amro, 119–20 Reagan, Ronald, 10, 99, 133–5, 182–3 Real Business Cycle Theory (RBCT), 15, 16–17 real estate, bubbles, 8–9, 188, 190, 192–3 reason, deferring to expectation, 47 recession predictions, 152 recessions, US, 40, 157 recycling mechanisms, 200 regulation, of banking system, 10, 122 relabelling, 14 religion, organized, 27 renminbi (RMB), 213, 214, 217, 218, 253 rentiers, 165, 187, 188 representative agents, 140 Reserve Bank of Australia, 148 reserve currency status, 101–2 risk: capitalists and, 31; riskless, 5, 6–9, 14 Roach, Stephen, 145 Robbins, Lionel, 66 Roosevelt, Franklin D., 165; attitude towards Britain, 69; and bank regulation, 10; New Deal, 45, 58–9 Roosevelt, Theodore (‘Teddy’), 180 Royal Bank of Scotland (RBS), 6, 151, 156; takeover of ABN-Amro, 119–20 Rudd, Kevin, 212 Russia, financial crisis, 190 Saudi Arabia, oil prices, 98 Scandinavia, Gold Standard, 44 Scholes, Myron, 13 Schopenhauer, Arthur, 19 Schuman, Robert, 75 Schumpter, Joseph, 34 Second World War, 45, 55–6; aftermath, 87–8; effect on the US, 57–8 seeds, commodification of, 163 shares, in privatized companies, 137, 138 silver, prices, 96 simulated markets, 170 simulated prices, 170 Singapore, 91 single currencies, ICU, 60–1 slave trade, 28 SMEs (small and medium-sized enterprises), 186 social welfare, 12 solidarity (asabiyyah), 33–4 South East Asia, 91; financial crisis, 190, 191–5, 213; industrialization, 86, 87 South Korea see Korea sovereign debt crisis, 205 Soviet Union: Africa, 79; disintegration, 201; Marshall Plan, 72–3; Marxism, 181, 182; relations with the US, 71 SPV (Special Purpose Vehicle), 174 see also EFSF stagflation, 97 stagnation, 37 Stalin, Joseph, 72–3 steel production, in Germany, 70 Strauss-Kahn, Dominique, 60, 254, 255 Summers, Larry, 230 strikes, 40 sub-prime mortgages, 2, 5, 6, 130–1, 147, 149, 151, 166 success, paradox of, 33–5, 53 Suez Canal trauma, 69 Suharto, President of Indonesia, 97 Summers, Larry, 3, 132, 170, 173, 180 see also Geithner–Summers Plan supply and demand, 11 surpluses: under capitalism, 31–2; currency unions, 61; under feudalism, 30; generation in the EU, 196; manufacturing, 30; origin of, 26–7; privatization of, 29; recycling mechanisms, 64–5, 109–10 Sweden, Crash of 2008, 155 Sweezy, Paul, 73 Switzerland: Crash of 2008, 155; UBS, 148–9, 151 systemic failure, Crash of 2008, 17–19 Taiwan, 191, 192 Tea Party (US), 162, 230, 231, 281 technology, and globalization, 28 Thailand, 91 Thatcher, Margaret, 117–18, 136–7 Third World: Crash of 2008, 162; debt crisis, 108, 219; interest rate rises, 108; mineral wealth, 106; production of goods for Walmart, 125 tiger economies, 87 see also South East Asia Tillman Act (1907), 180 time, and economic models, 139–40 Time Warner, 117 tin, prices, 96 toxic theory, 13–17, 115, 133–9, 139–42 trade: balance of, 61, 62, 64–5; deficits (US), 111, 243; global, 27, 90; surpluses, 158 trades unions, 124, 137, 202 transfer unions, New Deal, 65 Treasury Bills (US), 7 Treaty of Rome, 237 Treaty of Versailles, 237 Treaty of Westphalia, 237 trickle-down, 115, 135 trickle-up, 135 Truman Doctrine, 71, 71–2, 77 Truman, Harry, 73 tsunami, effects of, 194 UBS, 148–9, 151 Ukraine, and the Crash of 2008, 156 UN Security Council, 253 unemployment: Britain, 160; Global Plan, 96–7; rate of, 14; US, 152, 158, 164 United States see US Unocal, 106 US economy, twin deficits, 22–3, 25 US government, and South East Asia, 192 US Mortgage Bankers Association, 161 US Supreme Court, 180 US Treasury, 153–4, 156, 157, 159; aftermath of the Crash of 2008, 160; Geithner–Summers Plan, 171–2, 173; bonds, 227 US Treasury Bills, 109 US (United States): aftermath of the Crash of 2008, 161–2; assets owned by foreign state institutions, 216; attitude towards oil price rises, 97–8; China, 213–14; corporate bond purchases, 228; as a creditor nation, 57; domestic policies during the Global Plan, 82–5; economy at present, 184; economy praised, 113–14; effects of the Crash of 2008, 2, 183; foreign-owned assets, 225; Greek Civil War, 71; labour costs, 105; Plaza Accord, 188; profit rates, 106; proposed invasion of Afghanistan, 106–7; role in the ECSC, 75; South East Asia, 192 value, costing, 50–1 VAT, reduced, 156 Venezuela, oil prices, 97 Vietnamese War, 86, 91–2 vital spaces, 192, 195, 196 Volcker, Paul: 2009 address to Wall Street, 122; demand for dollars, 102; and gold convertibility, 94; interest rate rises, 99; replaced by Greenspan, 10; warning of the Crash of 2008, 144–5; on the world economy, 22, 100–1, 139 Volcker Rule, 180–1 Wachowski, Larry and Andy, 50 wage share, 34–5 wages: British workers, 137; Japanese workers, 185; productivity, 104; prophecy paradox, 48; US workers, 124, 161 Wal-Mart: The High Cost of Low Price (documentary, Greenwald), 125–6 Wall Street: Anglo-Celtic model, 12; Crash of 2008, 11–12, 152; current importance, 251; Geithner–Summers Plan, 178; global profits, 23; misplaced confidence in, 41; private money, 136; profiting from sub-prime mortgages, 131; takeovers and mergers, 115–17, 115, 118–19; toxic theory, 15 Wallace, Harry, 72–3 Walmart, 115, 123–7, 126; current importance, 251 War of the Currents, 39 Washington Mutual, 153 weapons of mass destruction, 27 West Germany: labour costs, 105; Plaza Accord, 188 Westinghouse, George, 39 White, Harry Dexter, 59, 70, 109 Wikileaks, 212 wool, as a global commodity, 28 working class: in Britain, 136; development of, 28 working conditions, at Walmart, 124–5 World Bank, 253; origins, 59; recession prediction, 149; and South East Asia, 192 World Trade Organization, 78, 215 written word, 27 yen, value against dollar, 96, 188, 193–4 Yom Kippur War, 96 zombie banks, 190–1

A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data available ISBN 978 1 78032 646 7 Contents ABBREVIATIONS PREFACE TO THE NEW EDITION ACKNOWLEDGEMENTS 1 Introduction 2 Laboratories of the future 3 The Global Plan 4 The Global Minotaur 5 The beast’s handmaidens 6 Crash 7 The handmaidens strike back 8 The Minotaur’s global legacy: the dimming sun, the wounded tigers, a flighty Europa and an anxious dragon 9 A world without the Minotaur? POSTCRIPT TO THE NEW EDITION NOTES RECOMMENDED READING SELECT BIBLIOGRAPHY INDEX Abbreviations AC alternating current ACE aeronautic–computer–electronics complex AIG American Insurance Group ATM automated telling machine CDO collateralized debt obligation CDS credit default swap CEO chief executive officer DC direct current ECB European Central Bank ECSC European Coal and Steel Community EFSF European Financial Stability Facility EIB European Investment Bank EMH Efficient Market Hypothesis ERAB Economic Recovery Advisory Board EU European Union FDIC Federal Deposit Insurance Corporation GDP gross domestic product GM General Motors GSRM global surplus recycling mechanism IBRD International Bank for Reconstruction and Development ICU International Currency Union IMF International Monetary Fund LTCM Long-Term Capital Management (hedge fund) MIE military–industrial establishment NAFTA North American Free Trade Agreement NATO North Atlantic Treaty Organization OECD Organisation for Economic Co-operation and Development OEEC Organisation for European Economic Co-operation OMT outright monetary operations OPEC Organization of the Petroleum Exporting Countries RBCT Real Business Cycle Theory RBS Royal Bank of Scotland REH Rational Expectations Hypothesis RMB renminbi – Chinese currency SME small and medium-sized enterprise SPV Special Purpose Vehicle TARP Troubled Asset Relief Program For Danae Stratou, my global partner Preface to the new edition This book originally aimed at pressing a useful metaphor into the service of elucidating a troubled world; a world that could no longer be understood properly by means of the paradigms that dominated our thinking before the Crash of 2008.

 

pages: 261 words: 86,905

How to Speak Money: What the Money People Say--And What It Really Means by John Lanchester

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asset allocation, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Swan, blood diamonds, Bretton Woods, BRICs, Capital in the Twenty-First Century by Thomas Piketty, Celtic Tiger, central bank independence, collapse of Lehman Brothers, collective bargaining, credit crunch, Credit Default Swap, crony capitalism, Dava Sobel, David Graeber, disintermediation, double entry bookkeeping, en.wikipedia.org, estate planning, financial innovation, Flash crash, forward guidance, Gini coefficient, global reserve currency, high net worth, High speed trading, hindsight bias, income inequality, inflation targeting, interest rate swap, Isaac Newton, Jaron Lanier, joint-stock company, joint-stock limited liability company, Kodak vs Instagram, liquidity trap, London Interbank Offered Rate, London Whale, loss aversion, margin call, McJob, means of production, microcredit, money: store of value / unit of account / medium of exchange, moral hazard, neoliberal agenda, New Urbanism, Nick Leeson, Nikolai Kondratiev, Nixon shock, Northern Rock, offshore financial centre, oil shock, open economy, paradox of thrift, Plutocrats, plutocrats, Ponzi scheme, purchasing power parity, pushing on a string, quantitative easing, random walk, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, road to serfdom, Ronald Reagan, Satoshi Nakamoto, security theater, shareholder value, Silicon Valley, six sigma, South Sea Bubble, sovereign wealth fund, Steve Jobs, The Chicago School, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, trickle-down economics, Washington Consensus, working poor, yield curve

This is a major example of reversification at work. credit default swap (CDS) A financial instrument arising from interest rate swaps. The simplest way of looking at a CDS is as a form of insurance. If you are receiving interest from someone to whom you’ve lent money, you may start to wonder what happens if she starts to have trouble paying you. If you get worried, you might want to insure the interest you’re getting, so that in the event of a default by your borrower, you still get your money. That’s a credit default swap: you pay someone a fee to take on the risk of default, and in return, in the event of a default, she pays you the money you are owed. This might sound straightforward, but the picture is complicated by the fact that you can take out a credit default swap against loans you haven’t actually made.

This might sound straightforward, but the picture is complicated by the fact that you can take out a credit default swap against loans you haven’t actually made. That’s right: you can insure against the risk of a default not of your own loan, but of somebody else’s loan. That’s less like insurance and more like a form of gambling, since you’re basically betting on someone else’s debts. Credit default swaps of this sort played a big role in the credit crunch. currency wars Conflicts that happen when countries adopt “beggar thy neighbor” policies: they make their own currency cheap to bolster their own exports. Since the crisis of 2008 there have been accusations that China in particular has been carrying out a form of currency war—though the renminbi has risen sharply since 2011, and it’s not clear the charge still holds. Another country benefiting from an artificially weak currency is Germany, which has reason to be grateful to the weaker countries in the euro zone for keeping the value of the currency down, and hence making German exports more affordable.

That wouldn’t work for retail banking, where there is a strong social interest in keeping banks lending, but it might be a viable structure for investment banks, and would certainly make their risks more in line with their rewards. The British bank C. Hoare and Co. is unusual in being an unlimited liability bank, wholly owned by one family. London Whale The nickname of Bruno Iksil, the trader at J. P. Morgan’s London branch who was paid $7.32 million in 2010 and $6.76 million in 2011, and then in 2012 lost $6.2 billion betting on credit default swaps. The first response of Jamie Dimon, chairman and CEO of J. P. Morgan, was to describe the affair as “a tempest in a teacup,” until the scale of the losses became apparent. The thing that’s interesting about his nickname is that “whale” is a term from gambling: a whale is a punter who gets free hospitality from casinos because he (usually a he) bets such huge sums. According to the amazing Senate subcommittee report into the affair, by the time the bets went wrong, Iksil and his colleagues were out on the limb for $157 billion53—this nearly four years after the collapse of Lehman Brothers, when the lessons about excessive risk taking were supposed to have been learned.

 

pages: 297 words: 91,141

Market Sense and Nonsense by Jack D. Schwager

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asset allocation, Bernie Madoff, Brownian motion, collateralized debt obligation, commodity trading advisor, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index arbitrage, index fund, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, pattern recognition, performance metric, pets.com, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sharpe ratio, short selling, statistical arbitrage, statistical model, transaction costs, two-sided market, value at risk, yield curve

Given the extremely poor quality of the subprime mortgages that were the building blocks of these bonds (adjustable rates, no verification, etc.), these securities were extraordinarily vulnerable to any downturn in the housing market. So surely at the first sign of trouble in the housing market subprime bond prices should have fallen sharply below par. Figure 2.9 shows the prices of the ABX-HE-AAA index, an index of credit default swaps tied to 20 subprime-loan bonds rated AAA. (Credit default swaps are derivatives that mirror the risk premiums of the reference bonds.) Note that prices remained near par until early July 2007 when they went over a cliff. Figure 2.9 ABX-HE-AAA 07-1 Index, January to August 2007 Source: Markit.com. Did the real estate market suddenly worsen in early summer 2007, as one might infer from this price chart? Figure 2.10 shows that subprime delinquencies actually reached multiyear highs a year earlier and continued to climb steadily higher.

Frequently, accepted truths about investment prove to be unfounded assumptions when exposed to the harsh light of the facts. *Some of the text in the first two paragraphs has been adapted from Jack D. Schwager, Managed Trading: Myths & Truths (New York: John Wiley & Sons, 1996). 1Commodity trading advisor (CTA) is the official designation of regulated managers who trade the futures markets. 2Although the most widely used model to price mortgage-backed securitizations used credit default swaps (CDSs) rather than default rates as a proxy for default risk, CDS prices would have been heavily influenced by historical default rates that were based on irrelevant mortgage default data. PART ONE MARKETS, RETURN, AND RISK Chapter 1 Expert Advice Comedy Central versus CNBC On March 4, 2009, Jon Stewart, the host of The Daily Show, a satirical news program, lambasted CNBC for a string of poor prognostications.

This section has been excerpted from Jack Schwager, Hedge Fund Market Wizards (Hoboken, NJ: John Wiley & Sons, 2012). 2CDOs were a general type of securitization that were also built from many other types of instruments besides mortgage bonds, but these other constructions are not germane to this discussion. 3Although correlations for individual mortgages could also be significant during severe economic downturns, the degree of correlation would still not be nearly as extreme as the correlations between different BBB tranches. 4To be precise, the Gaussian copula formula, which was widely used to price CDOs, used credit default swaps (CDSs) on mortgage-backed securitizations (MBSs) as a proxy for default risk. However, CDS prices would have been heavily influenced by historical default rates that were based on irrelevant data. Moreover, the historical period for which CDS data existed was characterized by steadily rising housing prices and low default rates, thereby implying misleadingly low correlation among defaults in different securitizations and grossly understating the risk in CDOs, which were constructed by combining MBSs. 5Source for this section: see chapter, “The Curious Case of Palm and 3Com,” in Mastering Investment by James Pickford (Upper Saddle River, NJ: Financial Times Prentice Hall, 2002). 6The data on historical S&P daily percentage declines comes from Stock Market Volatility: Ten Years after the Crash, a 1997 study by G.

 

pages: 447 words: 104,258

Mathematics of the Financial Markets: Financial Instruments and Derivatives Modelling, Valuation and Risk Issues by Alain Ruttiens

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algorithmic trading, asset allocation, asset-backed security, backtesting, banking crisis, Black Swan, Black-Scholes formula, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, discrete time, diversification, fixed income, implied volatility, interest rate derivative, interest rate swap, margin call, market microstructure, martingale, p-value, passive investing, quantitative trading / quantitative finance, random walk, risk/return, Sharpe ratio, short selling, statistical model, stochastic process, stochastic volatility, time value of money, transaction costs, value at risk, volatility smile, Wiener process, yield curve, zero-coupon bond

This collateral secures that, in case of default, the protection seller can assume his role vis-à-vis the protection buyer (see product example). 13.1.5 Example of a credit derivative Before looking at credit derivative valuation properly said, let us present the most traded product, the credit default swap (CDS). The CDS is an OTC contract between two parties (at least one is a bank, active in credit derivatives), with a contractual maturity and notional amount, on a specific underlying risky bond (reference obligation): The “protection buyer” can be viewed as a hedger: he holds the bond and pays for being compensated in case of default on this bond; said payment is called “premium”; The “protection seller” receives a premium in exchange of supporting the default risk. If this occurs, under the “vanilla” form of the CDS, he pays 100% of the bond value, but receives the bond from the protection buyer. If no default occurs until the CDS maturity, nothing is paid by the seller, as illustrated in Figure 13.2. Figure 13.2 Diagram of a credit default swap The rationale for “indemnifying” 100% of the bond and its transfer to the indemnifying party is that at the time of a defaulted bond, its price is rather imprecise in the market, and subject to further erratic moves, given a strong lack of market liquidity during such a perturbation.

Exchanged cash flows can be assets cash flows originating from assets payments, in this case one talk about asset swaps, or cash flows originating from debts interest payments, hence the naming of liability swaps. If the whole set of exchanged cash flows involves a common single currency, the swap is called an interest rate swap (IRS). If the exchange of cash flows involves two currencies, one talks of currency rate swap (CRS) or cross currency rate swap (CCRS).2 A swap is an unconditional product: the exchange of cash flows cannot depend from any kind of condition. A contrario, credit default swaps and similar derivatives on a default risk are not swaps, strictly speaking, because there are conditional. We will look at these in Chapter 13. The market trades swaps on maturities from 2 to 30 years, 3 the peak of traded volumes being between 5 and 10 years. If one excludes some attempts to trade swaps on a derivative exchange (but up to now, the traded volumes are too tiny), the swap market is an OTC or interbank market, at least one of the counterparts being a bank.

The deterministic approach leads to the valuation of products such as vanilla swaps and futures, for which the forward value is obtained independently from the further evolution of their underlying instrument. The non-deterministic approach allows for taking into account a random evolution of the underlying spot instrument, which is necessarily the case for valuing products conditioned by such an evolution, that is, for options or any products presenting a conditional feature (for example, credit default swaps). The evolution of the prices or returns of a financial instrument is to be represented by a mathematical model describing, at best, how prices or returns behave. It is important to distinguish between a forecasting model and an ex post – or explanatory – model. Here, we consider only ex post models. In the most general case, a process can be either deterministic or stochastic, or combining both features.

 

pages: 559 words: 155,372

Chaos Monkeys: Obscene Fortune and Random Failure in Silicon Valley by Antonio Garcia Martinez

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Airbnb, airport security, Amazon Web Services, Burning Man, Celtic Tiger, centralized clearinghouse, cognitive dissonance, collective bargaining, corporate governance, Credit Default Swap, crowdsourcing, death of newspapers, El Camino Real, Elon Musk, Emanuel Derman, financial independence, global supply chain, Goldman Sachs: Vampire Squid, hive mind, income inequality, interest rate swap, intermodal, Jeff Bezos, Malcom McLean invented shipping containers, Mark Zuckerberg, Maui Hawaii, means of production, Menlo Park, minimum viable product, move fast and break things, Network effects, Paul Graham, performance metric, Peter Thiel, Ponzi scheme, pre–internet, Ralph Waldo Emerson, random walk, Sand Hill Road, Scientific racism, second-price auction, self-driving car, Silicon Valley, Silicon Valley startup, Skype, Snapchat, social graph, social web, Socratic dialogue, Steve Jobs, telemarketer, urban renewal, Y Combinator, éminence grise

While the underlying value of my writing skill will fluctuate within a relatively narrow band even if I’m successful, in the improbable event of literary immortality, that derivative can be worth very much indeed (or nothing at all). What’s a credit-default swap (CDS) then? A CDS is like car insurance, except it protects a pile of money someone has lent, rather than a pile of glass and steel called an automobile. Some asshole keys your car and destroys $500 of value; the insurance contract pays you that amount. The thing gets stolen? The policy pays out the total value of the car. Credit-default swaps work superficially the same way. You lend someone money in the form of a bond. They don’t pay you back, or pay you back only partially? The guy who sold you the CDS makes you whole again, and you recover what you lost by lending money.

They are on the wrong side of technological history; the real-time interaction of human desire with online capitalism is here to stay. Heck, even Wall Street has seen the light. Remember how we described a postcrisis Goldman considering but rejecting the notion of trading credit default swaps on exchanges, the inevitable evolution of that derivatives market? In 2013, Goldman finally partnered with the InterContinental Exchange (ICE), a pioneering electronic exchange trading everything from jet fuel to orange juice, to clear trades on European credit default swaps via ICE for Goldman’s clients. Perhaps Facebook will one day show itself to be as much of a leader and innovator as Goldman Sachs. What of Facebook’s great enemy, Google, and its encroaching social network copy Google Plus; Carthage must be destroyed!

To continue the car analogy, when an insurance company insures your jalopy, it doesn’t take into account the infinite combinations of features, car colors, wheel rims, postpurchase modifications, and dangling air fresheners. It knows the make, model, year, and location of the vehicle, and the value insured. That’s it. There are really only a few hundred types of car insurance when you break it down; likewise with credit-default swaps. So why not trade CDSs on exchanges, as we do shares of Google? The question was raised in 2008 as the financial world burned. The internal chatter on the desk was that the government would exploit the crisis to regulate our Wild West market. Goldman (briefly) considered taking the initiative and self-regulating into exchange-traded markets instead. It decided against doing so, with reasoning I’d see again at Facebook: an incumbent in a market dominated by a few, with total information asymmetry, and the ability to make prices on the market rather than just take them, has little incentive to increase transparency.

 

pages: 372 words: 107,587

The End of Growth: Adapting to Our New Economic Reality by Richard Heinberg

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3D printing, agricultural Revolution, back-to-the-land, banking crisis, banks create money, Bretton Woods, carbon footprint, Carmen Reinhart, clean water, cloud computing, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, David Graeber, David Ricardo: comparative advantage, dematerialisation, demographic dividend, Deng Xiaoping, Elliott wave, en.wikipedia.org, energy transition, falling living standards, financial deregulation, financial innovation, Fractional reserve banking, full employment, Gini coefficient, global village, happiness index / gross national happiness, I think there is a world market for maybe five computers, income inequality, invisible hand, Isaac Newton, Kenneth Rogoff, late fees, money: store of value / unit of account / medium of exchange, mortgage debt, naked short selling, Naomi Klein, Negawatt, new economy, Nixon shock, offshore financial centre, oil shale / tar sands, oil shock, peak oil, Ponzi scheme, post-oil, price stability, private military company, quantitative easing, reserve currency, ride hailing / ride sharing, Ronald Reagan, short selling, special drawing rights, The Wealth of Nations by Adam Smith, Thomas Malthus, Thorstein Veblen, too big to fail, trade liberalization, tulip mania, working poor

It’s true that many derivatives largely cancel each other out, and that their ostensible purpose is to reduce financial risk. Nevertheless, if a contract is settled, somebody has to pay — unless they can’t. Credit default swaps (CDSs, discussed in the last chapter) are usually traded “over the counter” — meaning without the knowledge of anyone other than the two counterparties; they are a sort of default insurance: a contract holder acts as “insurer” against default, bankruptcy, or other “credit event,” and collects regular “insurance” payments as premiums; this comes as “free money” to the “insurer.” But if default occurs, then a huge payment becomes due. Perversely, it is perfectly acceptable to take out a credit default swap on someone else’s debt. Here’s one example: In 2005, auto parts maker Delphi defaulted on $5.2 billion in outstanding bonds and loans — but over $20 billion in credit default derivative contracts had been written on those bonds and loans.

Paper currencies not backed by metal had sprung up from time to time, starting as early as the 13th century ce in China; by the late 20th century, they were the near-universal norm. Along with more abstract forms of currency, the past century has also seen the appearance and growth of ever more sophisticated investment instruments. Stocks, bonds, options, futures, long- and short-selling, credit default swaps, and more now enable investors to make (or lose) money on the movement of prices of real or imaginary properties and commodities, and to insure their bets — even their bets on other investors’ bets. Probably the most infamous investment scheme of all time was created by Charles Ponzi, an Italian immigrant to the US who, in 1919, began promising investors he could double their money within 90 days.

However, they have more recently attracted considerable controversy, as the total nominal value of outstanding derivatives contracts has grown to colossal proportions — in the hundreds of trillions of dollars globally, according to some estimates. Prior to the crash of 2008, investor Warren Buffett famously called derivatives “financial weapons of mass destruction,” and asserted that they constitute an enormous bubble. Indeed, during the 2008 crash, a subsidiary of the giant insurance company AIG lost more than $18 billion on a type of swap known as a credit default swap, or CDS (essentially an insurance arrangement in which the buyer pays a premium at periodic intervals in exchange for a contingent payment in the event that a third party defaults). Société Générale lost $7.2 billion in January of the same year on futures contracts. Often, mundane financial jargon conceals truly remarkable practices. Take the common terms long and short for example. If a trader is “long” on oil futures, for example, that means he or she is holding contracts to buy or sell a specified amount of oil at a specified future date at a price agreed today, in expectation of a rise in price.

 

pages: 304 words: 80,965

What They Do With Your Money: How the Financial System Fails Us, and How to Fix It by Stephen Davis, Jon Lukomnik, David Pitt-Watson

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Admiral Zheng, banking crisis, Basel III, Bernie Madoff, Black Swan, centralized clearinghouse, clean water, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, crowdsourcing, David Brooks, Dissolution of the Soviet Union, diversification, diversified portfolio, en.wikipedia.org, financial innovation, financial intermediation, Flash crash, income inequality, index fund, invisible hand, London Whale, Long Term Capital Management, moral hazard, Northern Rock, passive investing, performance metric, Ponzi scheme, principal–agent problem, rent-seeking, Ronald Coase, shareholder value, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, Steve Jobs, the market place, The Wealth of Nations by Adam Smith, transaction costs, Upton Sinclair, value at risk, WikiLeaks

If someone has to report every time they do something questionable, they will be far more hesitant to do it in the first place. How could regulators use information to improve the system? An overarching principle would be to ensure that there is maximum transparency in situations where the system might be abused. Here is one example. At present we have a huge market in securities known as credit default swaps (CDSs). These are effectively life insurance contracts on a company, which pay out if a company defaults on its debt. Like human life insurance, they can be useful for anyone—say, someone who had lent the company money—who would be in trouble should the company fail. But unlike life insurance, CDSs do not need the permission of the party whose life is being insured. No one knows who holds a CDS or even the exact size of the CDS market.

Deutsche, of course, managed that money for thousands, if not millions, of individuals and had a fiduciary obligation to them to vote the way it saw best for them, not necessarily what was best for Deutsche Bank. 49. Henry T. C. Hu and Bernard Black, “Equity and Debt Decoupling and Empty Voting II: Importance and Extensions,” University of Pennsylvania Law Review 156 (2008): 625–739. 50. The authors of this book have served on a number of creditor committees. On at least one occasion, we have thought that other “creditors” have hedged their positions using credit default swaps, a type of derivative. Our opinion is that their participation in the reorganization process was not helpful, as their economic interests were not in reorganizing the company. This sounds technical and like a matter only of interest to “vulture investors” (banks and hedge funds), but the company involved was Adelphia Communications, which was the fifth largest cable television company in the United States, employing thousands of people.

., 254n2 BrightScope, 122 Brokers, fiduciary duty and, 256n23 Brooks, David, 167 Buffett, Warren, 45, 63, 64, 80, 150, 221 Business judgment rule, 78–79 Business school curriculum, 190–92 Buy and Hold Is Dead (Again) (Solow), 65 Buy and Hold Is Dead (Kee), 65 Buycott, 118 Cadbury, Adrian, 227 Call option, 93 CalPERS, 91, 110, 111–12, 208, 221, 241n37 CalSTRS, 208 Canada, pension funds in, 59, 111, 209 Capital Aberto (magazine), 117 Capital gains, taxation of, 92 Capital Institute, 59, 87 Capital losses, 92 Capitalism: agency, 33, 74–80 defined, 243n2 Eastern European countries’ transition to, 167 financial system and, 9 injecting ownership back into, 83–93 private ownership and, 62 reforming, 11–12 Carbon Disclosure Project, 89 Career paths, new economic thinking and, 189–90 CDC. See Collective pension plans CDFIs. See Community Development Financial Institutions (CDFIs) CDSs. See Credit default swaps (CDSs) CEM Benchmarking, 54 Central banks, 20, 213 Centre for Policy Studies, 105 CEOs: performance metrics, 68, 86–87 short-term mindset among, 67–68. See also Executive compensation Ceres, 120 CFA Institute, 121 Chabris, Christopher, 174 Charles Schwab, 29, 31 Cheating, regulations and, 144–45 Chinese Academy of Social Sciences, 167 Citadel, 29 Citicorp, 76 Citizen investors/savers, 19 charter for, 227–31 communication between funds and, 110–11 dependence on others to manage money, 5–6, 19, 20 goals of, 48, 49 government regulation to safeguard, 107–9 lack of accountability to, 5–7, 96, 99–106 technology and, 90–92 trading platforms that protect, 88–89 City Bank of Glasgow, 257n34 Civil society organizations (CSOs), 153 corporate accountability and, 119–23 scrutiny of funds by, 224 “Civil Stewardship Leagues,” 122 Clark, Gordon L., 101, 106 Classical economics, 159–61 Clegg, Nick, 9 Clinton, Bill, 68–69 Clinton, Hillary Rodham, 119 Coase, Ronald, 169–70, 243n2, 261n31 Cohen, Lauren, 102 Coles Myer, 82 Collective Defined Contribution (CDC), 266n28 Collective pension plans, 263n1, 266n28 duration of liabilities, 264n3 in Netherlands, 197, 199, 209, 264n6.

 

pages: 741 words: 179,454

Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

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affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, financial independence, financial innovation, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, Kevin Kelly, labour market flexibility, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, merger arbitrage, Mikhail Gorbachev, Milgram experiment, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Naomi Klein, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, pets.com, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, Richard Thaler, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond

Synthetic Stuff In the 1990s, securitization underwent a makeover, being rebranded CDOs (collateralized debt obligations), a term subsuming various types of underlying loans and securitization formats. In 1997 JP Morgan introduced synthetic securitization, overcoming the unwieldy need to transfer the underlying loans to the SPV and also lowering the cost of transferring the risk. Instead of selling the loans, the lender now purchased credit insurance against the risk of loss using a credit default swap (CDS). The structure is shown in Figure 11.3. The bank purchased separate credit insurance policies from the SPV on each loan it wanted to transfer. As in a traditional ABS structure, the SPV issued securities. Instead of issuing securities equal to the face value of the loans insured, they issued a smaller amount—$80 million against an underlying portfolio of $1,000 million. The proceeds of the bonds were used to buy government bonds, such as U.S.

Assuming demand for $30 billion of mezzanine debt, this translated into up to $128 billion of underlying mortgages, compared to total subprime loans of around $450 billion in 2006, 28 percent of the total market.5 As other hedge funds and banks started doing the same thing, volumes exceeded the underlying stock of mortgage loans. The normal CDS was designed for companies where payment was triggered by bankruptcy or failure to make interest and principal repayments on loans. In June 2005, ABS PAYG CDS (asset-backed securities pay-as-you-go credit default swaps) were introduced. Under this form of credit insurance, buyers of insurance received payments where there was simply a permanent write down in the underlying loans, a downgrade to CCC credit rating or extension of maturity. Traders benefited from any deterioration in the quality of the underlying loans, making it easier to short the housing market. In 2006, the ABX.HE (asset-backed securities home equity), an index of MBSs similar to a stock index, was created.

The settlement revealed that Howard Sosin had received $182 million from AIG upon termination. Free Money Around 1997, banks began using synthetic securitization to get risk off their books to reduce capital needs. The structure created the low-risk super senior tranche that banks wanted to sell off. After JP Morgan introduced the idea, FP began selling credit insurance, in the form of credit default swaps (CDS). Under the contract, AIG received a fee from the bank. In return, FP agreed to insure the bank against the small risk of loss on the super senior tranche. By 2008, FP had insured around $450 billion of this risk. AIG’s AAA rating and ability to take these risks more cheaply than a regulated bank made FP the go-to house now for super senior risk. When FP entered into any contract on interest rates, currencies, equities, or commodities, it simultaneously entered into offsetting contracts to minimize its own risk.

 

pages: 349 words: 134,041

Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das

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accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mutually assured destruction, new economy, New Journalism, Nick Leeson, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk-adjusted returns, risk/return, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

Strippers Pearls of wisdom Own goals Taxing times Fund times 9 Credit where credit is due – fun with CDS and CDO Credit wars Credit epiphanies 242 245 246 248 249 250 253 254 257 260 262 265 266 267 DAS_A01.QXD 5/3/07 8:01 PM Page xii Contents xii First-to-credit derivatives Remote credit Mistaken identity Heard it on the grapevine Guaranteed delivery Re-re-re-re-restructuring – CDS stutters Beyond the push and pull Imitation and flattery Tranche warfare It’s super A capital idea The arbitrage age Hangovers UFOs Geeks with Greeks Never believe your own lies Russian dolls Black holes 269 271 274 276 277 279 281 282 285 287 289 290 291 292 293 295 297 298 Epilogue 301 The Asian century redux Vexatious litigation The more things change Hot tubbing Rogue trader Bangs and whimpers The China Club BOAT (Best of all time) Knowns and unknowns 302 305 308 310 313 316 317 318 319 Notes 321 Index 325 DAS_A01.QXD 5/3/07 8:01 PM Page xiii List of figures and tables Figure 1.1 Figure 1.2 Figure 1.3 Figure 1.4 Figure 1.5 Figure 6.1 Figure 7.1 Figure 7.2 Figure 9.1 Figure 9.2 Figure 9.3 Figure 9.4 Figure 9.5 Parallel loans 1981 World Bank – IBM currency swap Interest rate swap Inverse floater Leveraged inverse floater Share price and option values Asset swap Repackaging vehicle Credit default swap (CDS) Collateralized loan obligation (CLO) Synthetic securitization Fully funded CDO capital structure Synthetic CDO capital structure 35 36 37 46 50 196 231 232 272 283 285 286 288 Table 3.1 Table 3.2 Table 5.1 Table 6.1 Table 6.2 Table E.1 Investment styles Unique selling propositions Critical events 1987–2005 Expected share price in one year Option expected value Job description – rogue trader 111 118 165 191 192 313 DAS_A01.QXD 5/3/07 8:01 PM Page xiv Preface In March 1977, I began working in banking.

In 1995, Mexico experienced the Tequila crisis. In 1997, the Asian century was still- DAS_C02.QXP 8/7/06 4:22 PM Page 45 1 N Financial WMDs – derivatives demagoguery 45 born. In 1998, Russia defaulted. In 2001, Argentina completed its transition from first world to third world economy under the weight of debts that the country would never be able to service, let alone repay. Credit derivative products emerged. Credit default swaps and collateralized debt obligations (CDOs) allowed investors to take on credit risk. On schedule, in 2001, the CDO market collapsed, leaving the investors to nurse sizeable losses. In between, there were dalliances with gold, weather and catastrophe bonds that kept the markets busy. Forbidden fruit Back at the training programme, I generally finished my class for trainees by taking them through a structured product – an inverse floater, which I used to illustrate structured products.

Remote credit Credit derivatives did not enjoy immediate success and many of the original innovators were disappointed at the lack of growth, a lot left to do other things. It was only in the late 1990s that they took off. Suddenly, people talked of credit derivatives being larger than interest rate derivatives, the biggest part of the derivatives markets. The pioneers had been ahead of their time. The breakthrough was the credit default swap (CDS). The basic idea of a CDS is simple. Assume that a bank has made a loan to a client. The bank now wants to sell the risk on the loan; it has too much exposure to the client, industry or country. This is ‘concentration risk’, the opposite of diversification. Alternatively, the bank is worried – it knows something that makes it worry about whether it will get its money back. The reason doesn’t matter, the bank just wants to sell the credit risk on the loan.

 

pages: 515 words: 132,295

Makers and Takers: The Rise of Finance and the Fall of American Business by Rana Foroohar

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3D printing, accounting loophole / creative accounting, additive manufacturing, Airbnb, algorithmic trading, Asian financial crisis, asset allocation, bank run, Basel III, bonus culture, Bretton Woods, British Empire, call centre, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, centralized clearinghouse, clean water, collateralized debt obligation, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, crowdsourcing, David Graeber, deskilling, Detroit bankruptcy, diversification, Double Irish / Dutch Sandwich, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial deregulation, financial intermediation, Frederick Winslow Taylor, George Akerlof, gig economy, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, High speed trading, Home mortgage interest deduction, housing crisis, Howard Rheingold, Hyman Minsky, income inequality, index fund, interest rate derivative, interest rate swap, Internet of things, invisible hand, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, knowledge economy, labor-force participation, labour mobility, London Whale, Long Term Capital Management, manufacturing employment, market design, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, new economy, non-tariff barriers, offshore financial centre, oil shock, passive investing, pensions crisis, Ponzi scheme, principal–agent problem, quantitative easing, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, Rana Plaza, RAND corporation, random walk, rent control, Robert Shiller, Robert Shiller, Ronald Reagan, Second Machine Age, shareholder value, sharing economy, Silicon Valley, Silicon Valley startup, Snapchat, sovereign wealth fund, Steve Jobs, technology bubble, The Chicago School, The Spirit Level, The Wealth of Nations by Adam Smith, Tim Cook: Apple, Tobin tax, too big to fail, trickle-down economics, Tyler Cowen: Great Stagnation, Vanguard fund

But here’s a telling statistic on the credit default swaps, those risky securities that blew up the housing market: Back in 2008, their notional value was $67 trillion, while the market value of all the outstanding bonds issued by US companies underlying that market was only $15 trillion. When the value of what’s being traded is more than four times the underlying asset that actually exists in the real world, it’s safe to say that a good chunk of what’s happening in the market is purely speculative.44 While some portions of the derivatives markets, including credit default swaps, have contracted sharply since the 2008 crisis, the overall market remains enormous. Globally, the value of all outstanding derivatives contracts (including credit default swaps, interest rate derivatives, foreign exchange rate derivatives, commodities-linked derivatives, and so on) was $630 trillion at the beginning of 2015, while the gross market value of those contracts was $21 trillion.45 One big problem with derivatives is that it’s often difficult to tell apart speculation and healthy hedging of real risks, especially when large, complex institutions are doing it.

Airlines or trucking companies might need to “hedge” oil so that price increases don’t put them out of business. But by the 1990s, and much more so after 2000, derivatives began to explode and expand in a way that made it clear that at least some of what was being traded had nothing to do with protecting people or companies in the real economy, but was more about speculation—one could call it gambling—with an increasingly complex array of financial instruments, on things like interest rate swaps, credit default swaps, and even bets on what the weather would be like from day to day. Derivatives are best known to most people as the “financial weapons of mass destruction” that Warren Buffett has warned us about, the complex securities that blew up our financial system in 2008. These financial instruments—be they interest rate swaps, foreign exchange bets, or grain futures—have very real, very tangible impacts.

It was a catalyst for many big asset managers to start getting into the commodities space. Amazingly, nobody thought too much about the fact that those academics had been funded to do their research by AIG Financial Products, which was looking to expand the portion of its business that allowed investors to buy index-linked bundles of commodities.26 Of course, by 2008, AIG, which helped bring down the US and global economy with its enormous credit default swap bets, was in the news for bigger and more alarming reasons. Academics pushing paid-for research that made a potentially risky market segment look safe were a minor thing by comparison. In any case, the financialization of commodities had already begun to take off. Institutional investors poured into the market for natural resources; between 2004 and 2007, the number of commodities futures contracts outstanding in the world nearly doubled.

 

pages: 823 words: 206,070

The Making of Global Capitalism by Leo Panitch, Sam Gindin

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accounting loophole / creative accounting, airline deregulation, anti-communist, Asian financial crisis, asset-backed security, bank run, banking crisis, barriers to entry, Basel III, Big bang: deregulation of the City of London, bilateral investment treaty, Branko Milanovic, Bretton Woods, BRICs, British Empire, call centre, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collective bargaining, continuous integration, corporate governance, Credit Default Swap, crony capitalism, currency manipulation / currency intervention, currency peg, dark matter, Deng Xiaoping, disintermediation, ending welfare as we know it, eurozone crisis, facts on the ground, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, floating exchange rates, full employment, Gini coefficient, global value chain, guest worker program, Hyman Minsky, imperial preference, income inequality, inflation targeting, interchangeable parts, interest rate swap, Kenneth Rogoff, land reform, late capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, manufacturing employment, market bubble, market fundamentalism, Martin Wolf, means of production, money: store of value / unit of account / medium of exchange, Monroe Doctrine, moral hazard, mortgage debt, mortgage tax deduction, new economy, non-tariff barriers, Northern Rock, oil shock, precariat, price stability, quantitative easing, Ralph Nader, RAND corporation, regulatory arbitrage, reserve currency, risk tolerance, Ronald Reagan, seigniorage, shareholder value, short selling, Silicon Valley, sovereign wealth fund, special drawing rights, special economic zone, structural adjustment programs, The Chicago School, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, transcontinental railway, trickle-down economics, union organizing, very high income, Washington Consensus, Works Progress Administration, zero-coupon bond

But another catastrophe—at Lehman Brothers, whose banking business had begun with commodities-trading and brokerage operations in the 1850s—was not.45 When Geithner once again convened Wall Street CEOs, now in the depths of the greatest crisis they had ever seen, and urged them to arrange a private-sector bailout of Lehman, their fear of ending up with each other’s bad debts ruled out the kind of collective action they had agreed to a decade earlier with LTCM.46 As Lehman went bankrupt, and investors immediately questioned both the government’s commitment and organizational capacity to support the private institutional pillars of the financial system, Fed Chairman Bernanke came to the conclusion that twelve of the thirteen most important institutions in the United States “were at risk of failure within a period of a week or two.”47 What had to be faced most immediately was the imminent collapse of AIG, the world’s largest insurance company, which had provided so much credit-default-swap protection for the investment banks.48 The Federal Reserve had already gone well beyond the normal boundaries of its regulatory remit by extending help to investment banks, but it now ventured into even newer territory as it took responsibility for the survival of an insurance company whose commitments constituted a key pillar of the markets for securitized products and complex derivatives. By virtue of this bailout of AIG, which involved paying 100 percent of face value to AIG’s credit default swap counterparties, Goldman Sachs notoriously received almost $20 billion; but upwards of two-thirds of the payments to AIG counterparties actually went to foreign financial institutions, including some $17 billion to Société Générale, $15 billion to Deutsche Bank, $8.5 billion to Barclay’s, and $5.5 billion to UBS. 49 The Fed now fast-tracked applications by both Goldman Sachs and Morgan Stanley to be regulated as bank holding companies, thereby giving them permanent access to the Fed’s discount window.

The large US multinational commercial banks were also now fully engaged in what Gillian Tett has described as the “years of bold innovation that made high-risk trading and aggressive deal-making the gold standard of the Street [where] a ‘kill or be killed’ ethic prevailed.”61 She notes that, shortly after Salomon Brothers engineered the first major derivative bond swap between IBM and the World Bank in the early 1980s, J.P. Morgan used its City of London operations to circumvent the Glass-Steagall Act and allow its clients to take advantage of the explosion of derivatives markets. By the early 1990s, after also pioneering the development of credit default swaps, half of Morgan’s trading revenues came from derivatives contracts. But Morgan was only one of eight US banks that by then accounted for over 50 percent of interest-rate and currency swaps worldwide, as well as 90 percent of US bank derivatives activity; and there was a similar concentration of derivatives activity in the US investment banking sector.62 This concentration was closely related to the highly complex information and risk-management systems that were required to allow the risk on bonds with different interest-rate and currency structures to be traded without any bonds actually changing hands.

Following the recession of the early 1980s, these custom-made derivative products supplemented Wall Street’s fresh knack for tapping pension funds and rendering them into the loans that leveraged the corporate takeovers, mergers, and restructurings that Reagan’s tax allowances encouraged. The practice developed in the 1970s by the Bank of America, among others, of “slicing and dicing” mortgage loans and selling them to institutional investors, was applied to corporate bonds and loans in the 1980s, and to credit default swaps in the 1990s.64 What had initially led Wall Street’s investment banks to sell mortgage-backed instruments that “looked and tasted” like safe bonds was the desire to gain access to the large investor base represented by institutional investors such as pension funds and insurance companies: “If there was a master plan, it was to meet the needs of our institutional investor clients,” noted Laurence Fink, at the time Wall Street’s leading player in this arena.65 The 1970s had seen the introduction and tightening of minimum funding requirements for pension funds, while new tax breaks for individual contributions to retirement savings plans had launched a massive explosion of mutual funds.

 

pages: 348 words: 99,383

The Financial Crisis and the Free Market Cure: Why Pure Capitalism Is the World Economy's Only Hope by John A. Allison

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Affordable Care Act / Obamacare, bank run, banking crisis, Bernie Madoff, clean water, collateralized debt obligation, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, fiat currency, financial innovation, Fractional reserve banking, full employment, high net worth, housing crisis, invisible hand, life extension, low skilled workers, market bubble, market clearing, minimum wage unemployment, moral hazard, obamacare, price mechanism, price stability, profit maximization, quantitative easing, race to the bottom, reserve currency, risk/return, Robert Shiller, Robert Shiller, The Bell Curve by Richard Herrnstein and Charles Murray, too big to fail, transaction costs, yield curve

Of course, many of the B and C bonds had been sold to other financial institutions, which also suffered large earnings and capital losses. A substantial portion of the losses early in the financial crisis occurred in these bonds, not in direct real estate loans. Also, as discussed, this capital destruction was magnified by the leverage ratios of financial intermediaries, resulting in significant liquidity problems in the capital markets. Another important and obscure financial instrument is a credit default swap (CDS). A CDS is basically an insurance policy that is purchased to reduce the credit risk in a debt instrument. For example, Goldman Sachs has a $100 million B-rated bond backed by home mortgages. Goldman wants to hold the bond in its portfolio temporarily. However, based on the SEC capital guidelines, Goldman will need significantly less capital if the bond is A-rated. To accomplish this objective, Goldman purchases a CDS (an insurance policy against default) from AIG.

., and administration: action in financial panic, 161, 167 banking regulations, 133–136 economic proposals, 15 Patriot Act, 45, 46 regulation of Fannie Mae and Freddie Mac, 63 California, 21, 74, 90 CalPERS (California Public Employees’ Retirement System), 93, 116, 121, 131 Canada, 192 Capital: against GSE loans, 137 and leverage, 70–71 and loan loss reserves, 153 misinvestment of, 9–11, 14 wasting of, 159–160 Capital markets, 85–87, 101 Capital standards: for banks, 190 for loans, 51–52 and TARP, 170–171 Capitalism: crony, 6, 102, 129, 179 and freedom, 253–254 at universities, 231–233 Capitalism (Alan Greenspan), 32 Carter, Jimmy, 161, 179 Cash basis accounting, 110 Cash flows, 106–107, 115 Cato Institute, 201 CDOs (collateralized debt obligations), 124–126 CDSs (credit default swaps), 126–128 CEOs (Chief Executive Officers): behavior of, 2–3 decisions of Federal Reserve vs., 34 and rules-based accounting, 109 wage rates of, 210 China: currency standard, 77 demographics, 205 education, 230 GDP of U.S. vs., 183 government debt in, 200 manufacturing in, 10, 25–26, 161 market-based pricing in, 34 military spending in, 198 stimulus fund use, 181–182 trade with, 204–205 U.S. investment by, 29, 159 Chrysler, 130, 179–180 Citigroup: bailout of, 50, 104, 130, 177 CDOs of, 125–126 credit decisions, 238 crony capitalism, 6 funding of shadow banking system, 120 long-term debt of, 71 and panic during financial crisis, 163 pragmatism at, 217–218 reason at, 245 “too-big-to-fail” firms, 173 Clearing, 104 Clinton, Bill: lending reforms, 42–44, 56 subprime lending requirements, 58–60 Collateralized debt obligations (CDOs), 124–126 Colonial Bank, 47–48 Commercial real estate, 11, 97 Common good, 215–216 Community Reinvestment Act (CRA), 42, 55–57, 59 Compensation, 50, 83–84, 197–198 Confidence, 84–87, 184–185 Conservatives, 108 Consumer compliance, 193 Consumer Price Index (CPI), 26–27 Consumption: borrowing for, 57–58 housing as, 9–12, 54–55, 73–74 Contagion risk, 123 Corporate debt, 107 Counterparty risk, 123, 124 Countrywide: crony capitalism at, 6 and fair-value accounting change, 114, 118 and FDIC insurance, 39, 41, 46 necessary failure of, 159 pick-a-payment mortgages of, 91–93 subprime business at, 99 thrift history of, 98 CPI (see Consumer Price Index) CRA (see Community Reinvestment Act) Creativity, 7, 247 Credit default swaps (CDSs), 126–128 Credit rating agencies (see Rating agencies) Crony capitalism, 6, 102, 129, 179 Cross-guarantor insurance fund, 48–52 Cuba, 34, 247, 252 Cuomo, Andrew, 58 Currency, debasing, 22 Debt, 21–22, 107 Declaration of Independence, 220, 252 Defaults, 90–91, 126–128 Defense spending, 198–199, 227 Deflation, 22 Demand, supply and, 104, 185, 209, 210 Department of Housing and Urban Development (HUD), 15, 58 Deposits, disintermediation of, 120–121 Derivatives, 3, 120, 122–124 Disclosure requirements, 150–152 Dodd, Christopher, 7, 46, 61, 63, 64 Dodd-Frank Wall Street Reform and Consumer Protection Act: deficiencies of, 193 introduction of, 63–64, 183 as misregulation, 147 results of, 130 and TARP, 173, 174 Dollar, U.S., 77, 188, 229 Durbin amendment, 193 Earnings, operating, 103–106 East Germany, 34, 247 Eastern Europe, 34, 252 Economic cycles, 108, 189–193 Economic health, 159–161 Economic recovery, 1, 207–208 Economy, banking industry in, 67–69 Edison, Thomas, 19, 158–159 Education, 230–235, 247 Egypt, ancient, 230 Elitism, 7 Ely, Bert, 48 Employee Retirement Income Security Act (ERISA), 82, 149 Enron, 60, 109, 133, 149 Entitlement programs, reforms for, 199–204 Equal Credit Opportunity Act, 42, 55 ERISA (Employee Retirement Income Security Act), 82, 149 Ethical incentives, lending, 57–58 Euro, 189 European banking crisis, 51–52, 137 Expensing (stock options), 114–117 Experiential learners, 244–245 Fair Housing Act, 55 Fair-value accounting, 103–118 asset valuation in, 106–108 and expensing of stock options, 114–117 and losses on CDSs, 126–127 private accounting systems vs., 177–178 SEC involvement in, 151–152 for selling vs. servicing mortgages, 113–114 Fannie Mae: accounting scandal, 112–113, 149 in current environment, 251 and disintermediation of deposits, 121 failure of, 61–65, 164 and fair-value accounting, 118 in housing policy, 58–61 misallocation of resources by, 14 misleading of rating agencies by, 83 mortgage lending by, 97–101 reforms for, 190–192 selling mortgages to, 113–114 subprime lending by, 58, 99–101 FASB (see Financial Accounting Standards Board) FDIC (see Federal Deposit Insurance Corporation) FDIC insurance, 37–52 and bank liquidity, 171 and failing banks, 140 and fractional reserve banking, 68–69 and pick-a-payment mortgages, 91 reform of, 190 and S&L failures, 97 Federal Deposit Insurance Corporation (FDIC), 37–38 as external auditors, 134 and failing banks, 47–48 misallocation of resources by, 14 and pick-a-payment mortgages, 91 as regulator, 41–48, 143 take over of Washington Mutual, 75–77 Federal Housing Administration (FHA), 15, 190–192, 252 Federal Reserve, 22–23, 102, 189 antitrust policy, 174 bailouts by, 120–121, 190, 192 and banking industry reforms, 187–188 as external auditors, 134 and federal debt, 21–22 and leverage, 72 mathematical modeling by, 136 misallocation of resources by, 14, 208 misleading information from, 46, 83, 101, 125 monetary policy of, 17–20, 31–35, 96 overreaction by, 154 stimulus from, 152, 153, 208 and TARP, 165, 167–168, 171 and unemployment, 213 and Washington Mutual, 75 Federal Reserve Board, 18 Federal Reserve Open Market Committee, 31 Federal Savings and Loan Insurance Corporation (FSLIC), 37–38, 50, 96 FHA (see Federal Housing Administration) Financial Accounting Standards Board (FASB), 105, 106, 114–117 Financial crisis (2007-2009), 1–3, 251–254 banking industry in, 70–72 derivatives in, 122–124 Freddie Mac and Fannie Mae in, 65 free-market response to, 177–186 and Great Depression, 25 lessons from, 251–252 SEC role in, 154–155 Financial reporting requirements, SEC, 150–152 Financial Services Roundtable (FSR), 32, 61–62 First Horizon, 237 Fitch, John Knowles, 150 Fitch Ratings: investor confidence in, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Flat tax, 197 Forbes, Steve, 197 Ford, 179 Foreclosure laws, 77–80 Fractional reserve banking, 69–70 Frank, Barney, 7, 61, 63, 64 Fraud, 109–113 Freddie Mac: accounting scandal, 112–113, 149 current environment, 251 and disintermediation of deposits, 121 failure of, 61–65, 164 in housing policy, 58–61 misallocation of resources by, 14 misleading information from, 83 mortgage lending by, 97–101 reforms for, 190–192 selling mortgages to, 113–114 subprime lending by, 58, 99–101 Free markets: experimentation in, 19 justice in, 92, 177 market corrections in, 157–159 and monetary policy, 31–35 risk taking by banks in, 40–41 wage rates in, 210–211 Free trade, 204–205 Friedman, Milton, 20, 189 FSLIC (see Federal Savings and Loan Insurance Corporation) FSR (Financial Services Roundtable), 32, 61–62 GAAP accounting, 116, 117 Gates, Bill, 216 GDP, 183, 197–199 General Electric, 168, 169 General Motors (GM), 169, 178–180 General Theory of Employment, Interest and Money, The (Keynes), 181 Germany, 52 GM (General Motors), 169, 178–180 GMAC, 168, 169, 178–180 Gold standard: and deflation, 25–26 and economic future of U.S., 188–189 Greenspan’s view of, 32 Golden West, 39, 91, 92, 98, 159 Goldman Sachs, 71, 173 as AIG counterparty, 128–129 bailout of, 104, 164, 179 CDSs of, 126 counterparty risk at, 124 crony capitalism at, 6 financial “innovations” of, 101 Government policy: as cause of financial crisis, 1, 5–6, 251 and residential real estate bubble, 6 (See also Housing policy; Policy reforms) Government regulation, 5–8, 41–48, 204 Government spending, 180–183, 197–199 Government-sponsored enterprises (GSEs), 59, 64–65, 98, 137 (See also Fannie Mae; Freddie Mac) Great Depression: and avoidance of stock market, 74 banking industry in, 70–72 economic policies after, 161 and Federal Reserve, 19–20, 24, 188 and gold standard, 188 and government interference, 170 and Smoot-Hawley Tariff Act, 205 Great Recession, 1, 251–254 and Federal Reserve, 188 Freddie Mac and Fannie Mae in, 65 and interest-rate variation, 33 market corrections and depth of, 160 and monetary policy, 17 and residential real estate, 9–15 Great Society, 6, 55, 96 Greece, 51, 52, 137, 228 Greenspan, Alan, 23–30, 32, 33, 160 Gross domestic product, 183, 197–199 Hamilton, Alexander, 19 Harvard University, 43, 131 Hayek, Friedrich, 31 Health insurance, 201–202 High-net-worth shareholders, 93 Home Builders Association, 60 Home foreclosure laws, 77–80 Homeownership, 53–55 Hoover, Herbert, 24, 161, 205 Housing: as consumption, 9–12, 54–55, 73–74 government support of, 12 Housing policy, 53–65 HUD (Department of Housing and Urban Development), 15, 58 Human Action (von Mises), 238 Immigration, 19, 205–206 India, 10, 25, 205 IndyMac, 39, 75, 98 Inflation: CPI as indicator of, 26–27 and fair-value accounting, 103 and Federal Reserve, 21–22 and prices, 24–25 (See also Monetary policy) Initial public offerings, 150 Insurance: bond, 86–87 cross-guarantor, 48–52 FDIC (see FDIC insurance) health, 201–202 private deposit, 48–52 self-insurance at banks, 48–52 unemployment, 212–213 Interest rates, 26–27, 31–35 Inverted yield curves, 27–29 Investment banks: disclosure requirements for, 151 government bailout of, 162 “innovations” of, 101–102 leverage ratios of, 71–72 IPOs, 150 Iran, 198, 199, 227 Iraq, 198 Ireland, 77 Isaac, Bill, 107–108, 161–162 Italy, 51, 52 Japan, 159, 200, 205 Jefferson, Thomas, 19, 220 Johnson, Lyndon Baines, 6, 55, 96, 161, 188 JPMorgan Chase, 75 and Bear Stearns, 162 and shadow banking system, 120 as “too-big-to-fail” firm, 173 and Washington Mutual, 163 Keynes, John Maynard, 181 Labor: allocation of, 10–11, 14 minimum-wage laws, 209–212 Lehman Brothers, 71, 76, 101, 104, 129, 164 and Bear Stearns bailout, 162–163 corporate debt at, 107 counterparty risk at, 124 derivatives from, 123 Limited government, 182–183, 195, 231, 253 Liquidity: of banks, 68–69 and FDIC insurance, 171 and financial crises, 70–72 and housing prices, 74–75 and TARP, 171–172 Loan loss reserves accounting, 152–154 Loans: capital standards for, 51–52 qualified, 98 substandard, 140–141 Madoff, Bernie, 149, 225 March of Dimes, 241 Market corrections, 157–165 Federal Reserve’s prevention of, 23, 32 prevention of, 13 residential real estate, 78 and response to financial crisis, 177–180 Market discipline, 21, 38 Market-based monetary policy, 31–35 Market-clearing price, 209 Mathematical modeling: for loan loss reserves, 152–153 by ratings agencies, 82–83 for risk management, 136–138 MBIA, 86 Medicaid, 6, 55, 201 Medicare, 6, 8, 55, 201, 203 Meltdown (Michaels), 35 Merrill Lynch, 101, 124–125 Michaels, Patrick J., 35 Microsoft, 217 Military spending, 198–199, 227 Minimum-wage laws, 209–212 Mises, Ludwig von, 34, 238 Monetary policy, 17–35 of Bernanke, 27–31, 33, 35, 40, 125, 213 and federal debt, 21–22 and Federal Reserve, 17–23 of Greenspan, 23–27 market-based, 31–35 and unemployment, 208–209 Money market mutual funds, bailout of, 120–121, 192 Money supply, 21–22, 24, 189 Moody, John, 83, 150 Moody’s, 81–87 investor confidence in, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Morgan Stanley, 71, 101, 124, 173 Mortgage lending, 95–102 by Fannie Mae and Freddie Mac, 97–101 and investment bank innovations, 101–102 prime, 59, 97–99 by private banks, 97–99 savings and loan industry in, 95–97 subprime, 43, 56–57, 99–101 Mortgages: by BB&T Corporation, 97–98 jumbo, 62 pick-a-payment (see Pick-a-payment mortgages) selling vs. servicing, 113–114 Mozilo, Angelo, 46 Multiplier effect, 181 Naked shorting, 127–128, 151 Nationally recognized statistical rating organizations, 82 Negative real interest rates, 26–27 Neo-Keynesian response to financial crisis, 185–186 Neutral taxes, 197 New Deal, 53, 170, 232 Nixon, Richard, 96, 161, 188 North Korea, 34, 198, 227, 247, 252 NRSROs, 82 Obama administration, 142–144: and Dodd-Frank Act, 64 economic policies of, 15, 161 healthcare bill, 183, 201 and Patriot Act, 45 stimulus plan, 181–182 Office of the Comptroller of the Currency (OCC), 40, 154 Office of Thrift Supervision, 40, 41, 45–46 Operating earnings, 103–106 OTS, 40, 41, 45–46 Panics, 137–138, 161–165 Patriot Act, 45, 46, 48, 133–136, 147 Paulson, Henry: in 2008 panic, 164, 167 and AIG bailout, 128, 129 credibility of, 164 development of TARP, 76, 168–170, 172 Pick-a-payment mortgages, 89–93 borrowers using, 90–91 and FDIC, 91 and rise of Fannie Mae/Freddie Mac, 98 Policy reforms, 195–206 for entitlement programs, 199–204 and free trade, 204–205 and government regulations, 204 for government spending, 197–199 for immigration, 205–206 for political system, 206–207 and tax rate, 196–197 Politics: in banking regulation, 42–46 and crony capitalism, 129 and failure of Fannie Mae/Freddie Mac, 59–62 and Federal Reserve appointments, 18 policy reforms for, 206–207 Poor, Henry Varnum, 150 Portugal, 51 Price fixing, 31, 193 Price setting, 31–32 Prime lending, 59, 97–99 Prince, Charlie, 217 Principles-based accounting, 109 Privacy Act, 133, 135 Private accounting systems, 177–178 Private banks, 97–99, 187–188 Private deposit insurance, 48–52 Public schools, 228, 233–235 Racial discrimination (in lending), 42–45 Raines, Frank, 59 Rand, Ayn, 225, 231 Rating agencies, 81–87 investor confidence in, 84–87 mathematical modeling by, 136 and subprime mortgage bonds, 82–84 and “too-big-to-fail” firms, 173 and SEC, 81–82, 149–150 Real estate: commercial, 11, 97 residential (see Residential real estate market) Recessions, 28, 29, 160 Recovery (see Economic recovery) Reforms: banking industry (see Banking industry reforms) government policy (see Policy reforms) Regions Bank, 237 Regulation: of banking industry (see Banking regulation) by government (see Government regulation) Reporting, financial, 150–152 Reserve currency, U.S. dollar as, 77, 188, 229 Residential real estate market: economics of, 73–74 misinvestment in, 9–15 Residential real estate market bubble, 73–80 and government policy, 6 international impact of, 77 and job creation, 80 and state home foreclosure laws, 77–80 Risk: contagion, 123 counterparty, 123, 124 with derivatives, 122–124 diversification of, 67–69 and economic cycles, 189–193 and FDIC insurance, 38–41 and government regulation, 50–51 liquidity, 68–70 mathematical modeling for, 136–138 and “originate and sell” model, 100 systemic, 50–51 RMBS (residential mortgage-backed securities), 81 Roman empire, fall of, 230 Roosevelt, Franklin D., 24, 37, 103, 161 Rules-based accounting, 109 Russia, 198 Samuelson, Paul, 238 Sarbanes-Oxley Act, 133–134 and fair-value accounting, 106 and Fannie Mae/Freddie Mac, 99 misregulation by, 48, 147 and SEC, 150 violations of, 136 SARs (Suspicious Activity Reports), 136 Satchwell, Jack, 57 Savings and loan (S&L) industry, 95–97, 110, 191 Securities and Exchange Commission (SEC), 149–155 capital ratio guidelines, 71–72 and complexity of accounting rules, 116–117 and expensing of stock options, 114, 115 loan loss reserves accounting for, 152–154 misallocation of resources by, 14 and rating agencies, 81–82, 149–150 requirements for shorting stock, 127–128, 151 and rules-based accounting, 109, 110 and Sarbanes-Oxley Act, 150 Self-insurance, 48–52 Selgin, George, 189 Senate Banking Committee, 46 Shadow banking system, 119–131 and AIG bailout, 128–130 credit default swaps in, 126–128 and derivatives, 122–124 Federal Reserve’s role in, 30 losses from, 131 S&L industry, 95–97, 110, 191 Small businesses, 144–147, 183–184 Smoot-Hawley Tariff Act, 205 Social Security, 8, 199–204 South Financial, 237 South Korea, 247 Soviet Union, 34, 195–196, 252, 254 S&P (see Standard & Poor’s) Spain, 51, 52, 77 Spitzer, Eliot, 71, 134–135, 151 Stagflation, 181, 208 Standard & Poor’s (S&P), 81–87 investor confidence, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Standard of living, 6–7, 10, 161, 177 Start-up banks, 38–39 State home foreclosure laws, 77–80 Stimulus plan, 181–182 Stock options, expensing of, 114–117 Stocks, shorting, 127–128, 151 Stress tests, banks, 171 Subprime lending: and CRA, 56–57 by Fannie Mae and Freddie Mac, 99–101 and racial discrimination in lending study, 43 Subprime mortgage bonds, 82–87 Substandard loans, 140–141 SunTrust, 152, 237 Suspicious Activity Reports (SARs), 136 Tails (mathematical models), 137 TARP (see Troubled Asset Relief Program) Tax rate, 196–197 Tea Party Movement, 218, 231 Technology industry, 5 “Too-big-to-fail” firms, 130, 173, 193 Trader principle, 92, 223–224 Troubled Asset Relief Program (TARP), 167–175 and 2008 panic, 165 and FDIC, 37 Underwriters Laboratories, 117, 150 Unemployment, 207–213 in economic recovery, 207–208 and minimum-wage laws, 209–212 and misinvestment in residential real estate, 10–11 and monetary policy, 208–209 Unemployment insurance, 212–213 Unions, 179, 180, 212 United Auto Workers, 179, 180 United States: demographic problem in, 228 economic future of, 8, 227–230, 252–253 educational system of, 230–235 founding concepts of, 219–220 as free trade zone, 204–205 GDP of China vs., 183 mixed economy of, 5–6 public schools of, 233–235 university system of, 230–233 United Way, 224, 241 University system, 230–233 U.S.

., 183 government debt in, 200 manufacturing in, 10, 25–26, 161 market-based pricing in, 34 military spending in, 198 stimulus fund use, 181–182 trade with, 204–205 U.S. investment by, 29, 159 Chrysler, 130, 179–180 Citigroup: bailout of, 50, 104, 130, 177 CDOs of, 125–126 credit decisions, 238 crony capitalism, 6 funding of shadow banking system, 120 long-term debt of, 71 and panic during financial crisis, 163 pragmatism at, 217–218 reason at, 245 “too-big-to-fail” firms, 173 Clearing, 104 Clinton, Bill: lending reforms, 42–44, 56 subprime lending requirements, 58–60 Collateralized debt obligations (CDOs), 124–126 Colonial Bank, 47–48 Commercial real estate, 11, 97 Common good, 215–216 Community Reinvestment Act (CRA), 42, 55–57, 59 Compensation, 50, 83–84, 197–198 Confidence, 84–87, 184–185 Conservatives, 108 Consumer compliance, 193 Consumer Price Index (CPI), 26–27 Consumption: borrowing for, 57–58 housing as, 9–12, 54–55, 73–74 Contagion risk, 123 Corporate debt, 107 Counterparty risk, 123, 124 Countrywide: crony capitalism at, 6 and fair-value accounting change, 114, 118 and FDIC insurance, 39, 41, 46 necessary failure of, 159 pick-a-payment mortgages of, 91–93 subprime business at, 99 thrift history of, 98 CPI (see Consumer Price Index) CRA (see Community Reinvestment Act) Creativity, 7, 247 Credit default swaps (CDSs), 126–128 Credit rating agencies (see Rating agencies) Crony capitalism, 6, 102, 129, 179 Cross-guarantor insurance fund, 48–52 Cuba, 34, 247, 252 Cuomo, Andrew, 58 Currency, debasing, 22 Debt, 21–22, 107 Declaration of Independence, 220, 252 Defaults, 90–91, 126–128 Defense spending, 198–199, 227 Deflation, 22 Demand, supply and, 104, 185, 209, 210 Department of Housing and Urban Development (HUD), 15, 58 Deposits, disintermediation of, 120–121 Derivatives, 3, 120, 122–124 Disclosure requirements, 150–152 Dodd, Christopher, 7, 46, 61, 63, 64 Dodd-Frank Wall Street Reform and Consumer Protection Act: deficiencies of, 193 introduction of, 63–64, 183 as misregulation, 147 results of, 130 and TARP, 173, 174 Dollar, U.S., 77, 188, 229 Durbin amendment, 193 Earnings, operating, 103–106 East Germany, 34, 247 Eastern Europe, 34, 252 Economic cycles, 108, 189–193 Economic health, 159–161 Economic recovery, 1, 207–208 Economy, banking industry in, 67–69 Edison, Thomas, 19, 158–159 Education, 230–235, 247 Egypt, ancient, 230 Elitism, 7 Ely, Bert, 48 Employee Retirement Income Security Act (ERISA), 82, 149 Enron, 60, 109, 133, 149 Entitlement programs, reforms for, 199–204 Equal Credit Opportunity Act, 42, 55 ERISA (Employee Retirement Income Security Act), 82, 149 Ethical incentives, lending, 57–58 Euro, 189 European banking crisis, 51–52, 137 Expensing (stock options), 114–117 Experiential learners, 244–245 Fair Housing Act, 55 Fair-value accounting, 103–118 asset valuation in, 106–108 and expensing of stock options, 114–117 and losses on CDSs, 126–127 private accounting systems vs., 177–178 SEC involvement in, 151–152 for selling vs. servicing mortgages, 113–114 Fannie Mae: accounting scandal, 112–113, 149 in current environment, 251 and disintermediation of deposits, 121 failure of, 61–65, 164 and fair-value accounting, 118 in housing policy, 58–61 misallocation of resources by, 14 misleading of rating agencies by, 83 mortgage lending by, 97–101 reforms for, 190–192 selling mortgages to, 113–114 subprime lending by, 58, 99–101 FASB (see Financial Accounting Standards Board) FDIC (see Federal Deposit Insurance Corporation) FDIC insurance, 37–52 and bank liquidity, 171 and failing banks, 140 and fractional reserve banking, 68–69 and pick-a-payment mortgages, 91 reform of, 190 and S&L failures, 97 Federal Deposit Insurance Corporation (FDIC), 37–38 as external auditors, 134 and failing banks, 47–48 misallocation of resources by, 14 and pick-a-payment mortgages, 91 as regulator, 41–48, 143 take over of Washington Mutual, 75–77 Federal Housing Administration (FHA), 15, 190–192, 252 Federal Reserve, 22–23, 102, 189 antitrust policy, 174 bailouts by, 120–121, 190, 192 and banking industry reforms, 187–188 as external auditors, 134 and federal debt, 21–22 and leverage, 72 mathematical modeling by, 136 misallocation of resources by, 14, 208 misleading information from, 46, 83, 101, 125 monetary policy of, 17–20, 31–35, 96 overreaction by, 154 stimulus from, 152, 153, 208 and TARP, 165, 167–168, 171 and unemployment, 213 and Washington Mutual, 75 Federal Reserve Board, 18 Federal Reserve Open Market Committee, 31 Federal Savings and Loan Insurance Corporation (FSLIC), 37–38, 50, 96 FHA (see Federal Housing Administration) Financial Accounting Standards Board (FASB), 105, 106, 114–117 Financial crisis (2007-2009), 1–3, 251–254 banking industry in, 70–72 derivatives in, 122–124 Freddie Mac and Fannie Mae in, 65 free-market response to, 177–186 and Great Depression, 25 lessons from, 251–252 SEC role in, 154–155 Financial reporting requirements, SEC, 150–152 Financial Services Roundtable (FSR), 32, 61–62 First Horizon, 237 Fitch, John Knowles, 150 Fitch Ratings: investor confidence in, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Flat tax, 197 Forbes, Steve, 197 Ford, 179 Foreclosure laws, 77–80 Fractional reserve banking, 69–70 Frank, Barney, 7, 61, 63, 64 Fraud, 109–113 Freddie Mac: accounting scandal, 112–113, 149 current environment, 251 and disintermediation of deposits, 121 failure of, 61–65, 164 in housing policy, 58–61 misallocation of resources by, 14 misleading information from, 83 mortgage lending by, 97–101 reforms for, 190–192 selling mortgages to, 113–114 subprime lending by, 58, 99–101 Free markets: experimentation in, 19 justice in, 92, 177 market corrections in, 157–159 and monetary policy, 31–35 risk taking by banks in, 40–41 wage rates in, 210–211 Free trade, 204–205 Friedman, Milton, 20, 189 FSLIC (see Federal Savings and Loan Insurance Corporation) FSR (Financial Services Roundtable), 32, 61–62 GAAP accounting, 116, 117 Gates, Bill, 216 GDP, 183, 197–199 General Electric, 168, 169 General Motors (GM), 169, 178–180 General Theory of Employment, Interest and Money, The (Keynes), 181 Germany, 52 GM (General Motors), 169, 178–180 GMAC, 168, 169, 178–180 Gold standard: and deflation, 25–26 and economic future of U.S., 188–189 Greenspan’s view of, 32 Golden West, 39, 91, 92, 98, 159 Goldman Sachs, 71, 173 as AIG counterparty, 128–129 bailout of, 104, 164, 179 CDSs of, 126 counterparty risk at, 124 crony capitalism at, 6 financial “innovations” of, 101 Government policy: as cause of financial crisis, 1, 5–6, 251 and residential real estate bubble, 6 (See also Housing policy; Policy reforms) Government regulation, 5–8, 41–48, 204 Government spending, 180–183, 197–199 Government-sponsored enterprises (GSEs), 59, 64–65, 98, 137 (See also Fannie Mae; Freddie Mac) Great Depression: and avoidance of stock market, 74 banking industry in, 70–72 economic policies after, 161 and Federal Reserve, 19–20, 24, 188 and gold standard, 188 and government interference, 170 and Smoot-Hawley Tariff Act, 205 Great Recession, 1, 251–254 and Federal Reserve, 188 Freddie Mac and Fannie Mae in, 65 and interest-rate variation, 33 market corrections and depth of, 160 and monetary policy, 17 and residential real estate, 9–15 Great Society, 6, 55, 96 Greece, 51, 52, 137, 228 Greenspan, Alan, 23–30, 32, 33, 160 Gross domestic product, 183, 197–199 Hamilton, Alexander, 19 Harvard University, 43, 131 Hayek, Friedrich, 31 Health insurance, 201–202 High-net-worth shareholders, 93 Home Builders Association, 60 Home foreclosure laws, 77–80 Homeownership, 53–55 Hoover, Herbert, 24, 161, 205 Housing: as consumption, 9–12, 54–55, 73–74 government support of, 12 Housing policy, 53–65 HUD (Department of Housing and Urban Development), 15, 58 Human Action (von Mises), 238 Immigration, 19, 205–206 India, 10, 25, 205 IndyMac, 39, 75, 98 Inflation: CPI as indicator of, 26–27 and fair-value accounting, 103 and Federal Reserve, 21–22 and prices, 24–25 (See also Monetary policy) Initial public offerings, 150 Insurance: bond, 86–87 cross-guarantor, 48–52 FDIC (see FDIC insurance) health, 201–202 private deposit, 48–52 self-insurance at banks, 48–52 unemployment, 212–213 Interest rates, 26–27, 31–35 Inverted yield curves, 27–29 Investment banks: disclosure requirements for, 151 government bailout of, 162 “innovations” of, 101–102 leverage ratios of, 71–72 IPOs, 150 Iran, 198, 199, 227 Iraq, 198 Ireland, 77 Isaac, Bill, 107–108, 161–162 Italy, 51, 52 Japan, 159, 200, 205 Jefferson, Thomas, 19, 220 Johnson, Lyndon Baines, 6, 55, 96, 161, 188 JPMorgan Chase, 75 and Bear Stearns, 162 and shadow banking system, 120 as “too-big-to-fail” firm, 173 and Washington Mutual, 163 Keynes, John Maynard, 181 Labor: allocation of, 10–11, 14 minimum-wage laws, 209–212 Lehman Brothers, 71, 76, 101, 104, 129, 164 and Bear Stearns bailout, 162–163 corporate debt at, 107 counterparty risk at, 124 derivatives from, 123 Limited government, 182–183, 195, 231, 253 Liquidity: of banks, 68–69 and FDIC insurance, 171 and financial crises, 70–72 and housing prices, 74–75 and TARP, 171–172 Loan loss reserves accounting, 152–154 Loans: capital standards for, 51–52 qualified, 98 substandard, 140–141 Madoff, Bernie, 149, 225 March of Dimes, 241 Market corrections, 157–165 Federal Reserve’s prevention of, 23, 32 prevention of, 13 residential real estate, 78 and response to financial crisis, 177–180 Market discipline, 21, 38 Market-based monetary policy, 31–35 Market-clearing price, 209 Mathematical modeling: for loan loss reserves, 152–153 by ratings agencies, 82–83 for risk management, 136–138 MBIA, 86 Medicaid, 6, 55, 201 Medicare, 6, 8, 55, 201, 203 Meltdown (Michaels), 35 Merrill Lynch, 101, 124–125 Michaels, Patrick J., 35 Microsoft, 217 Military spending, 198–199, 227 Minimum-wage laws, 209–212 Mises, Ludwig von, 34, 238 Monetary policy, 17–35 of Bernanke, 27–31, 33, 35, 40, 125, 213 and federal debt, 21–22 and Federal Reserve, 17–23 of Greenspan, 23–27 market-based, 31–35 and unemployment, 208–209 Money market mutual funds, bailout of, 120–121, 192 Money supply, 21–22, 24, 189 Moody, John, 83, 150 Moody’s, 81–87 investor confidence in, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Morgan Stanley, 71, 101, 124, 173 Mortgage lending, 95–102 by Fannie Mae and Freddie Mac, 97–101 and investment bank innovations, 101–102 prime, 59, 97–99 by private banks, 97–99 savings and loan industry in, 95–97 subprime, 43, 56–57, 99–101 Mortgages: by BB&T Corporation, 97–98 jumbo, 62 pick-a-payment (see Pick-a-payment mortgages) selling vs. servicing, 113–114 Mozilo, Angelo, 46 Multiplier effect, 181 Naked shorting, 127–128, 151 Nationally recognized statistical rating organizations, 82 Negative real interest rates, 26–27 Neo-Keynesian response to financial crisis, 185–186 Neutral taxes, 197 New Deal, 53, 170, 232 Nixon, Richard, 96, 161, 188 North Korea, 34, 198, 227, 247, 252 NRSROs, 82 Obama administration, 142–144: and Dodd-Frank Act, 64 economic policies of, 15, 161 healthcare bill, 183, 201 and Patriot Act, 45 stimulus plan, 181–182 Office of the Comptroller of the Currency (OCC), 40, 154 Office of Thrift Supervision, 40, 41, 45–46 Operating earnings, 103–106 OTS, 40, 41, 45–46 Panics, 137–138, 161–165 Patriot Act, 45, 46, 48, 133–136, 147 Paulson, Henry: in 2008 panic, 164, 167 and AIG bailout, 128, 129 credibility of, 164 development of TARP, 76, 168–170, 172 Pick-a-payment mortgages, 89–93 borrowers using, 90–91 and FDIC, 91 and rise of Fannie Mae/Freddie Mac, 98 Policy reforms, 195–206 for entitlement programs, 199–204 and free trade, 204–205 and government regulations, 204 for government spending, 197–199 for immigration, 205–206 for political system, 206–207 and tax rate, 196–197 Politics: in banking regulation, 42–46 and crony capitalism, 129 and failure of Fannie Mae/Freddie Mac, 59–62 and Federal Reserve appointments, 18 policy reforms for, 206–207 Poor, Henry Varnum, 150 Portugal, 51 Price fixing, 31, 193 Price setting, 31–32 Prime lending, 59, 97–99 Prince, Charlie, 217 Principles-based accounting, 109 Privacy Act, 133, 135 Private accounting systems, 177–178 Private banks, 97–99, 187–188 Private deposit insurance, 48–52 Public schools, 228, 233–235 Racial discrimination (in lending), 42–45 Raines, Frank, 59 Rand, Ayn, 225, 231 Rating agencies, 81–87 investor confidence in, 84–87 mathematical modeling by, 136 and subprime mortgage bonds, 82–84 and “too-big-to-fail” firms, 173 and SEC, 81–82, 149–150 Real estate: commercial, 11, 97 residential (see Residential real estate market) Recessions, 28, 29, 160 Recovery (see Economic recovery) Reforms: banking industry (see Banking industry reforms) government policy (see Policy reforms) Regions Bank, 237 Regulation: of banking industry (see Banking regulation) by government (see Government regulation) Reporting, financial, 150–152 Reserve currency, U.S. dollar as, 77, 188, 229 Residential real estate market: economics of, 73–74 misinvestment in, 9–15 Residential real estate market bubble, 73–80 and government policy, 6 international impact of, 77 and job creation, 80 and state home foreclosure laws, 77–80 Risk: contagion, 123 counterparty, 123, 124 with derivatives, 122–124 diversification of, 67–69 and economic cycles, 189–193 and FDIC insurance, 38–41 and government regulation, 50–51 liquidity, 68–70 mathematical modeling for, 136–138 and “originate and sell” model, 100 systemic, 50–51 RMBS (residential mortgage-backed securities), 81 Roman empire, fall of, 230 Roosevelt, Franklin D., 24, 37, 103, 161 Rules-based accounting, 109 Russia, 198 Samuelson, Paul, 238 Sarbanes-Oxley Act, 133–134 and fair-value accounting, 106 and Fannie Mae/Freddie Mac, 99 misregulation by, 48, 147 and SEC, 150 violations of, 136 SARs (Suspicious Activity Reports), 136 Satchwell, Jack, 57 Savings and loan (S&L) industry, 95–97, 110, 191 Securities and Exchange Commission (SEC), 149–155 capital ratio guidelines, 71–72 and complexity of accounting rules, 116–117 and expensing of stock options, 114, 115 loan loss reserves accounting for, 152–154 misallocation of resources by, 14 and rating agencies, 81–82, 149–150 requirements for shorting stock, 127–128, 151 and rules-based accounting, 109, 110 and Sarbanes-Oxley Act, 150 Self-insurance, 48–52 Selgin, George, 189 Senate Banking Committee, 46 Shadow banking system, 119–131 and AIG bailout, 128–130 credit default swaps in, 126–128 and derivatives, 122–124 Federal Reserve’s role in, 30 losses from, 131 S&L industry, 95–97, 110, 191 Small businesses, 144–147, 183–184 Smoot-Hawley Tariff Act, 205 Social Security, 8, 199–204 South Financial, 237 South Korea, 247 Soviet Union, 34, 195–196, 252, 254 S&P (see Standard & Poor’s) Spain, 51, 52, 77 Spitzer, Eliot, 71, 134–135, 151 Stagflation, 181, 208 Standard & Poor’s (S&P), 81–87 investor confidence, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Standard of living, 6–7, 10, 161, 177 Start-up banks, 38–39 State home foreclosure laws, 77–80 Stimulus plan, 181–182 Stock options, expensing of, 114–117 Stocks, shorting, 127–128, 151 Stress tests, banks, 171 Subprime lending: and CRA, 56–57 by Fannie Mae and Freddie Mac, 99–101 and racial discrimination in lending study, 43 Subprime mortgage bonds, 82–87 Substandard loans, 140–141 SunTrust, 152, 237 Suspicious Activity Reports (SARs), 136 Tails (mathematical models), 137 TARP (see Troubled Asset Relief Program) Tax rate, 196–197 Tea Party Movement, 218, 231 Technology industry, 5 “Too-big-to-fail” firms, 130, 173, 193 Trader principle, 92, 223–224 Troubled Asset Relief Program (TARP), 167–175 and 2008 panic, 165 and FDIC, 37 Underwriters Laboratories, 117, 150 Unemployment, 207–213 in economic recovery, 207–208 and minimum-wage laws, 209–212 and misinvestment in residential real estate, 10–11 and monetary policy, 208–209 Unemployment insurance, 212–213 Unions, 179, 180, 212 United Auto Workers, 179, 180 United States: demographic problem in, 228 economic future of, 8, 227–230, 252–253 educational system of, 230–235 founding concepts of, 219–220 as free trade zone, 204–205 GDP of China vs., 183 mixed economy of, 5–6 public schools of, 233–235 university system of, 230–233 United Way, 224, 241 University system, 230–233 U.S.

 

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What's Next?: Unconventional Wisdom on the Future of the World Economy by David Hale, Lyric Hughes Hale

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affirmative action, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Berlin Wall, Black Swan, Bretton Woods, capital controls, Cass Sunstein, central bank independence, cognitive bias, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, debt deflation, declining real wages, deindustrialization, diversification, energy security, Erik Brynjolfsson, Fall of the Berlin Wall, financial innovation, floating exchange rates, full employment, Gini coefficient, global reserve currency, global village, high net worth, Home mortgage interest deduction, housing crisis, index fund, inflation targeting, invisible hand, Just-in-time delivery, Kenneth Rogoff, labour market flexibility, labour mobility, Long Term Capital Management, Mahatma Gandhi, Martin Wolf, Mexican peso crisis / tequila crisis, Mikhail Gorbachev, money: store of value / unit of account / medium of exchange, mortgage tax deduction, Network effects, new economy, Nicholas Carr, oil shale / tar sands, oil shock, open economy, passive investing, payday loans, peak oil, Ponzi scheme, post-oil, price stability, private sector deleveraging, purchasing power parity, quantitative easing, race to the bottom, regulatory arbitrage, rent-seeking, reserve currency, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, sovereign wealth fund, special drawing rights, technology bubble, The Great Moderation, Thomas Kuhn: the structure of scientific revolutions, Tobin tax, too big to fail, total factor productivity, trade liberalization, Washington Consensus, women in the workforce, yield curve

These include: • Developing Country Debt Crisis (1983) • US Savings and Loan Crisis (1980s) • Resolution Trust Company, which created REITS (Real Estate Investment Trusts) (late 1980s) • The 1988 Basel Capital Accord (1988) • The beginning of derivatives (early 1990s) • Proliferation of derivatives and Special Purpose Entities (SPEs) (1990s) • Asian Financial Crisis (1997–1998) • Collapse of Long-Term Capital Management (LTCM) (1998) • The repeal of Glass-Steagall (1999) and the adoption of Gramm-Leach-Bliley Financial Modernization Act (GLBA) (1998) • The failure of dot-coms (2000) Causes of the Global Financial Crisis after SOX and Prior to September 18, 2008 It is also important to understand the events and economic climate after the July 31, 2002, passage of SOX and prior to September 18, 2008. These events include: • The increasing complexity of derivative products, including CDSs (Credit Default Swaps) and CDOs (Collateralized Debt Obligations)4 • The ascendancy of rating agencies • Alt-A subprime lending • Basel II (2005–2006) • The subprime housing crisis in the United States, including the rise of “NINJA” (no income, no jobs, no assets) financing • The rise of hedge funds • The oil crisis (2008) • The collapse of Bear Stearns, Fannie Mae, Freddie Mac, and Lehman Brothers (2008) Understanding the causes of the global financial crisis will go hand in hand with regulatory reform and increasing targeted global compliance and ethics programs.5 Why SOX Failed SOX was supposed to remedy the financial improprieties and excesses that existed prior to July 31, 2002.

These events include: • The increasing complexity of derivative products, including CDSs (Credit Default Swaps) and CDOs (Collateralized Debt Obligations)4 • The ascendancy of rating agencies • Alt-A subprime lending • Basel II (2005–2006) • The subprime housing crisis in the United States, including the rise of “NINJA” (no income, no jobs, no assets) financing • The rise of hedge funds • The oil crisis (2008) • The collapse of Bear Stearns, Fannie Mae, Freddie Mac, and Lehman Brothers (2008) Understanding the causes of the global financial crisis will go hand in hand with regulatory reform and increasing targeted global compliance and ethics programs.5 Why SOX Failed SOX was supposed to remedy the financial improprieties and excesses that existed prior to July 31, 2002. The debacles of WorldCom, Enron, Adelphia, and Tyco were only the last in a long series of financial abuses. Further, after SOX, despite the subprime mortgage crisis in the United States, rating services failed to calculate the risk of credit default swaps (CDSs), collateralized debt obligations (CDOs), and other financial abuses. Until September 18, 2008, there was no general sense that SOX had not alleviated the possibility of a global financial meltdown, or at least a US financial meltdown. No one seemed to question SOX’s ability to create greater transparency and integrity in the US financial market. However, SOX ultimately failed to deliver the kind of protection its framers anticipated.

., 36 buy America provisions, 24–25 Calderón, Felipe, 37–39 Canada, aging population of, 25–26; banking system in, 15–16; consumer debt in, 18–19; corporate sector in, 20; economic recovery in, xvii–xviii, 14–15; economy of, 12–28; employment in, 17–18; environmental policies, 27–28; fiscal deficit of, 257; fiscal situation in, 21–22; foreign investment in, 26–27; household sector in, 17–20; long-term issues and challenges for, 25–28; monetary policy, 22–23; productivity in, 26; real estate market in, 16–17, 19–20; risks facing, 23–25; tax policy, 20, 26; US and, 13–14, 24 Canada Mortgage and Housing Corporation (CMHC), 17 Canadian dollar, 23 cap-and-trade system, xxvi, 5 capital flows, 7–8 capital requirements, 233–235, 237–238, 241–244, 246–248 capital spending, 259 carbon emissions, xxvi–xxvii, 5, 219, 227. See also climate change career risk, 289 Carr, Nicholas, xxix, 292–293 CDOs. See collateralized debt obligations (CDOs) CDSs. See credit default swaps (CDSs) Central Africa, 126 central banks, Asia, 82–83; asset buying by, 81; demand for gold by, 169–170, 174–175; money supply and, 246–248; selling public debt to, 259 Chile, 8, 33, 48, 49, 51 China, xv, xx; Australian exports to, 145–146; climate change and, xxvi, 225; consumption in, 89–90; currency intervention by, 10; economic growth in, 10, 52; economy of, xxiii, 24; equity markets, 83–84, 85; excess of thrift in, 88–89; as financial capital, 245–246; financial sector in, xxvii; fiscal deficit, 257; gold market in, 170–171; gold reserves, xxv, 168–169, 170, 174; household incomes in, 89; influence of, in Africa, 122–123; labor costs in, 86–87, 89–90; monetary policy, 10; savings rate in, 245–246; structural shift in, 84–85 Citigroup, 272 Clean Development Mechanism (CDM), 225 climate change, adaptation to, 227–229; Canada and, xviii, 27–28; future outcomes for, 224–225; international agreements on, 220–223; oil industry and, xxv, 189–191; public policy and, xxvi–xxvii, 219–230; South Africa and, xxii coal, 125 Coates, John, 290 cognitive abilities, 293–294 cognitive biases, 287, 288–289 collateralized debt obligations (CDOs), 275 Colombia, 33, 48, 49 commodity prices, xv, xxii, 50, 52–54, 117, 195 Common Market for Eastern and Southern Africa (COMESA), 122 compensation plans, 277 composite currencies, 161–163 Conference of the Parties to the Convention (COP), 222 confirmatory evidence, 288 conflicts, in Sub-Saharan Africa, 123–124 Congdon, Tim, xxvii Constitutionalist Revolution (1906), 206 consumer debt, 18–19 Consumer Protection Financial Bureau, 267, 269 consumer spending, 8, 18 consumption-based taxes, 261–263 Copenhagen Accord, 222, 225 Cordero, Ernesto, 45 corporate compliance, xxviii–xxix, 271–282 corporate governance, 267, 268 corporate profits, 8 corporate sector: Canada, 20; US, xvi, 4, 8 corporate taxes, 260 cortisol, 290 Costa Rica, 48 Côte D’Ivoire, 127 credit default swaps (CDSs), 275 creditor status, 156 Creel, Santiago, 37, 45 crime, in Mexico, 43 culture of ethics, 276–280 currencies: African, 122; composite, 161–163; domestic, 155; international, 155–156; synthetic, 161–163.

 

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The Irrational Economist: Making Decisions in a Dangerous World by Erwann Michel-Kerjan, Paul Slovic

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Andrei Shleifer, availability heuristic, bank run, Black Swan, Cass Sunstein, clean water, cognitive dissonance, collateralized debt obligation, complexity theory, conceptual framework, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, cross-subsidies, Daniel Kahneman / Amos Tversky, endowment effect, experimental economics, financial innovation, Fractional reserve banking, George Akerlof, hindsight bias, incomplete markets, invisible hand, Isaac Newton, iterative process, Loma Prieta earthquake, London Interbank Offered Rate, market bubble, market clearing, moral hazard, mortgage debt, placebo effect, price discrimination, price stability, RAND corporation, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, statistical model, stochastic process, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, too big to fail, transaction costs, ultimatum game, University of East Anglia, urban planning

The goal is to make the municipal bond insurer bankruptcy remote from losses that might occur on other insurance lines covered by the same holding company (i.e., with no possible contagion). In addition, the chartering laws have imposed relatively high capital requirements on the firms. Quite irrationally, in recent years, insurance regulators have also allowed municipal bond insurers to provide coverage against default risks on subprime mortgage securitizations and related collateralized debt obligations (CDOs) and credit default swaps (CDSs). It is unclear why the insurance regulators allowed the insurers to mix the relatively limited credit risks on municipal bonds with the high risks on subprime mortgages and their derivatives, since this clearly violated the monoline principle on which the insurers were chartered. Worse yet, losses on the subprime mortgage derivatives now threaten the solvency of the municipal bond insurers.9 The failure of these firms would have significant negative externalities in two regards.

LIBOR OIS declined precipitously. However, the shortage of capital in banks also resulted in very high shadow rates (usually not reported to the general public) for use of intermediary capital. This outcome is represented in Figure 20.6 by the black line, which delineates the bond-CDS basis—that is, the difference between the spreads on corporate bonds and the derivative contracts that insure them (i.e., credit default swaps, or CDS).3 Why the bond-CDS spread, and what does it tell us? CDS contracts are relatively liquidly traded contracts that measure the credit risk on bonds. In theory, this basis, the difference between bond and CDS yields, should be near zero, since the cost of insurance against a bond’s default should be about the same as the additional yield demanded by bondholders to compensate them against this same default.

Chapter 20 Froot: Toward Financial Stability 1 I modify markets with dealer-centric to indicate the many dealer-intermediated markets that exist, and to contrast them from exchange-centric markets. 2 The London Interbank Offered Rate (LIBOR) is a daily reference rate based on the interest rates at which banks borrow funds from other banks in the London wholesale money market (or interbank market). Overnight index swaps (OIS) are instruments that allow financial institutions to swap the interest rates they are paying without having to refinance or change the terms of the loans they have taken from other financial institutions. 3 A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the specified events occur. Sources: Wikipedia. 4 The average duration of the corporate bonds and CDS is about seven and five years, respectively.

 

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The Clash of the Cultures by John C. Bogle

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asset allocation, collateralized debt obligation, corporate governance, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, estate planning, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, Flash crash, Hyman Minsky, income inequality, index fund, interest rate swap, invention of the wheel, market bubble, market clearing, mortgage debt, new economy, Occupy movement, passive investing, Ponzi scheme, principal–agent problem, profit motive, random walk, rent-seeking, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, short selling, South Sea Bubble, statistical arbitrage, The Wealth of Nations by Adam Smith, transaction costs, Vanguard fund, William of Occam

For example, trading in S&P 500-linked futures totaled more than $60 trillion(!) in 2011, five times the S&P 500 Index total market capitalization of $12.5 trillion. We also have credit default swaps, which are essentially bets on whether a corporation can meet the interest payments on its bonds. These credit default swaps alone had a notional value of $33 trillion. Add to this total a slew of other derivatives, whose notional value as 2012 began totaled a cool $708 trillion. By contrast, for what it’s worth, the aggregate capitalization of the world’s stock and bond markets is about $150 trillion, less than one-fourth as much. Is this a great financial system . . . or what! Much of the trading in derivatives—including stock index futures, credit default swaps, and commodities—reflects risk aversion and hedging. However, a substantial portion—perhaps one-half or more—reflects risk seeking, or rank speculation, another component of the whirling dervish of today’s trading activity.

However high the levels of mutual fund trading in stocks have soared relative to traditional norms, they pale by comparison to the trading volumes of hedge funds, to say nothing of the levels of trading in exotic securities such as interest rate swaps, collateralized debt obligations, derivatives such as futures on commodities, stock indexes, stocks, and even bets on whether a given company will go into bankruptcy (credit default swaps). The aggregate nominal value of these instruments, as I noted in Chapter 1, now exceeds $700 trillion. Yes, what we have come to describe as speculation has clearly come to play the starring role in our nation’s huge financial market colossus, with investment taking only a supporting role, if not a cameo role. The Creation of Corporate Value As I mentioned at the start of this chapter, the focus of our two sets of powerful agents has seemingly united on the quest to enhance the economic value of the corporation.

 

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Austerity: The History of a Dangerous Idea by Mark Blyth

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accounting loophole / creative accounting, balance sheet recession, bank run, banking crisis, Black Swan, Bretton Woods, capital controls, Carmen Reinhart, Celtic Tiger, central bank independence, centre right, collateralized debt obligation, correlation does not imply causation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, deindustrialization, disintermediation, diversification, en.wikipedia.org, ending welfare as we know it, Eugene Fama: efficient market hypothesis, eurozone crisis, financial repression, fixed income, floating exchange rates, Fractional reserve banking, full employment, German hyperinflation, Gini coefficient, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, interest rate swap, invisible hand, Irish property bubble, Joseph Schumpeter, Kenneth Rogoff, liquidationism / Banker’s doctrine / the Treasury view, Long Term Capital Management, market bubble, market clearing, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, Occupy movement, offshore financial centre, paradox of thrift, price stability, quantitative easing, rent-seeking, reserve currency, road to serfdom, savings glut, short selling, structural adjustment programs, The Great Moderation, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, unorthodox policies, value at risk, Washington Consensus

Tales of Two Small European Countries,” (Giavazzi), 169, 170, 171, 176, 209–210 Canada fiscal adjustment in, 173 Capitalism, Socialism and Democracy, (Schumpeter), 128, 129 Cassel, Gustav, 191 central banks, independence of, 156–158 certificates of deposit (CDs), 234 Chin, Menzie, 11 China, 55 Chowdhury, Anis, 176 Churchill, Winston, 123 and the gold standard, 189 1929 budget speech, 124 Citigroup, 48 Clinton, Bill, 12 Clinton, Hillary, 218 Cochrane, John, 2, 239 Colander, David, 99 collateralized debt obligations, 28, 234 Congressional Research Group, 242 Considine, John, 208 Coolidge, Calvin, 120 Credit Agricole, 87 credit default swaps, 26, 29, 30 Daimler/Mercedes Benz, 132 Darwin’s Dangerous Idea (Dennett), 159 De Grauwe, Paul, 86 debt inflation, 150 default as a way out of financial crises, 183 mortgage, 41, 42, 44, 50 risk, 24 sovereign, 113, 210, 241 See also credit default swaps (CDSs) deflation, 240, 241 demand-side economics, 127 See also supply-side economics Denmark, 207, 209 as a welfare state, 214 austerity in, 17, 169–170, 170–171, 179 expansion, 205, 206, 209 fiscal adjustment in, 173 Dennett, Daniel Darwin’s Dangerous Idea, 159 derivatives, 27–30 credit default swaps, 27–30 special investment vehicles, 29 See also mortgages; real estate Deutsche Bank, 83 devaluation and hyperinflation, 194 as a way out of financial crises, 75, 173, 208, 213 of currency, 76, 77, 147, 169, 171, 188, 191, 197 Diamond, Peter, 243 disintermediation, 23, 49, 232 Dittman, Wilhelm, 195 Dow Jones Industrial Average, 1, 2–3 Duffy, James, 208 Eatwell, John, 42 Economic and Financial Affairs Council of the European Council of Ministers (ECOFIN), 173, 175, 176 economics Adam Smith, 109 Austrian school of, 31, 144 demand-side, 127 Frieburg school of, 135 Germany’s Historical school of, 143 Keynesian, ix, 39, 54 liberal, 99 London School of, 31, 144 macro, 40 neoclassical, 41 neoliberal, 41, 92 public choice, 166 supply-side, 111 zombie, 10, 234 Economics of the Recovery Program, The, (Schumpeter), 128 Economist, The, 69, 166, 216 efficient markets hypothesis, 42 Eichengreen, Barry, 183, 231 Einaudi, Luigi, 165, 167 Eisenhower, Dwight, 243 Englund, Peter, 211 Estonia austerity in, 18, 103, 179, 216–226, 217 fig. 6.1 Eucken, Walter, 135–136 centrally administered economy, 135–136 transaction economy, 135–136 Euro, 74–75, 77 success or failure of, 78–81, 87–93 European banks austerity and, 87 fall of, 84–87 “too big to bail”, 6, 16 European Bond Market, 1 European Central Bank, 54, 55, 84 and austerity, 60, 122 and bailouts, 71–73 and loans to Ireland, 235 and the success of the REBLL states, 216 emergency liquidity assistance program, 4 limitations of, 87–93 long-term refinancing operation, 4, 86 Monthly Bulletin, June 2010, 176 See also Trichet, Jean Claude European Commission, 122 and austerity, 221 and loans to Ireland, 235 and the success of the REBLL states, 216 European Economic Community, 62–64 European Exchange Rate Mechanism, 77 European Union and austerity, 221 and bailouts, 71–73, 208, 221 influence on Europe, 74–75 Eurozone and current economic conditions, 213 current account imbalances, 78 fig. 3.1 ten-year government bond yields, 80 fig. 3.2 exchange-traded funds (ETFs), 234 Fama, Eugene, 55 Fannie Mae, 121 Farrell, Henry, 55 Federal Deposit Insurance Corporation (FDIC), 24 Feldstein, Martin, 55, 78 Ferguson, Niall, 72 Figaro, Le, 201 financial repression, 241 Financial Stability Board, 49 Financial Times, 60 Fisher, Irving, 150 Fitch Ratings, 238 Flandin, Pierre-Étienne, 202 fractional reserve banking, 110 France, 4 and Germany’s nonpayment of Versailles treaty debt, 57 and John Law, 114 and the gold standard, 185, 204 assets of large banks in, 6 austerity in, 17, 126, 178–180 and the global economy in the 1920s and 1930s, 184–189 bond rates in, 6 depression in, 201–202 Eurozone Current Account Imbalances, 78 fig. 3.1 Eurozone Ten-Year Government Bond Yields, 80 fig. 3.2 war debts to the United States, 185 See also Blum, Leon; Flandin, Pierre-Étienne; Laval, Pierre; Poincaré, Raymond Freddie Mac, 121 free option, 29 Freiberg school of economics, 135, 136, 138–139 Frieden, Jeffry, 11 Friedman, Milton, 103, 155, 156, 165, 173 G20 2010 meeting in Toronto, 59–62 Gates, Bill, 7, 8, 13 Gaussian distribution, 33, 34 General Theory (Keynes), 126, 127, 145 Gerber, David, 136 Germany, 2, 16 and repayment war damage in France, 200–201 and the gold standard, 185 and the Treaty of Versailles, 185 as an economic leader, 75–78 austerity in, 17, 25, 57, 59, 101–103, 132–134 and the global economy in the 1920s and 1930s, 178–180, 184–189, 186, 193–197 Bismarkian patriarchal welfare state, 137 Bundesbank, 54, 156, 172, 173 capital drain after World War I, 186 Center Party, 194 Christian Democrats, 137, 139 competition, 137–138 economic ideology of, 56–58, 59–60 entrance into world economy, 134–135 Eurozone Current Account Imbalances, 78 fig. 3.1 Eurozone Ten-Year Government Bond Yields, 80 fig. 3.2 fiscal prudence of, 2, 17, 54 founder’s crisis, 134 German Council of Economic Advisors Report, 169 gold standard and, 196 Historical school of economics, 143 hyperinflation in the 1920s, 56–57, 185, 194, 200, 204 industry in, 132–134 See also BASF, Daimler/Mercedes Benz, Krups, Siemens, ThyssenKrupp ordoliberalism in, 101, 131, 133 origins of, 135–137 order-based policy, 136 National Socialists, 194–195 Nazi period in, 136, 196 Social Democratic Party, 140, 194, 195, 204 social market economy, 139 Stability and Growth Pact, 92, 141 stimulus in, 55–56 See also Freiburg school of economics stop in capital flow from United States in 1929, 190, 194 unemployment in, 196 WTB plan, 195, 196 Giavazzi, Francesco, 179, 205, 206 “Can Severe Fiscal Contractions be Expansionary?

Note here that this has nothing to do either with the state, which now gets the blame for the debt stemming from this crisis—a wonderful confusion of cause and effect—or with the individual moral failings of the bankers.10 You can blame regulators for being lax or negligent and politicians for caving to banking interests all you like, but this was a quintessentially private-sector crisis, and it was precisely how you get a multi-billion-dollar financial panic out of a bunch of defaulting mortgages. But it was not yet sufficient to cause a global crisis. To get there, you have to understand how the structure of these mortgage securities combined with unbacked insurance policies called “credit default swaps” (CDSs) to produce a “correlation bomb” that spread the repo market crisis into the global banking system. Again, this had nothing to do with states and their supposedly profligate spending habits and everything to do with weaknesses internal to the private sector. The Amplifier: Derivatives It’s hard to describe derivatives in the abstract. To say they are securities that derive their value from some other underlying financial asset, index, or referent, which is a typical definition, doesn’t say all that much.

 

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The Ascent of Money: A Financial History of the World by Niall Ferguson

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Admiral Zheng, Andrei Shleifer, Asian financial crisis, asset allocation, asset-backed security, Atahualpa, bank run, banking crisis, banks create money, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, BRICs, British Empire, capital asset pricing model, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, collateralized debt obligation, colonial exploitation, Corn Laws, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, deglobalization, diversification, diversified portfolio, double entry bookkeeping, Edmond Halley, Edward Glaeser, Edward Lloyd's coffeehouse, financial innovation, financial intermediation, fixed income, floating exchange rates, Fractional reserve banking, Francisco Pizarro, full employment, German hyperinflation, Hernando de Soto, high net worth, hindsight bias, Home mortgage interest deduction, Hyman Minsky, income inequality, interest rate swap, Isaac Newton, iterative process, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, labour mobility, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, means of production, Mikhail Gorbachev, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, mortgage tax deduction, Naomi Klein, Nick Leeson, Northern Rock, pension reform, price anchoring, price stability, principal–agent problem, probability theory / Blaise Pascal / Pierre de Fermat, profit motive, quantitative hedge fund, RAND corporation, random walk, rent control, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, seigniorage, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spice trade, structural adjustment programs, technology bubble, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Malthus, Thorstein Veblen, too big to fail, transaction costs, value at risk, Washington Consensus, Yom Kippur War

In 2006, for example, the volume of leveraged buyouts (takeovers of firms financed by borrowing) surged to $753 billion. An explosion of ‘securitization’, whereby individual debts like mortgages are ‘tranched’ then bundled together and repackaged for sale, pushed the total annual issuance of mortgage backed securities, asset-backed securities and collateralized debt obligations above $3 trillion. The volume of derivatives - contracts derived from securities, such as interest rate swaps or credit default swaps (CDS) - has grown even faster, so that by the end of 2007 the notional value of all ‘over-the-counter’ derivatives (excluding those traded on public exchanges) was just under $600 trillion. Before the 1980s, such things were virtually unknown. New institutions, too, have proliferated. The first hedge fund was set up in the 1940s and, as recently as 1990, there were just 610 of them, with $38 billion under management.

A put option is just the opposite: the buyer has the right, but not the obligation, to sell an agreed quantity of something to the seller of the option. A third kind of derivative is the swap, which is effectively a bet between two parties on, for example, the future path of interest rates. A pure interest rate swap allows two parties already receiving interest payments literally to swap them, allowing someone receiving a variable rate of interest to exchange it for a fixed rate, in case interest rates decline. A credit default swap, meanwhile, offers protection against a company’s defaulting on its bonds. Perhaps the most intriguing kind of derivative, however, are the weather derivatives like natural catastrophe bonds, which allow insurance companies and others to offset the effects of extreme temperatures or natural disasters by selling the so-called tail risk to hedge funds like Fermat Capital. In effect, the buyer of a ‘cat bond’ is selling insurance; if the disaster specified in the bond happens, the buyer has to pay out an agreed sum or forfeit his principal.

For the proponents of what George Soros has disparaged as ‘market fundamentalism’, here was a painful anomaly: among the biggest winners of the latest crisis were state-owned entities.bi And yet there are reasons why this seemingly elegant, and quintessentially Chimerican, resolution of the American crisis has failed to happen. Part of the reason is simply that the initial Chinese forays into US financial stocks have produced less than stellar results.bj There are justifiable fears in Beijing that the worst may be yet to come for Western banks, especially given the unknowable impact of a US recession on outstanding credit default swaps with a notional value of $62 trillion. But there is also a serious political tension now detectable at the very heart of Chimerica. For some time, concern has been mounting in the US Congress about what is seen as unfair competition and currency manipulation by China, and the worse the recession gets in the United States, the louder the complaints are likely to grow. Yet US monetary loosening since August 2007 - the steep cuts in the federal funds and discount rates, the various auction and lending ‘facilities’ that have directed $150 billion to the banking system, the underwriting of JP Morgan’s acquisition of Bear Stearns - has amounted to an American version of currency manipulation.112 Since the onset of the American crisis, the dollar has depreciated roughly 25 per cent against the currencies of its major trading partners, including 9 per cent against the renminbi.

 

pages: 524 words: 143,993

The Shifts and the Shocks: What We've Learned--And Have Still to Learn--From the Financial Crisis by Martin Wolf

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air freight, anti-communist, Asian financial crisis, asset allocation, asset-backed security, balance sheet recession, bank run, banking crisis, banks create money, Basel III, Ben Bernanke: helicopter money, Berlin Wall, Black Swan, bonus culture, Bretton Woods, call centre, capital asset pricing model, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, debt deflation, deglobalization, Deng Xiaoping, diversification, double entry bookkeeping, en.wikipedia.org, Erik Brynjolfsson, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, fiat currency, financial deregulation, financial innovation, financial repression, floating exchange rates, forward guidance, Fractional reserve banking, full employment, global rebalancing, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, inflation targeting, invisible hand, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, margin call, market bubble, market clearing, market fragmentation, Martin Wolf, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, new economy, North Sea oil, Northern Rock, open economy, paradox of thrift, price stability, private sector deleveraging, purchasing power parity, pushing on a string, quantitative easing, Real Time Gross Settlement, regulatory arbitrage, reserve currency, Richard Feynman, Richard Feynman, risk-adjusted returns, risk/return, road to serfdom, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, Second Machine Age, secular stagnation, shareholder value, short selling, sovereign wealth fund, special drawing rights, The Chicago School, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, too big to fail, Tyler Cowen: Great Stagnation, very high income, winner-take-all economy

While the European Central Bank did stand behind the banks of these countries as a lender of last resort, it definitely did not stand behind their public debt. 32. John B. Taylor, ‘The Financial Crisis and the Policy Response: An Empirical Analysis of What Went Wrong’, National Bureau of Economic Research Working Paper 14631, January 2009, www.nber.org. 33. Ferguson and Johnson note that ‘prices of credit default swaps on the four largest American banks, controlling some 40 per cent of all deposits, for example, all rose like rockets before falling back when Paulson, Bernanke and Geithner reversed course two days later and once again embraced single payer by bailing out AIG. The same holds for credit default swaps of Goldman Sachs and Morgan Stanley, the two most important remaining investment banks … Another excellent general indicator of stress, the “option adjusted” spread on broad investment grade debt – what banks had to pay to raise new capital – also shows a sharp rise as Lehman gave up the ghost.’

This proved what investors (and critics) had long believed, namely, that the US government stood behind the vast borrowings of these allegedly private companies ($5,400bn in outstanding liabilities at the time of the rescue).14 Yet it then, controversially, allowed (or felt obliged to allow) Lehman Brothers to go bankrupt on 15 September.15 Merrill Lynch was sold to Bank of America for $50bn, or $29 a share, on the same day – a big premium above its share price of $17, but a reduction of 61 per cent on its share price of $75 a year before and 70 per cent from its pre-crisis peak.16 Then, promptly after refusing to rescue Lehman, the US government saved the insurance giant, AIG, taking a 79.9 per cent equity stake and lending it $85bn on 16 September.17 In his book, Mr Paulson argues that the decisions were not inconsistent, because, ‘Unlike with Lehman, the Fed felt it could make a loan to help AIG because we were dealing with a liquidity, not a capital, problem.’18 If the Fed really believed that, it was soon proved wrong. A more likely reason is that Mr Paulson believed (wrongly, as it turned out) that the markets would take Lehman’s failure in their stride, but was sure the same would not be true for AIG, given its role as a seller of ‘credit default swaps’ – insurance contracts on bonds, including the securitized assets that had become increasingly toxic. Then, on 17 September, one of the money-market funds managed by Reserve Management Corporation (a manager of mutual funds) ‘broke the buck’ – that is, could no longer promise to redeem money invested in the fund at par (or dollar for dollar) – because of its exposure to loss-making loans to Lehman.

It created new forms of non-deposit near-money – notably, money-market funds, predominantly held by households, which financed supposedly safe short-term securities, and repos (repurchase agreements), a form of secured lending by corporate treasurers to investment banks and the investment-banking operations of universal banks (banks that provide both retail and investment-banking services).35 It allowed companies increasingly to issue commercial paper instead of relying on conventional bank loans. It converted conventional loans into tradeable asset-backed securities and CDOs (versions of asset-backed securities in which the repayments were ‘tranched’ or divided, with the highly rated paper receiving the first payments and the lower-rated paper receiving the later payments, if any). It created instruments that insured such assets, known as credit-default swaps, often deemed an adequate substitute for the capital required by regulators, even though they did not in any way increase the capital in the system. It led to the dissolution of the boundary between retail banking and wholesale markets. It created intense and non-transparent networks of financial relationships among institutions, both vertically and horizontally, in place of the vertically integrated silos characteristic of more traditional banking.

 

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The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money by Steven Drobny

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Albert Einstein, Asian financial crisis, asset allocation, asset-backed security, backtesting, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, business process, capital asset pricing model, capital controls, central bank independence, collateralized debt obligation, Commodity Super-Cycle, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, diversification, diversified portfolio, equity premium, family office, fiat currency, fixed income, follow your passion, full employment, Hyman Minsky, implied volatility, index fund, inflation targeting, interest rate swap, inventory management, invisible hand, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, market microstructure, moral hazard, North Sea oil, open economy, peak oil, pension reform, Ponzi scheme, prediction markets, price discovery process, price stability, private sector deleveraging, profit motive, purchasing power parity, quantitative easing, random walk, reserve currency, risk tolerance, risk-adjusted returns, risk/return, savings glut, Sharpe ratio, short selling, sovereign wealth fund, special drawing rights, statistical arbitrage, stochastic volatility, The Great Moderation, time value of money, too big to fail, transaction costs, unbiased observer, value at risk, Vanguard fund, yield curve

I calculated that the sum of all the government interventions—fiscal stimulus plans, interest rate cuts, and other emergency government programs—amounted to multiples of the contraction in global GDP. Although global GDP contracted 6 percent, something like 20 percent was being thrown at the problem, much of which had not yet been deployed at the time. I also looked at the swap rate and credit default swap levels. The swap rate is the inter-bank interest rate—the rate that banks use to lend to other banks. In November 2008, it reached a high of 5 percent amidst a total breakdown in confidence in the financial system. By March 2009, it came back to 2 percent and it is now at a quarter of a percent, which is the long-term trend. Credit default swaps, which are indications of credit deterioration, were also improving. Meanwhile, every corporate bond that I bought in November ‘08 was up 10 to 15 points. So you could see liquidity back in the market, the monetary aggregates returning to normal, the flow of money being guaranteed by governments; a colossal amount of money had been thrown at the problem and the rate of deterioration of the economy was beginning to slow.

By investing in positions that would profit from spread widening, you risked about 10 basis points of further tightening, while the eventual widening in 2008 took the spread out to almost 300 basis points. This was in a market that was entirely liquid and allowed even a large manager to establish positions of sufficient size to be meaningful. Looking further back not too many years ago, the credit default swap (CDS) contracts on European sovereign credits with 10-year maturities were trading at 5 basis points. The loss from paying on a CDS is limited to the interest rate charged, which in this case was 5 basis points a year for 10 years. Yet many of these moved to levels over 80 basis points during 2008. This resembles an insurance contract with limited downside, but asymmetric upside in the event of material changes to the investment universe.

It was the same as trading the Nasdaq at 5,000, whereby you do a calculation on the back of an envelope and you can only come to one conclusion—the price is horribly wrong, it’s horribly mispriced. But the NASDAQ was already mispriced in 1997. It was definitely mispriced in 1998, then more so in 1999. Sometimes these things take time. For our credit bubble trades, we received the first installment of our payoff two years after we first entered the positions. One of the reasons we had staying power is that we structured the trade through option-like structures. Even though credit default swaps are not technically options, they behave like options. You can lose the bulk of what you paid for CDS, but when spreads become really tight you don’t need to sell them because your downside becomes very limited and you still have all the upside. This is especially true for tranches. Figure 4.1 CDX Generic Credit Spreads, 2005-2008 SOURCE: Bloomberg. Figure 4.2 Total Credit Market as a Percentage of GDP, 1916-2006 SOURCE: U.S.

 

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Meltdown: How Greed and Corruption Shattered Our Financial System and How We Can Recover by Katrina Vanden Heuvel, William Greider

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Asian financial crisis, banking crisis, Bretton Woods, capital controls, carried interest, central bank independence, centre right, collateralized debt obligation, conceptual framework, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, declining real wages, deindustrialization, Exxon Valdez, falling living standards, financial deregulation, financial innovation, Financial Instability Hypothesis, fixed income, floating exchange rates, full employment, housing crisis, Howard Zinn, Hyman Minsky, income inequality, kremlinology, Long Term Capital Management, margin call, market bubble, market fundamentalism, McMansion, mortgage debt, Naomi Klein, new economy, offshore financial centre, payday loans, pets.com, Plutocrats, plutocrats, Ponzi scheme, price stability, pushing on a string, race to the bottom, Ralph Nader, rent control, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, sovereign wealth fund, structural adjustment programs, The Great Moderation, too big to fail, trade liberalization, transcontinental railway, trickle-down economics, union organizing, wage slave, Washington Consensus, women in the workforce, working poor, Y2K

The result was a frenzied bid-ding up of prices for a bewildering maze of arcane securities that neither buyers nor sellers could accurately value. Giant Ponzi scheme? Not to worry, responded the Wall Street geniuses. By spreading risks among more people, the miracle of “diversity” was actually turning bad loans into good ones. Anyway, banks were buying insurance policies against default, which in turn were transformed into a set of even murkier securities called “credit default swaps” and marketed to hedge funds, pension managers and in some cases back to the banks that were being insured in the first place. At the end of 2007 the market for these swaps was estimated at $45.5 trillion—roughly twice as large as all U.S. stock markets combined. This huge pyramid of debt was made possible by thirty years of relentless deregulation of financial markets, culminating in the 1999 repeal of the Glass-Steagall Act, which had prohibited banks from dealing in high-risk securities.

Probably there is also need for new rules on reserve requirements across the board and restrictions on the use of insured deposits. Above all, trading in complex derivatives—the main cause of the current disaster—has to be completely overhauled, at once. Derivatives have to be standardized and move to public exchanges that collectively guarantee them. Failure to do this will just start the whole nonsense over again. Just imagine being told a year from now that losses on credit default swaps written by firms that were bailed out under the new plan require the United States to pony up still more cash. Congressional Options It is fine for Democrats to hold out for mortgage relief and for another stimulus package. The best way to do the first, probably, is by reviving something like the Home Owners Loan Corporation that worked so well in the New Deal. That bought mortgages from people who were in danger of losing their houses and converted them into obligations that they could afford to repay.

Moderated by Nation Washington editor Christopher Hayes, the panel featured national correspondent William Greider, famed author of the classic book on the Fed, Secrets of the Temple; Frances Fox Piven, longtime poor people’s activist and author of many books, including The Breaking of the American Social Compact; contributing editor Doug Henwood, author of Wall Street; Arun Gupta, activist and editor of the Indypendent newspaper; and columnist Naomi Klein, author of the bestseller, The Shock Doctrine: The Rise of Disaster Capitalism. Following is an edited transcript of their discussion. Chris Hayes: There are a lot of technical questions about this crisis that I don’t think we’re going to be able to resolve tonight: what’s a credit default swap and how does it work, for example. But the key two political questions a lot of us are asking are: how do we fit what is happening now into our political understanding, into our power analysis—what has led us to the moment we’re in politically? And second is the old organizer question, which is, what are our demands—what do we want? When Hank Paulson and Ben Bernanke came to the Hill, it was clear what they wanted.

 

pages: 267 words: 71,123

End This Depression Now! by Paul Krugman

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airline deregulation, Asian financial crisis, asset-backed security, bank run, banking crisis, Bretton Woods, capital asset pricing model, Carmen Reinhart, centre right, correlation does not imply causation, credit crunch, Credit Default Swap, currency manipulation / currency intervention, debt deflation, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, full employment, German hyperinflation, Gordon Gekko, Hyman Minsky, income inequality, inflation targeting, invisible hand, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, low skilled workers, Mark Zuckerberg, moral hazard, mortgage debt, paradox of thrift, price stability, quantitative easing, rent-seeking, Robert Gordon, Ronald Reagan, Upton Sinclair, We are the 99%, working poor, Works Progress Administration

Before taking on the full outlines of a recovery strategy, I want to spend the next few chapters delving more deeply into how we got into this depression in the first place. CHAPTER FOUR BANKERS GONE WILD [R]ecent regulatory reform, coupled with innovative technologies, has stimulated the development of financial products, such as asset-backed securities, collateral loan obligations, and credit default swaps, that facilitate the dispersion of risk. . . . These increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago. —Alan Greenspan, October 12, 2005 IN 2005 ALAN GREENSPAN was still regarded as the Maestro, a source of oracular economic wisdom.

We now know that the sale of “asset-backed securities”—basically, the ability of banks to sell bunches of mortgages and other loans to poorly informed investors, instead of keeping them on their own books—encouraged reckless lending. Collateralized loan obligations—created by slicing, dicing, and pureeing bad debt—initially received AAA ratings, again sucking in gullible investors, but as soon as things went bad, these assets came to be known, routinely, as “toxic waste.” And credit default swaps helped banks pretend that their investments were safe because someone else had insured them against losses; when things went wrong, it became obvious that the insurers, AIG in particular, didn’t have anything like enough money to make good on their promises. The thing is, Greenspan wasn’t alone in his delusions. On the eve of the financial crisis, discussion of the financial system, both in the United States and in Europe, was marked by extraordinary complacency.

., 200 conservatives: anti-government ideology of, 66 anti-Keynesianism of, 93–96, 106–8, 110–11 Big Lie of 2008 financial crisis espoused by, 64–66, 100 free market ideology of, 66 Consumer Financial Protection Bureau, 84 Consumer Price Index (CPI), 156–57, 159, 160 consumer spending, 24, 26, 30, 32, 33, 39, 41, 113, 136 effect of government spending on, 39 household debt and, 45, 47, 126, 146 income inequality and, 83 in 2008 financial crisis, 117 conventional wisdom, lessons of Great Depression ignored in, xi corporations, 30 see also business investment, slump in; executive compensation correlation, causation vs., 83, 198, 232–33, 237 Cowen, Brian, 88 credit booms, 65 credit crunches: of 2008, 41, 110, 113, 117 Great Depression and, 110 credit default swaps, 54, 55 credit expansion, 154 currency, manipulation of, 221 currency, national: devaluation of, 169 disadvantages of, 168–69, 170–71 flexibility of, 169–73, 179 optimum currency area and, 171–72 see also euro Dakotas, high employment in, 37 debt, 4, 34, 131 deregulation and, 50 high levels of, 34, 45, 46, 49–50, 51 self-reinforcing downward spiral in, 46, 48, 49–50 usefulness of, 43 see also deficits; government debt; household debt; private debt “Debt-Deflation Theory of Great Depressions, The” (Fisher), 45 debt relief, 147 defense industry, 236 defense spending, 35, 38–39, 148, 234–35, 235, 236 deficits, 130–49, 151, 202, 238 Alesina/Ardagna study of, 196–99 depressions and, 135–36, 137 exaggerated fear of, 131–32, 212 job creation vs., 131, 143, 149, 206–7, 238 monetary policy and, 135 see also debt deflation, 152, 188 debt and, 45, 49, 163 De Grauwe, Paul, 182–83 deleveraging, 41, 147 paradox of, 45–46, 52 demand, 24–34 in babysitting co-op example, 29–30 inadequate levels of, 25, 29–30, 34, 38, 47, 93, 101–2, 118, 136, 148 spending and, 24–26, 29, 47, 118 unemployment and, 33, 47 see also supply and demand Democracy Corps, 8 Democrats, Democratic Party, 2012 election and, 226, 227–28 Denmark, 184 EEC joined by, 167 depression of 2008–, ix–xii, 209–11 business investment and, 16, 33 debt levels and, 4, 34, 47 democratic values at risk in, 19 economists’ role in, 100–101, 108 education and, 16 in Europe, see Europe, debt crisis in housing sector and, 33, 47 income inequality and, 85, 89–90 inflation rate in, 151–52, 156–57, 159–61, 189, 227 infrastructure investment and, 16–17 lack of demand in, 47 liquidity trap in, 32–34, 38, 51, 136, 155, 163 long-term effects of, 15–17 manufacturing capacity loss in, 16 as morality play, 23, 207, 219 private sector spending and, 33, 47, 211–12 unemployment in, x, 5–12, 24, 110, 117, 119, 210, 212 see also financial crisis of 2008–09; recovery, from depression of 2008– depressions, 27 disproportion between cause and effect in, 22–23, 30–31 government spending and, 135–36, 137, 231 Keynes’s definition of, x Schumpeter on, 204–5 see also Great Depression; recessions deregulation, financial, 54, 56, 67, 85, 114 under Carter, 61 under Clinton, 62 income inequality and, 72–75, 74, 81, 82, 89 under Reagan, 50, 60–61, 62, 67–68 rightward political shift and, 83 supposed benefits of, 69–70, 72–73, 86 derivatives, 98 see also specific financial instruments devaluation, 169, 180–81 disinflation, 159 dot-com bubble, 14, 198 Draghi, Mario, 186 earned-income tax credit, 120 econometrics, 233 economic output, see gross domestic product Economics (Samuelson), 93 economics, economists: academic sociology and, 92, 96, 103 Austrian school of, 151 complacency of, 55 disproportion between cause and effect in, 22–23, 30–31 ignorance of, 106–8 influence of financial elite on, 96 Keynesian, see Keynesian economics laissez-faire, 94, 101 lessons of Great Depression ignored by, xi, 92, 108 liquidationist school of, 204–5 monetarist, 101 as morality play, 23, 207, 219 renewed appreciation of past thinking in, 42 research in, see research, economic Ricardian, 205–6 see also macroeconomics “Economics of Happiness, The” (Bernanke), 5 economy, U.S.: effect of austerity programs on, 51, 213 election outcomes and, 225–26 postwar boom in, 50, 70, 149 size of, 121, 122 supposed structural defects in, 35–36 see also global economy education: austerity policies and, 143, 213–14 depression of 2008– and, 16 income inequality and, 75–76, 89 inequality in, 84 teachers’ salaries in, 72, 76, 148 efficient-markets hypothesis, 97–99, 100, 101, 103–4 Eggertsson, Gauti, 52 Eichengreen, Barry, 236 elections, U.S.: economic growth and, 225–26 of 2012, 226 emergency aid, 119–20, 120, 144, 216 environmental regulation, 221 Essays in Positive Economics (Friedman), 170 euro, 166 benefits of, 168–69, 170–71 creation of, 174 economic flexibility constrained by, 18, 169–73, 179, 184 fixing problems of, 184–87 investor confidence and, 174 liquidity and, 182–84, 185 trade imbalances and, 175, 175 as vulnerable to panics, 182–84, 186 wages and, 174–75 Europe: capital flow in, 169, 174, 180 common currency of, see euro creditor nations of, 46 debtor nations of, 4, 45, 46, 139 democracy and unity in, 184–85 fiscal integration lacking in, 171, 172–73, 176, 179 GDP in, 17 health care in, 18 inflation and, 185, 186 labor mobility lacking in, 171–72, 173, 179 1930s arms race in, 236 social safety nets in, 18 unemployment in, 4, 17, 18, 176, 229, 236 Europe, debt crisis in, x, 4, 40, 45, 46, 138, 140–41, 166–87 austerity programs in, 46, 144, 185, 186, 188, 190 budget deficits and, 177 fiscal irresponsibility as supposed cause of (Big Delusion), 177–79, 187 housing bubbles and, 65, 169, 172, 174, 176 interest rates in, 174, 176, 182–84, 190 liquidity fears and, 182–84 recovery from, 184–87 unequal impact of, 17–18 wages in, 164–65, 169–70, 174–75 European Central Bank, 46, 183 Big Delusion and, 179 inflation and, 161, 180 interest rates and, 190, 202–3 monetary policy of, 180, 185, 186 European Coal and Steel Community, 167 European Economic Community (EEC), 167–68 European Union, 172 exchange rates, fixed vs. flexible, 169–73 executive compensation, 78–79 “outrage constraint” on, 81–82, 83 expansionary austerity, 144, 196–99 expenditure cascades, 84 Fama, Eugene, 69–70, 73, 97, 100, 106 Fannie Mae, 64, 65–66, 100, 172, 220–21 Farrell, Henry, 100, 192 Federal Deposit Insurance Corporation (FDIC), 59, 172 Federal Housing Finance Agency, 221 Federal Reserve, 42, 103 aggressive action needed from, 216–19 creation of, 59 foreign exchange intervention and, 217 inflation and, 161, 217, 219, 227 interest rates and, 33–34, 93, 105, 117, 134, 135, 143, 151, 189–90, 193, 215, 216–17 as lender of last resort, 59 LTCM crisis and, 69 money supply controlled by, 31, 32, 33, 105, 151, 153, 155, 157, 183 recessions and, 105 recovery and, 216–19 in 2008 financial crisis, 104, 106, 116 unconventional asset purchases by, 217 Federal Reserve Bank of Boston, 47–48 Feinberg, Larry, 72 Ferguson, Niall, 135–36, 139, 160 Fianna Fáil, 88 filibusters, 123 financial crisis of 2008–09, ix, x, 40, 41, 69, 72, 99, 104, 111–16 Bernanke on, 3–4 Big Lie of, 64–66, 100, 177 capital ratios and, 59 credit crunch in, 41, 110, 113, 117 deleveraging in, 147 Federal Reserve and, 104, 106 income inequality and, 82, 83 leverage in, 44–46, 63 panics in, 4, 63, 111, 155 real GDP in, 13 see also depression of 2008–; Europe, debt crisis in financial elite: political influence of, 63, 77–78, 85–90 Republican ideology and, 88–89 top 0.01 percent in, 75, 76 top 0.1 percent in, 75, 76, 77, 96 top 1 percent in, 74–75, 74, 76–77, 96 see also income inequality financial industry, see banks, banking industry financial instability hypothesis, 43–44 Financial Times, 95, 100, 203–4 Finland, 184 fiscal integration, 171, 172–73, 176 Fisher, Irving, 22, 42, 44–46, 48, 49, 52, 163 flexibility: currency and, 18, 169–73 paradox of, 52–53 Flip This House (TV show), 112 Florida, 111 food stamps, 120, 144 Ford, John, 56 foreclosures, 45, 127–28 foreign exchange markets, 217 foreign trade, 221 Fox News, 134 Frank, Robert, 84 Freddie Mac, 64, 65–66, 100, 172, 220–21 free trade, 167 Friedman, Milton, 96, 101, 181, 205 on causes of Great Depression, 105–6 Gabriel, Peter, 20 Gagnon, Joseph, 219, 221 Gardiner, Chance (char.), 3 Garn–St.

 

pages: 193 words: 11,060

Ethics in Investment Banking by John N. Reynolds, Edmund Newell

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accounting loophole / creative accounting, banking crisis, capital controls, collapse of Lehman Brothers, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, discounted cash flows, financial independence, index fund, invisible hand, margin call, moral hazard, Nick Leeson, Northern Rock, quantitative easing, shareholder value, short selling, South Sea Bubble, stem cell, the market place, The Wealth of Nations by Adam Smith, too big to fail

Arranging finance would consist of preparing presentations to potential funders and securing financing (normally debt, but this can also include additional sources of equity finance) Bait and switch: investment banking practice of marketing a (senior) team of bankers to a client and then replacing them with more junior bankers once a mandate has been awarded Big cap: a quoted company with a large market capitalisation or share value Business ethics: an ethical understanding of business, applying moral philosophical principles to commerce Capital markets: collective term for debt and equity markets; reference to the businesses within an investment bank that manage activity in the capital markets Casino capitalism: term used to describe high-risk investment banking activities with an asymmetric risk profile Categorical imperative: the concept, developed by Immanuel Kant, of absolute moral rules CDS: credit default swap, a form of financial insurance against the risk of default of a named corporation CEO: chief executive officer, the most senior executive officer in a corporation viii Glossary ix Church Investors’ Group (CIG): a group of the investment arms of a number of church denominations, mainly from the UK and Ireland Code of Ethics: an investment bank’s statement of its requirements for ethical behaviour on the part of its employees Compensation: investment bankers’ remuneration or pay Compliance: structures within an investment bank to ensure adherence to applicable regulation and legislation Conflict of interest: situation where an investment bank has conflicting duties or incentives Corporate debt: loan made to a company Credit rating: an assessment of the creditworthiness of a corporation or legal entity given by a credit rating agency CSR: Corporate Social Responsibility DCF: discounted cash flow Debtor in Possession finance (DIP finance): secured loan facility made to a company protected from its creditors under chapter 11 of the US bankruptcy code Derivative: a security created out of an underlying security (such as an equity or a bond), which can then be traded separately Dharma: personal religious duty, in Hinduism and Buddhism Discounted cash flow valuation: the sum of: • the net present value (NPV) of the cash flows of a company over a defined timescale (normally 10 years); • the NPV of the terminal value of the company (which may be the price at which it could be sold after 10 years); and • the existing net debt of the company Distribution: the marketing of securities Dodd–Frank Act: the Dodd–Frank Wall Street Reform and Consumer Protection Act Downgrade: a reduction in the recommended action to take with regard to an equity; or a reduction in the credit rating of a corporation Duty-based ethics: ethical values based on deontological concepts EBITDA: Earnings Before Interest Tax Depreciation and Amortisation EIAG: the Ethical Investment Advisory Group of the Church of England Encyclical: official letter from the Pope to bishops, priests, lay people and people of goodwill x Glossary Enterprise value (EV): value of an enterprise derived from the sum of its financing, including equity, debt and any other invested capital, which should equate to its DCF value ERM: the European Exchange Rate Mechanism, an EU currency system predating the introduction of the euro ETR: effective tax rate EV:EBITDA: ratio used to value a company Exit: sale of an investment Free-ride: economic term for gaining a benefit from another’s actions Financial adviser: see Adviser Glass–Steagall: the 1933 Act that required a separation of investment and retail banking in the US Golden Rule: do to others as you would have them do to you Hedge fund: an investment fund with a specific investment mandate and an incentivised fee structure (see 2 and 20) High yield bond: debt sold to institutional investors that is not secured (on the company’s assets or cash-flows) HMRC: Her Majesty’s Revenue and Customs, the UK’s authority for collecting taxes Hold-out value: value derived from the contractual right to be able to agree or veto changes Ijara: Shariah finance structure for project finance Implicit Government guarantee: belief that a company or sector benefits from the likelihood of Government intervention in the event of crisis, despite the fact that no formal arrangements are in place Initial Public Offering (IPO): the initial sale of equity securities of a company to public market investors Insider dealing: trading in shares in order to profit from possessing confidential information Insider trading: see Insider dealing Integrated bank: a bank offering both commercial and investment banking services Integrated investment bank: an investment bank that is both active in capital markets and provides advisory services Internal rate of return (IRR): the annualised return on equity invested.

In normal market trading, it is common market practice to deal on the basis of well-understood assumptions, which do not need to be specified for each transaction – for example, when selling a share in a company, it is accepted that the share is equivalent to other shares normally traded, and that settlement terms are those under normal market rules. In this context, any difference from the norm needs to be disclosed in advance of a deal being agreed. Applying ethical standards to off-market trading The ethics of both on and off-market trading need to be considered as separate but related issues. For example, CDOs and CDSs (credit default swaps) have (to date) not been traded on recognised exchanges. Their position is therefore very different to that of equities traded on the NYSE or the London Stock Exchange. The ethical duty of an investment bank when trading off-market also depends on how it treats its market-related activities. There is an ethical duty to uphold the standards of market behaviour when trading on-market, but this does not necessarily apply to off-market trading.

., 73 conflicts of interest in, 112–14 cardinal virtues, 37 Caritas in Veritate (Benedict), 6, 52 cash compensation, 132, 134 casino capitalism emergence of, 43 in investment banking, 3 speculative, 16, 93 categorical imperative, 34, 59, 69 Caterpillar, 48 Central Finance Board of the Methodist Church (CFB), 54, 59 chief executive officer (CEO), 116 Christianity, 52–4 Anglican Communion, 53 Methodist Church, 53 Roman Catholic Church, 53 Christian Old Testament, 34 Church Investors’ Group (CIG), 135 Church of England, 9, 53, 58 Citigroup, 19, 112 claiming credit, 134 clients confidential information, 120 conflicts of interest, 105–10 171 duty of care, 105 engagement letters, 122–3 fees, 115–18 financial restructuring, 119–20 hold-out value, 120–1 honesty, 101–5 margin-calls, 121 practical issues, 110–15 promises, 100–1 restructuring fees, 121–2 syndication, 118–22 truth, 101–5 Code of Ethics, 47–50, 147–51 for Goldman Sachs business principles, 46 in investment banking, 47–9 Revised, 47 collatoralised debt obligations (CDOs), 30, 42, 75 command economies, 13 commercial banking, 19–21, 25 communication within markets, 88 Companies Act 2006, 27 compensation cash, 132, 134 defined, 132 for employees, 135 internal issues on, 8 for junior bankers, 136 levels of, 132–3, 138 objectivity of, 144 political issues with, 6, 137 restrictions on, 10 competitors, 113 compliance corporate, 20 danger of, 20 frameworks for, 68, 146 regulatory, 18 requirements of, 6 confidential information, 120 conflicts of interest, 105–10, 158 with capital markets, 109–10 with corporate finance, 107–8 personal, 47 with pre-IPO financing, 110 with private equity, 110 172 Index conflicts of interest – continued reconciling, 68–70 of trusted advisers, 108–9 consequentialist ethics, 36–7, 42 corporate compliance, 20 Corporate/Compliance Social Responsibility (CSR), 7 corporate debt, 17 corporate entertainment, 128–9, 159 corporate finance, 107–8 Corporate Sustainability Committee, 152 Costa, Ken, 9 Cox, Christopher, 96–7 creative accounting, 12 credit crunch, 17 credit default swap (CDS), 71 credit downgrade, 17, 76 Credit Lyonnais, 12 creditors, restricted, 121 credit rating, 75–7 calculating, 76 inaccurate, 5 manipulating, 75, 156, 158 unreliability of, 17 credit rating agencies, 76 Crisis and Recovery (Williams), 53 culture, 46, 136, 151 customers, 69 Daily Telegraph, 84 Debtor in Possession finance (DIP finance), 80 debts bank, 82–3, 120 corporate, 17 junior, 118 rated, 77 senior, 118 sovereign, 17 deferred equity, 5 deferred shares, 133 Del Monte Foods Co., 107 deontological ethics, 34–6 stockholders, 41–2 trust, 40–1 derivative, 27, 30 dharma, 63–4 Dharma Indexes, 57 discounted cash flow (DCF), 27 discount rate, 27 discriminatory behaviour, 129–31 distribution, 15, 35, 66 Dodd–Frank Wall Street Reform and Consumer Protection Act, 25 dotcom crisis, 94 dotcom stocks, 17 Dow Jones, 55–6 downgrade credit, 17, 76 defined, 76 multi-notch, 17, 76 duties, see rights vs. duties duty-based ethics, 66–8 duty of care, 105 Dynegy, 8 Earnings Before Interest Tax Depreciation and Amortisation (EBITDA), 27 economic free-ride, 5, 21 economic reality, 137 effective tax rate (ETR), 140 emissions trading, 14 employees, compensation for, 135 Encyclical, 52 engagement letters, 122–3, 159 Enron, 8, 12, 17, 20, 76 enterprise value (EV), 27 entertainment adult, 56 corporate, 128–9, 159 sexist, 159 equity deferred, 5 private, 2–3, 12, 110 equity research, 88–9, 113–15 insider dealing and, 83–4 ethical behaviour, 38–9 Ethical Investment Advisory Group (EIAG), 53, 58 ethical investment banking, 145–7 ethical standards, 47 Index ethics consequentialist, 36–7, 42 deontological, 34–6 duty-based, 66–8 exceptions and, effects of, 89–90 financial crisis and, 4–8 in investment banking, 1 in moral philosophy, 1 performance and, 8–10 rights-based, 66–8 virtue, 37–8, 43–4 see also business ethics; Code of Ethics Ethics Helpline, 48 Ethics of Executive Remuneration: a Guide for Christian Investors, The, 135 European Commission, 89 European Exchange Rate Mechanism (ERM), 17 exceptions, 89 external regulations, 19, 31 fair dealing, 45 Fannie Mae, 43 Federal Home Loan Mortgage Corporation, 43 Federal National Mortgage Association, 43 fees, 115–18 advisory, 107, 116 restructuring of, 121–2 2 and 20, 13 fiduciary duties, 27–8 financial advisers, 109 Financial Conduct Authority (FCA), 26 financial crisis, business ethics during CDOs during, 90 CDSs during, 90 ethics during, 4–8, 12–34 investment banking and, necessity of, 14–15 market capitalism, 12–14 necessity of, 14–15 non-failure of, 21 positive impact of, 18 problems with, 15–17 reality of, 16 speculation in, 91 173 Financial Crisis Inquiry Commission, 76 Financial Policy Committee (FPC), 25 financial restructuring, 119–20 Financial Services Modernization Act, 19 Financial Stability Oversight Council, 25 firm price, 67 Four Noble Truths, 57 Freddie Mac, 43 free-ride defined, 26 economic, 5, 21 in investment banking, 24 FTSE, 55 Fuhs, William, 8 General Board of Pension and Health Benefits, 54, 59 German FlowTex, 12 Gift Aid, 141 Glass–Steagall Act, 19 Global Settlement, 113 golden parachute arrangements, 133 Golden Rule, 35, 150 Goldman Sachs, 7, 16, 45, 63 Business Principles, 45–6 charges against, 78 Code of Business Conduct and Ethics, 45, 68 Code of Ethics for, 47–8 Goldsmith, Lord, 27 government, 59 business ethics within, 60 guarantees of, 24 intervention by, 22–3 government bonds, 23 greed, 4–5 Green, Stephen, 8–9 gross revenues, 59 Hedge fund behaviour of, 12 failure of, 21 funds for, raising, 2 investment fund, as type of, 3 rules for, 133 174 Index Hennessy, Peter, 42 Her Majesty’s Revenue and Customs (HMRC), 140–1 high returns, 28, 110 Hinduism, 56–7 Hobbes, Thomas, 36 hold-out value, 120–1 honesty, see trust hospitality, 128–9 hot IPOs, 94 hot-stock IPOs, 94 HSBC, 9, 28, 152 Ijara, 55 implicit government guarantee, 22–3 Independent Commission on Banking, 25 inequitable rewards, 6 informal authorisation, 81, 98 Initial Public Offering (IPO), 7 of dotcom stocks, 17 hot, allocation of, 94 hot-stock, 94 insider dealings, 83–4, 155 equity research and, 83–4 ethics of, 66, 70 laws on, 84 legal prohibition on, 82 legal restrictions on, 10 legal status of, 82 legislation on, 74 restrictions on, 83 rules of, 82, 90 securities, 70 insider trading, 12 insolvency, 24–5 institutional greed, 4 integrated bank, 28 integrated investment banking, 2, 30, 67, 106, 108 interest payments, 59–60 interest rate, 60 internal ethical issues, 126–43 abuse of resources, 127–8 corporate entertainment, 128–9 discriminatory behaviour, 129–31 hospitality, 128–9 management behaviour, 131–2 remuneration, 132–9 tax, 139–41 internal review process, managing, 134 investment banking, 94 casino capitalism in, 3 Code of Ethics in, 47–9 commercial and, convergence of, 20–1 defined, 2 ethics in, 1 free-ride in, 24 integrated, 2, 30, 67, 108, 112 in market position, role of, 65–6 moral reasoning and, 38 necessity of, 14–15 non-failure of, 19–20 positive impact of, 18 recommendations in, 94–7 sector exclusions for, 58–9 investment banking adviser, 121 investment banking behaviours, 3 investment banking ethics committee, 151–3 investment bubbles, 95 investment fund, 3 investment grade bonds, 118 investment grade securities, 76 investment recommendations, 94 investments personal account, 128, 156 principal, 15, 28 proprietary, 29 IRS, 140 Islam, 54–5 Islamic banking, 6, 54–5 Jewish Scriptures, 34 Joint Advisory Committee on the Ethics of Investment (JACEI), 54 JP Morgan, 16 Judaism, 56 junior bankers, 139 junior debt, 118 junk bond, 118 “just war” approach, 38 Index Kant, Immanuel, 35, 69 karma, 57 Kerviel, Jérôme, 44, 80 Krishna, 57 Law Society, 19 Lazard International, 9 leading adviser, 41 Leeson, Nick, 12, 44, 81 legislative change, 25–6 Lehman Brothers, 5–6, 15, 21, 23, 31, 43, 76 lenders, 26, 131 lending, 59–60 leverage levels of, 25 over, 75, 80, 119 Levin, Carl, 17, 63–4, 68 light-touch regulations, 4 liquidity market, 95 orderly, 25 withdrawal of, 24 loan-to-own, 80 Locke, John, 34 London Inter-Bank Offered Rate (LIBOR), 23 London School of Economics, 43 London Stock Exchange, 65, 71, 84 long-term values, 147 Lords Grand Committee, 27 LTCM, 23 lying, 101 MacIntyre, Alasdair, 38 management behaviour, 131–2 margin-calls, 121 market abuse, 14, 70, 75, 86–8, 155 market announcements, 88 market behaviours, 74 market capitalism, 12–14 market communications, 88 market liquidity, 95 market maker defined, 65–7 investment bank as, 66 primary activities of, 65 175 market manipulation, 75 market position, role of, 104 market rate, 117 markets advisory, 73 capital, 73, 117–18, 158 communication within, 88 duties to support, 71–2 primary, 103 qualifying, 70, 82 secondary, 103 market trading, 41 Maxwell, Robert, 12 Meir, Asher, 56 mergers and acquisitions (M&As), 41, 79 Merkel, Angela, 93 Merrill Lynch, 8, 16 Methodism, 53 Methodist Central Finance Board, 59 Methodist Church, 54 Midrash, 56 Milken, Michael, 12 Mill, John Stuart, 36 Mirror Newspaper Group, 12 misleading behaviours, 86, 105 mis-selling of goods and services, 77–9, 155 modern capitalism, 54 moral-free zones, 31 moral hazard, 22, 70 moral philosophy, 1 moral reasoning, 38 moral relativism, 38–9, 49, 68 Morgan Stanley, 47 multi-notch downgrade, 17, 79 natural law, 34, 37 natural virtues, 37 necessity of investment banking, 14–15 New York Stock Exchange (NYSE), 65, 71 New York Times, 8 Noble Eightfold Path, 57 Nomura Group Code of Ethics, 47 normal market trading, 71 Northern Rock, 43 176 Index offer price, 64 off-market trading, 71–3, 90, 155 Olis, Jamie, 8 on-market trading, 70–1 oppressive regimes, 61 option value, 121 Orderly Liquidation Authority, 25 orderly liquidity, 25 out-of-pocket expenses, 127–8 over-leverage, 75, 80, 119, 158 overvalued securities, 155 patronage culture, 131, 142 Paulson, Henry M., 86 Paulson & Co., 78 “people-based” activity, 67 P:E ratio, 27 performance, 8–10 personal abuse, 159 personal account investments, 128, 156 personal account trading, 128 personal conflicts of interest, 45 pitching, 102, 159 Plato, 37 practical issues, 110–15 competitors, relationships with, 113 equity research, 113–15 pitching, 111 sell-side advisers, 111–13 pre-IPO financing, 110 prescriptive regulations, 31, 145 price tension, 79, 113 primary market, 103 prime-brokerage, 2 principal investment, 15, 28 private equity, 2–3, 12, 110 private trading, 94 Project Merlin, 133, 141 promises, 100–1 proprietary investment, 29 proprietary trading, 15, 25, 66, 150, 155 Prudential Regulation Authority (PRA), 26 public ownership, bonus pools in, 136–9 “pump and dump” strategy, 86 qualifying instruments, 70, 87 qualifying markets, 70, 82 quality-adjusted life year (QALY), 36 Quantitative Easing (QE), 23 Queen Elizabeth II, 42 Qu’ran, 54 rated debt, 77 rates attrition, 132 discount, 27 interest, 60 market, 117 tax, 140 rating agencies, 76 Rawls, John, 35, 136 recognised exchanges, 71 Regal Petroleum, 84 regulations banking, 16 compliance with, 28 external, 19, 31 light-touch, 4 prescriptive, 31, 145 regulatory changes and, 18–20 securities, 114 self, and impact on legislation, 19 regulatory compliance, 18 religion, business ethics in, 51–62 Buddhism, 56 Christianity, 52–4 Governments, 59 Hinduism, 56–7 interest payments, 59–60 Islam, 54–5 Judaism, 56 lending, 59–60 thresholds, 60 usury, 59–60 remuneration, 132–9 bonus pools in public ownership and, 136–9 claiming credit, 134 ethical issues with, 142–3 internal review process, managing, 134 1 Timothy 6:10, 135–6 Index research, 156 resources, abuse of, 127–8 restricted creditors, 120 restructuring of fees, 121–2 financial, 119–20 syndication and, 118–22 retail banks, 16 returns, 28, 156 Revised Code of Ethics, 47 right livelihood, 57 rights-based ethics, 66–8 rights vs. duties advisory vs. trading/capital markets, 73 conflict between, reconciling, 68–70 duty-based ethics, 66–8 off-market trading, ethical standards to, 71–2 on-market trading, ethical standards in, 70–1 opposing views of, 63–74 reconciling conflict between, 68–70 rights-based ethics, 66–8 Roman Catholic Church, 52 Royal Dutch Shell, 85 Sarbanes–Oxley Act, 20 Schwarzman, Stephen, 20 scope of ethical issues, 7–8 secondary market, 103 sector exclusions for investment banking, 58–9 securities investment grade, 76 issuing, 103–5 overvalued, 155 Securities and Exchange Commission (SEC), 7, 16 Goldman Sachs, charges against, 78 rating agencies, review by, 77 short-selling, review of, 96–7 securities insider dealing, 70 securities mis-selling, 77–9 securities regulations, 114 self-regulation, 19 sell recommendation, 115 177 sell-side advisers, 107, 111–13 Senate Permanent Subcommittee on Investigations, 46 senior debt, 118 sexist entertainment, 159 shareholders, 27–9 shares, deferred, 133 Shariah finance, 55 short-selling, 94–7, 154–5 Smith, Adam, 14, 35–6 social cohesion, 53 socially responsible investment (SRI), 56 Société Générale, 44, 80 solidarity, 53 Soros, George, 17 South Sea Bubble, 90 sovereign debt, 17 speculation, 91–4, 155 in financial crisis, 93 traditional views of, 91–3 speculative casino capitalism, 16, 91 spread, 21 stabilisation, 89 stock allocation, 94–7 stockholders, 41–2 stocks, dotcom, 17 Strange, Susan, 43 strategic issues with business ethics, 30–1 syndication, 119 and restructuring, 118–22 systemic risk, 24–5 Takeover Panel, 109 Talmud, 56 taxes, 139–41 tax optimisation, 158 tax rates, 140 tax structuring, 140 Terra Firma Capital Partners, 79, 112 Theory of Moral Sentiments, The (Smith), 14 3iG FCI Practitioners’ Report, 51 thresholds, 60 1 Timothy 6:10, 135–6 178 Index too big to fail concept, 21–7 ethical duties, and implicit Government guarantee, 22–3 ethical implications of, 26–7 in government, 22–3 insolvency, systemic risk and, 24–5 legislative change, 25–6 Lehman, failure of, 23 systemic risk, 24–5 toxic financial products, 5 trading abusive, 93 emissions, 14 insider, 12 market, 41 normal market, 71 off-market, 71–83, 90, 155 on-market, 70–1 personal account, 128 private, 94 proprietary, 15, 25, 66, 150, 155 unauthorised, 7 “trash and cash” strategy, 86 Travellers, 19 Treasury Select Committee, 26 Trinity Church, 53 Trouble with Markets, The (Bootle), 4 trust, 40, 53 trusted adviser, 108–9, 125 truth, 101–5 bait and switch, 102–3 misleading vs. lying, 101 securities, issuing, 103–5 2 and 20 fee, 13 UBS Investment Bank, 9 unauthorised trading, 7, 80–1, 155 unethical behaviour, 68 UK Alternative Investment Market, 89 UK Business Growth Fund, 133 UK Code of Practice, 141 UK Independent Banking Commission, 4, 22 United Methodist Church, 54, 59 United Methodist Investment Strategy Statement, 59 US Federal Reserve, 24, 25 US Financial Crisis Inquiry Commission, 4 US Open, 126 US Senate Permanent Subcommittee on Investigations, 64, 73 US Treasury Department, 132 universal banks, 2, 21, 28, 67 untoward movement, 85 usury, 59–60 utilitarian, 84 utilitarian ethics, 49, 84, 139 values, 9, 46, 119–21, 148 Vedanta, 57 victimless crime, 82 virtue ethics, 37–8, 43–4 virtues, 9, 34 virtuous behaviours, 37 Vishnu, 57 Volcker, Paul, 25 Volcker Rule, 2, 25 voting shareholders, 29 Wall Street, 12, 19, 53 Wall Street Journal, 20 Wealth of Nations, The (Smith), 14 Wesley, John, 53 Wharf, Canary, 18 Williams, Rowan, 53 Wimbledon, 127 WorldCom, 12, 17, 20, 76 write-off, 80 zakat, 55 zero-sum games, 118–22

 

pages: 202 words: 66,742

The Payoff by Jeff Connaughton

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algorithmic trading, bank run, banking crisis, Bernie Madoff, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, cuban missile crisis, desegregation, Flash crash, locking in a profit, London Interbank Offered Rate, London Whale, Long Term Capital Management, naked short selling, Plutocrats, plutocrats, Ponzi scheme, risk tolerance, short selling, Silicon Valley, too big to fail, two-sided market, young professional

Clinton’s economic team (including Rubin and Summers) had fought to ensure that derivatives would remain unregulated. We knew that policymakers had pushed banks and quasi-agencies like Fannie Mae and Freddie Mac to make housing affordable; that subprime mortgages were pooled and securitized; that the rating agencies blew it and gave these pools AAA ratings; and that banks were leveraging thirty- and fifty-to-one and buying up these soon-to-be-toxic assets. Credit default swaps were being written and traded to hedge these risks without any understanding of who was writing how much and without any regulation or oversight. As Ted liked to say, Washington’s decades-long infatuation with deregulation had pulled all the referees off the football field. Then, the executives trusted to act in the best interests of shareholders had convinced themselves, against all reason and instinct, that they could engineer risk out of the system.

Ted reported back that Bernanke and Geithner were very concerned. On March 2, AIG had reported it had recorded a $61 billion loss in the fourth quarter of 2008. The next day, Treasury had announced an additional $30 billion in assistance to AIG, on top of the $150 billion it had already extended. Ted and others were wondering, “How could AIG lose $61 billion?” Bernanke and Geithner simply didn’t know who held the credit-default swaps. There were similar problems in England, in Iceland, and at the Bank of Scotland. Ted said: “It was like a friend of mine who has this oak tree out in front of his house, a gigantic tree, and the tree is surrounded by a driveway. The roots were coming up and knocking out the driveway. But when they tried to put a new driveway in, they didn’t know where the roots went. The roots went all over.

Merkley and Levin had gotten excited about their Volcker Rule amendment. They also began to host meetings of progressive Democratic senators who thought Dodd’s bill was too weak. Dick Durbin (D-IL) tried to coordinate the input of senators who were dissatisfied with the Dodd bill. Al Franken (D-MN) had developed an amendment on credit rating agencies and conflicts of interest. Dorgan began pushing for a ban on naked credit default swaps (when speculators take a short position on a bond without owning the bond itself). Blanche Lincoln (D-AR), the chair of the Agriculture Committee, which has jurisdiction over derivatives (futures markets originally existed to hedge commodities, especially agricultural commodities), had first worked out a compromise with the committee’s ranking Republican, Senator Saxby Chambliss (R-GA).

 

pages: 224 words: 13,238

Electronic and Algorithmic Trading Technology: The Complete Guide by Kendall Kim

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algorithmic trading, automated trading system, backtesting, corporate governance, Credit Default Swap, diversification, en.wikipedia.org, family office, financial innovation, fixed income, index arbitrage, index fund, interest rate swap, linked data, market fragmentation, natural language processing, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, short selling, statistical arbitrage, Steven Levy, transaction costs, yield curve

Electronic access to stocks has been more prevalent than for futures and options, but these asset classes are catching up particularly in foreign exchange. A growing number of trading platforms now support trading in over-the-counter (OTC) derivatives. According to the Bond Market Association in 2004, 25 platforms now allow users to execute transactions in 111 112 Electronic and Algorithmic Trading Technology interest rate swaps, credit default swaps, options, futures, and other derivative products. This is nearly double the number of platforms that supported derivatives trading in 2003. The equities markets will execute trades using some sort of algorithmic model, but the same will most likely be true for other products such as futures, options, and foreign exchange. Fixed income will be one of the last to move along because it is predominantly a dealer market, but when it does, the first asset class will most likely be the most liquid sectors such as the U.S.

U.S. corporate debt and their derivatives have become one of the fastestgrowing segments of the U.S. fixed-income market. By 2006, the total notional outstanding credit derivatives market is expected to reach US $8.5–9.0 trillion. One of the most interesting developments in E-bond trading over the past 18 months has occurred in credit markets. MarketAxess, the unquestioned market leader in high-grade corporate debt, recently rolled out the first multi-dealer-to-client trading platform for credit default swaps. MarketAxess is now facing increased competition from Thomson TradeWeb. U.S. corporate debt outstanding currently stands at US $5.0 trillion, accounting for 20% of all U.S. fixed-income securities outstanding by notional amount. Corporates, however, remain one of the most illiquid segments of the U.S. bond market with trading volume as of Q2 2005 at just US $20.9 billion average trading volume per day representing over 2% of all fixed-income activity.

.: 10. 122 Electronic and Algorithmic Trading Technology reporting has been the buy side, especially institutional investors who trade in smaller lots. Smaller firms gained market share and broker-dealers have lost revenue, as all traders were able to share the same prices. The transparency created by TRACE has squeezed soft dollar revenue for the sell side, causing broker-dealers to cut back on bond-research departments. At the same time, income is booming from securities that are derived from corporate bonds. The market for credit default swaps has more than doubled in size in the past year to cover $26 trillion of securities, according to the International Swaps and Derivatives Association (ISDA). Swaps allow traders to bet on creditworthiness of companies without actually owning the underlying bonds. In March 2006, the NYSE began seeking approval to start electronic trading of 4,000 corporate bonds. 11.6 Foreign Exchange Markets Electronic trading has had an important presence in interdealer spot foreign exchange market for over a decade.

 

pages: 584 words: 187,436

More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby

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Andrei Shleifer, Asian financial crisis, asset-backed security, automated trading system, bank run, barriers to entry, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, Bretton Woods, capital controls, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, currency peg, Elliott wave, Eugene Fama: efficient market hypothesis, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, full employment, German hyperinflation, High speed trading, index fund, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, market clearing, market fundamentalism, merger arbitrage, moral hazard, natural language processing, Network effects, new economy, Nikolai Kondratiev, pattern recognition, pre–internet, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical arbitrage, statistical model, technology bubble, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs

All of Wall Street knew that their reliance on short-term funding, coupled with extremely high leverage, made them vulnerable to a bank run; and the Morgan and Goldman stock prices began to show up permanently at the top of the CNBC screen, in what traders called the “death watch.”25 The trouble at the giant insurer AIG only made things worse. By writing credit default swaps, AIG had sold protection against the danger that all manner of bonds might go into default—it was the kind of crazy risk taking you got when you located an ambitious trading operation inside the bosom of a well-capitalized firm, imbuing the traders with a heady sense of invulnerability. Inevitably, AIG’s credit default swaps lost billions when the likelihood of default spiked up amid the crisis following Lehman. On Tuesday, September 16, the government was forced to rescue the firm, lending it an astonishing $85 billion. The day after that, rumors that Morgan Stanley was exposed to AIG’s mess helped to drive Morgan’s stock down 42 percent by the middle of the afternoon.

But once non-payments surpassed the 5 percent hurdle, the BBB securities would start suffering losses; and since the BBB tranche was only 1 percent thick, a nonpayment rate of 6 percent would take the whole lot of them to zero. In contrast to auto-company bonds, there was no franchise value to worry about, either. A bankrupt company might be worth something to someone. A pile of loans with zero payout is worth, simply, zero. In April 2005, Paulson placed his first bet against these mortgage securities. He bought a credit default swap—an insurance policy on a bond’s default—on $100 million worth of BBB-rated subprime debt. There was a huge asymmetry in the risk and the reward: He paid $1.4 million for a year’s worth of insurance, but if the securities were wiped out, he stood to pocket the full $100 million. The question was whether the odds of default were good: You can get a juicy payout by betting on a single number in roulette, but that’s because your chances of winning are abysmal.

But Paulson was not a man to be deterred. In the summer of 2006, he set up a new hedge fund to do exactly what his table said, seeding it partly with his own money and enlisting Pellegrini as the comanager. The challenge was how to do the trades in the size that he now wanted. Paulson could bet against mortgage bonds by borrowing them and selling them short, a cumbersome operation. Or he could buy an insurance policy—a credit default swap from a bank—but that depended upon finding a bank that was interested in selling. To Paulson’s great good fortune, in July 2006 Wall Street’s top investment banks created an easier option: Hoping to earn themselves a stream of trading commissions, they launched a subprime mortgage index, known as the ABX. Paulson now found that, on any given day, it was easy to buy insurance on, say, $10 million of subprime paper.

 

pages: 580 words: 168,476

The Price of Inequality: How Today's Divided Society Endangers Our Future by Joseph E. Stiglitz

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affirmative action, Affordable Care Act / Obamacare, airline deregulation, Andrei Shleifer, banking crisis, barriers to entry, Basel III, battle of ideas, Berlin Wall, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, collapse of Lehman Brothers, collective bargaining, colonial rule, corporate governance, Credit Default Swap, Daniel Kahneman / Amos Tversky, Dava Sobel, declining real wages, deskilling, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial innovation, Flash crash, framing effect, full employment, George Akerlof, Gini coefficient, income inequality, income per capita, indoor plumbing, inflation targeting, invisible hand, John Harrison: Longitude, John Maynard Keynes: Economic Possibilities for our Grandchildren, Kenneth Rogoff, labour market flexibility, London Interbank Offered Rate, lone genius, low skilled workers, Mark Zuckerberg, market bubble, market fundamentalism, medical bankruptcy, microcredit, moral hazard, mortgage tax deduction, obamacare, offshore financial centre, paper trading, patent troll, payday loans, price stability, profit maximization, profit motive, purchasing power parity, race to the bottom, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, Simon Kuznets, spectrum auction, Steve Jobs, technology bubble, The Chicago School, The Fortune at the Bottom of the Pyramid, The Myth of the Rational Market, The Spirit Level, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, transaction costs, trickle-down economics, ultimatum game, uranium enrichment, very high income, We are the 99%, women in the workforce

The ECB played, at best, an ambiguous role.36 For instance, in the case of Greece, it insisted that any restructuring of the debt (asking creditors to take a debt write-down and postpone repayment) be voluntary. They said whatever agreement was reached couldn’t be allowed to set off a “credit event,” meaning an event that would trigger a payment on credit default swaps, the risky securities that would pay off if Greece defaulted. In saying that, the ECB seemed to be placing the interests of the banks well above that of the Greek people. Greece needed a deep restructuring (another way of saying a large reduction in its debt burden), well beyond that which might emerge from a voluntary restructuring, but only a voluntary write-down would not be considered a credit event. There was something even more curious about the ECB position. Credit default swaps are supposed to provide insurance. If you have an insurance policy, you want the insurance company to be generous and declare that an “insurable event” has occurred: it is the only way that you can collect on your policy.

Congressional Oversight Panel, 193 consumerism, 104–6, 341 consumer protection, 136, 175, 192, 193, 197 contracts, 197, 271 Cordray, Richard, 370 corporate governance laws, 31, 38, 39, 41, 57, 66–67, 87, 111, 270, 271 corporations, xviii, 91, 100–101, 147, 348 deregulation in, 89, 102, 177–78 dishonest accounting in, 87, 110, 111, 271 dividend payments by, 88, 212 economic influence of, xxii–xxiii executive compensation in, 3, 21, 31, 40, 42, 65, 66, 67, 79, 87, 104, 109, 110, 111, 153–54, 271, 296, 309, 316, 328, 333 government munificence toward, 40, 48, 49–51, 97, 99, 136, 179–80, 189, 191, 210, 214, 215, 216, 222, 224, 228, 272–73 idea-shaping by, 147, 150–51, 160, 179 legal advantages of, 66, 132, 189–90, 191, 202, 272, 327, 374 patent control by, 43, 202–3 risk-taking by, xviii, 99, 189, 339 shareholder influence in, 31, 66, 67, 135, 271, 285, 328 taxation of, 62, 73–74, 95, 115, 142, 179, 214, 215, 221–22, 224, 225, 270, 272, 273–74, 278, 283, 296, 331 as tax shelters, 73, 270, 296 see also business Council of Economic Advisers, 99, 110, 174, 179, 185, 330, 387 credit default swaps (CDSes), 46, 248, 255, 256 creditworthiness, 58, 108 Crick, Francis, 41 crime, 15, 69, 303, 304 Daly, Lew, 78 debit cards, 324 debt: international, 138 U.S., 207, 217, 219 see also bankruptcy; credit default swaps (CDSes); deficit reduction; foreclosures; predatory lending; student loans debt ceiling, 207, 376 Declaration of Independence, 158 Defense Department, U.S., 209 defense industry, government procurement in, 40, 101, 176, 210, 224, 272 deficit, U.S., 114, 115, 179, 208–11, 251, 279, 330, 340, 383 deficit reduction, 207–32, 237, 256, 279, 377 expenditure implications of, 93, 115, 217 Right’s insistence on, 216, 217, 229 strategies for, 211–16, 224, 228, 235, 236 democracy, U.S., 118–45 corruption in, 132, 143, 162, 200 diminishing confidence in, xii, 120–21, 127–28, 129, 131, 132, 133, 134, 143, 144, 250–54, 288 disenfranchisement in, 129–35, 345 globalization and, 138–45 ideological battle over, 155, 162 media’s role in, 128–29, 135, 136, 163, 252, 286 trust and, 125–26 weakening of, 136–38, 142 see also politics, U.S.

In most smaller communities, there are at most one or two. When competition is so limited, prices are likely to be far in excess of competitive levels.41 That’s why the sector enjoys profits estimated to be more than $115 billion a year, much of which is passed along to its top officials and other bankers—helping create one of the major sources of inequality at the top.42 In some products, such as over-the-counter credit default swaps (CDSes), four or five very large banks totally dominate, and such market concentration always gives rise to the worry that they collude, albeit tacitly. (But sometimes the collusion is not even tacit—it is explicit. The banks set a critical rate, called the London Interbank Offered Rate, or Libor. Mortgages and many financial products are linked to Libor. It appears that the banks worked to rig the rate, enabling them to make still more money from others who were unaware of these shenanigans.)

 

pages: 840 words: 202,245

Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present by Jeff Madrick

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accounting loophole / creative accounting, Asian financial crisis, bank run, Bretton Woods, capital controls, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, desegregation, disintermediation, diversified portfolio, Donald Trump, financial deregulation, fixed income, floating exchange rates, Frederick Winslow Taylor, full employment, George Akerlof, Hyman Minsky, income inequality, index fund, inflation targeting, inventory management, invisible hand, laissez-faire capitalism, locking in a profit, Long Term Capital Management, market bubble, minimum wage unemployment, Mont Pelerin Society, moral hazard, mortgage debt, new economy, North Sea oil, Northern Rock, oil shock, price stability, quantitative easing, Ralph Nader, rent control, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, Ronald Reagan: Tear down this wall, shareholder value, short selling, Silicon Valley, Simon Kuznets, technology bubble, Telecommunications Act of 1996, The Chicago School, The Great Moderation, too big to fail, union organizing, V2 rocket, value at risk, Vanguard fund, War on Poverty, Washington Consensus, Y2K, Yom Kippur War

Joe Cassano, an executive at AIG, the giant insurance company, made inexplicably outsize bets that made the company liable for $80 billion should mortgage securities go bad. Cassano, a graduate of Brooklyn College and trained in Michael Milken’s junk bond department at Drexel Burnham in the 1980s, was a managerial tyrant consumed by his mini-empire and easy profits. In the 2000s, he effortlessly generated millions of dollars a year by selling what were known as credit default swaps—an insurance policy of sorts that guarantees to pay the value of a bond if it fails—for Hank Greenberg, the hard-nosed AIG chief executive, who was forced out in early 2005 in an accounting scandal. When Greenberg left, Cassano became temporarily even more aggressive, though he soon after halted his buying. It cost the U.S. Treasury more than $180 billion to bail out AIG in 2008 and 2009, due to both AIG’s insurance and also aggressive purchases of mortgage securities.

Cioffi may not have bought subprimes directly but he bought plenty of the complex CDOs that ultimately had large amounts of subprime mortgages as collateral. He claimed only 6 percent of their portfolios had exposure to subprime mortgages but others estimated that up to 60 percent of Bear’s $1.5 billion in assets were in reality backed by subprimes. A still newer CDO product had also been created, a synthetic CDO, which added more risk to the mortgage market and which Cioffi and Tannin bought enthusiastically. They were created out of the credit default swaps (CDSs) that AIG and soon others were liberally selling across Wall Street—the insurance on the CDOs. The great advantage of the synthetic CDOs is that their issuance was not restricted to the number of mortgages that could be sold to prospective homeowners. There was no collateral. There was one requirement, however: someone had to be willing to buy the CDSs—the insurance was the basis of the synthetic, “collateral-less” CDOs.

Many of them were rated triple-A. By late summer, Lehman needed some $40 billion in fresh capital to stay alive. In 1998, LTCM required only several billion dollars to stabilize the financial markets. The difference now was the sheer size of the pool of debt—$7–8 trillion of mortgages had been written, from which several trillion dollars of mortgage-backed securities had been created, and massive amounts of credit default swaps as well. Tim Geithner, president of the New York Fed, Ben Bernanke, chairman of the Fed, and Hank Paulson, treasury secretary, claiming helplessness, let Lehman go bankrupt. When the Lehman bankruptcy was announced on Sunday, September 14, a financial editor turned to me at a dinner party and said the crisis was now over. But it was merely the beginning of the most tumultuous financial period since early in the Great Depression.

 

pages: 497 words: 150,205

European Spring: Why Our Economies and Politics Are in a Mess - and How to Put Them Right by Philippe Legrain

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3D printing, Airbnb, Asian financial crisis, bank run, banking crisis, barriers to entry, Basel III, battle of ideas, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, BRICs, British Empire, business process, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, Celtic Tiger, central bank independence, centre right, cleantech, collaborative consumption, collapse of Lehman Brothers, collective bargaining, corporate governance, credit crunch, Credit Default Swap, crony capitalism, currency manipulation / currency intervention, currency peg, debt deflation, Diane Coyle, Downton Abbey, Edward Glaeser, Elon Musk, en.wikipedia.org, energy transition, eurozone crisis, fear of failure, financial deregulation, first-past-the-post, forward guidance, full employment, Gini coefficient, global supply chain, Growth in a Time of Debt, hiring and firing, hydraulic fracturing, Hyman Minsky, Hyperloop, immigration reform, income inequality, interest rate derivative, Irish property bubble, James Dyson, Jane Jacobs, job satisfaction, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, liquidity trap, margin call, Martin Wolf, mittelstand, moral hazard, mortgage debt, mortgage tax deduction, North Sea oil, Northern Rock, offshore financial centre, oil shale / tar sands, oil shock, open economy, price stability, private sector deleveraging, pushing on a string, quantitative easing, Richard Florida, rising living standards, risk-adjusted returns, Robert Gordon, savings glut, school vouchers, self-driving car, sharing economy, Silicon Valley, Silicon Valley startup, Skype, smart grid, smart meter, software patent, sovereign wealth fund, Steve Jobs, The Death and Life of Great American Cities, The Wealth of Nations by Adam Smith, too big to fail, total factor productivity, Tyler Cowen: Great Stagnation, working-age population, Zipcar

A weaker economy, in turn, further corrodes both banks’ balance sheets (as more households and businesses are unable to repay their loans) and governments’, as tax revenues fall and social spending rises. A banking crisis combined with a government backstop is thus a toxic mix. Banks in other eurozone countries were affected too, because they had lent to southern Europe or were exposed in other ways, notably through credit default swaps and other derivatives contracts. At the end of the first quarter of 2010, French banks had a €780.4 billion exposure to Greece, Ireland, Italy, Portugal and Spain; German banks a €557.8 billion exposure; Spanish banks a €134.5 billion foreign exposure, primarily to Portugal; Italian banks a $66.3 billion exposure; and other eurozone banks a €396.2 billion exposure. Non-eurozone banks were exposed too: to the tune of €387.4 billion in the case of British banks, predominantly to Ireland, and a total of €493.8 billion for US ones.130 Those foreign banks’ balance sheets took a hit as the value of their government bond holdings fell and as their loans to companies and households turned sour.

Offering Greece’s creditors new bonds of lesser value that were likely to be repaid in full in exchange for old ones that the government was incapable of repaying (and markets were pricing as such) would have given them much greater certainty.143 Nor can one compare a global investment bank’s very complex balance sheet and huge derivatives exposures to many counterparties, to the Greek government’s much simpler liabilities, with a relatively small amount of credit default swaps (contracts that insure holders against a borrower’s default) written on them. Yes, after a Greek restructuring, some banks would have needed recapitalising, but since markets were already pricing in a write-down, their balance sheets were impaired in any case. Last but not least, whereas investors didn’t know which banks were exposed to Lehman and so lost confidence in all of them, exposures to Greek debt were known after the first EU bank stress tests in 2009 and could have been publicised.

In June 2011, eurozone leaders officially recognised that Greece would need additional EU-IMF loans and a debt restructuring.257 They called for “voluntary private sector involvement… while avoiding a selective default” – a twisted piece of jargon which meant that owners of Greek government bonds should “voluntarily” agree to exchange them for less valuable ones so that the pretence that Greece had not defaulted could be maintained and credit default swaps (contracts that pay out in the event that a borrower defaults) wouldn’t be triggered. While there were incentives to exchange one’s bonds – notably that unlike the old ones issued under Greek law, the terms of which could be easily rewritten by the Greek parliament, the new ones would be issued under English law – there was also a threat that bondholders might otherwise get a worse deal.

 

Commodity Trading Advisors: Risk, Performance Analysis, and Selection by Greg N. Gregoriou, Vassilios Karavas, François-Serge Lhabitant, Fabrice Douglas Rouah

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Asian financial crisis, asset allocation, backtesting, capital asset pricing model, collateralized debt obligation, commodity trading advisor, compound rate of return, constrained optimization, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, discrete time, distributed generation, diversification, diversified portfolio, dividend-yielding stocks, fixed income, high net worth, implied volatility, index arbitrage, index fund, interest rate swap, iterative process, linear programming, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, p-value, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk-adjusted returns, risk/return, Sharpe ratio, short selling, stochastic process, systematic trading, technology bubble, transaction costs, value at risk

The different types of credit derivatives and their regulatory status are discussed by Ali (2000). Credit default swaps are the most common type of credit derivative. In a credit default swap, one party (the protection seller) agrees with its counterparty (the protection buyer), in exchange for the payment of a premium or fee, to assume the credit risk on a portfolio of loans or bonds (reference obligations) made by the protection buyer to, or issued by, one or more third parties (reference entities). If a credit event (e.g., where a reference entity defaults on the reference obligations or becomes insolvent), the protection seller will be obligated to purchase the reference obligations for their face value from the protection buyer (in the case of a physically settled 266 MANAGED FUTURES INVESTING, FEES, AND REGULATION credit default swap) or make a payment to the protection buyer of the difference between the face value of the reference obligations and their then market value (in the case of a cash-settled credit default swap).

., where a reference entity defaults on the reference obligations or becomes insolvent), the protection seller will be obligated to purchase the reference obligations for their face value from the protection buyer (in the case of a physically settled 266 MANAGED FUTURES INVESTING, FEES, AND REGULATION credit default swap) or make a payment to the protection buyer of the difference between the face value of the reference obligations and their then market value (in the case of a cash-settled credit default swap). Thus, just as the manager of a managed futures fund seeks to service the principal and interest payments on any debt securities issued by it out of trading profits, the issuer of debt securities in a CSO seeks to service those securities out of the premiums received by the issuer from selling credit risk protection under credit derivatives and any profits realized from the trading of credit derivatives (Tavakoli 2003). Corporate trustee issuers in CSOs, in contrast to corporate issuers that are not trustees, are potentially subject to Chapter 5C of the Corporations Act.6 Individually Managed Futures Accounts The status of individually managed accounts (IMAs) is less obvious.

 

pages: 413 words: 117,782

What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences by Steven G. Mandis

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algorithmic trading, Berlin Wall, bonus culture, BRICs, business process, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, diversification, Emanuel Derman, financial innovation, fixed income, friendly fire, Goldman Sachs: Vampire Squid, high net worth, housing crisis, London Whale, Long Term Capital Management, merger arbitrage, new economy, passive investing, performance metric, risk tolerance, Ronald Reagan, Saturday Night Live, shareholder value, short selling, sovereign wealth fund, The Nature of the Firm, too big to fail, value at risk

Some people still remember the large layoffs in the late 1980s, affecting how employees think about the firm as a place to work, and it was now happening so soon again (O, C). Despite issues, the firm is still ranked first in US and foreign common stock offerings, IPOs, worldwide completed mergers and acquisitions, investment-grade debt, and US equity research. J.P. Morgan pioneers the concept of the modern credit default swap, which will play a major role in the credit crisis. Eric Mindich, who ran the equities arbitrage department that invested the firm’s own capital, becomes, at age twenty-seven, the youngest partner in the firm’s history, signaling the importance of proprietary trading (O, C). Restrictions are put on the withdrawal of partners’ capital (O). Goldman opens a Beijing office (O). 1995: Corzine replaces the twelve-member management committee with a six-member executive committee (O).

Goldman experiments with e-mail (C). 1997: Paulson says Goldman’s policy of not advising on hostile takeovers is no longer in the firm’s interest, but Corzine resists any change that might damage Goldman’s image. They compromise on an experiment with a test case outside the United States, and Goldman advises Krupp in a successful hostile take-over of Thyssen (O, C). J.P. Morgan develops a proprietary product that helps banks clean up their balance sheets using credit default swaps—the first synthetic collateralized debt obligations (CDOs) (T, C). Morgan Stanley merges with Dean Witter Reynolds, the financial services business of Sears that serves retail clients (C). The acquisition extends Morgan Stanley’s ability to sell stock offerings and makes Morgan Stanley larger. Travelers Group, run by Sandy Weill, purchases Salomon Brothers, a major bond dealer and investment bank, for $9 billion (C).

Technology-driven trading is starting to dominate (T). In November, Goldman establishes the Pine Street Leadership Development Initiative, in part, to help socialize larger numbers of managers (O). The Euro becomes an accounting currency and was scheduled to enter circulation in 2002, helping to accelerate pan-European banking consolidation. 2000: The Commodity Futures Modernization Act determines that credit default swaps are neither futures nor securities and therefore are not subject to regulation by the Securities and Exchange Commission or the Commodities Futures Trading Commission (CFTC) (R, T). The CFTC changes a rule called Regulation 1.25 to permit futures brokers to take money from their customers’ accounts and invest it in an expanded number of approved securities (some people think this contributed to the issues related to MF Global) (R).

 

pages: 493 words: 132,290

Vultures' Picnic: In Pursuit of Petroleum Pigs, Power Pirates, and High-Finance Carnivores by Greg Palast

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anti-communist, back-to-the-land, bank run, Berlin Wall, Bernie Madoff, British Empire, capital asset pricing model, capital controls, centre right, Chelsea Manning, clean water, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, Donald Trump, energy security, Exxon Valdez, invisible hand, means of production, offshore financial centre, random walk, Ronald Reagan, sensible shoes, transfer pricing, uranium enrichment, Washington Consensus, Yogi Berra

In May 2010, after the banks burned, Greece’s Prime Minister George Papandreou said, “Everyone in Greece, whether three years old or ninety-eight years old, now knows what a spread is.” If you’re not a Greek three-year-old, I’ll let you in on it. A spread is the extra interest demanded by speculators and banks to insure against a nation’s bankruptcy and default. When sold as a derivative, the bankruptcy insurance is called a credit default swap (CDS).25 How much does this insurance cost? If you have to ask, you can’t afford it. In 2010 and 2011, the “spread” for Greece hit as much as 10 percent versus German debt. That is, Germany could borrow at 5 percent while Greece paid 15 percent. (At the same time, U.S. banks had the right to borrow for next to nothing, less than 1 percent, from the U.S. Federal Reserve.) On Greece’s roughly $100 billion debt, the extra vigorish demanded by lenders raised the interest payments to $14,000 a year per family, over half a year’s salary for the average Greek worker.

Apparently, a whole lot of capitalists felt more secure with their own money in the hands of socialists, even though each mid-ocean oil derrick is a floating middle finger to Summers and Rubin. Most important, Lula sealed the borders against new financial “products” from foreign banks. Guards were ordered to shoot derivatives on sight. Brazil dodged the bullet in the 2008–11 worldwide Recession by rejecting credit default swap bingo and sub-prime blind-man’s bluff. Foreign banks are particularly incensed that they couldn’t open shop in Brazil without a “presidential decree,” that is, Lula’s personal approval. And he approved of very little. It saved his nation’s life. Such conduct would not be indulged. Lula must be spanked, his allowance taken away, and his banks and his ass-kicking economy. Matty Pass scored a copy of the plan for punishment, the confidential “EC Request to Brazil.”

Why did our nice President put a half-nelson on the lady Chancellor? Because Barack Obama is not just President of the United States, he was also chief executive of AIG Insurance, which the U.S. Treasury had just bought for $170 billion in bail-out funds. One single corporation, AIG, not a bank even, was given this $170 billion (six times California’s deficit) because it was the “counter-party” that had sold the world’s banks these crap Credit Default Swaps, thereby promising insurance against the underlying loans going bust. The U.S. taxpayers had it up to here with bank bail-outs, so slipping the money to AIG was a way for the U.S. Treasury to back-door a hundred billion to The Boys indirectly. Goldman got $12.9 billion via the AIG bail-out fund, but so did the Swiss ($5 billion to UBS); and, Angela, your Deutsche Bank got $11.8 billion, all of it hidden from Americans’ jingoistic eyes.

 

pages: 364 words: 99,613

Servant Economy: Where America's Elite Is Sending the Middle Class by Jeff Faux

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back-to-the-land, Bernie Sanders, Black Swan, Bretton Woods, BRICs, British Empire, call centre, centre right, cognitive dissonance, collateralized debt obligation, collective bargaining, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, David Brooks, David Ricardo: comparative advantage, falling living standards, financial deregulation, financial innovation, full employment, hiring and firing, Howard Zinn, Hyman Minsky, illegal immigration, indoor plumbing, informal economy, invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, lake wobegon effect, Long Term Capital Management, market fundamentalism, Martin Wolf, McMansion, medical malpractice, mortgage debt, Naomi Klein, new economy, oil shock, Plutocrats, plutocrats, price mechanism, price stability, private military company, Ralph Nader, reserve currency, rising living standards, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, school vouchers, Silicon Valley, single-payer health, South China Sea, statistical model, Steve Jobs, Thomas L Friedman, Thorstein Veblen, too big to fail, trade route, Triangle Shirtwaist Factory, union organizing, upwardly mobile, urban renewal, War on Poverty, We are the 99%, working poor, Yogi Berra, Yom Kippur War

This was American ingenuity at its best for all the world to see and admire. The commentators assured their audiences that by spreading risks among more people, the miracle of “diversity” was actually turning bad loans into good ones. And there was nothing to worry about, they said, for the banks were buying insurance policies against default. In fact, these policies were quickly transformed into a set of even murkier derivatives called credit default swaps, which are bets on price movements of securities that in turn are bets on the default rate of loans held by other people. These swaps were marketed to hedge funds, pension managers, and, in some cases, back to the banks that were being insured in the first place. With money on all sides of every trade, it was hard for many players to tell at the end of the day whether they’d lost or won.

It extended the government’s regulatory authority and required more transparency in the trading of exotic securities. It also created a government subagency within the Federal Reserve to protect consumers from abuses. But Dodd-Frank, as the law is known, restored none of the Glass-Steagall Act’s firewall between lenders and borrowers. It allowed trading in the most volatile and dangerous derivatives, credit default swaps, and other securities that represented exotic gambling with other people’s money. It did not end the embedded conflict of interest among securities underwriters and rating agencies, accountants, and insurers. And it did little to curb the influence of the financial sector over its regulators through the corrupt revolving door between Washington and Wall Street. There was some shifting of organizational charts, the result of which was to strengthen the authority of the Federal Reserve.

See social mobility Clay, Henry Clinton, Bill on education financial meltdown of 2008 and fiscal policy 1992 election of Reagan’s influence on Clinton, Hillary Coehlo, Tony Cognizant Technology Solutions Corporation Colbert, Steve collateralized debt obligations (CDO) college education for-profit free trade policy and Obama on servant economy and See also education Colombia, U.S. military spending and Commission on Wartime Contracting Commodities Futures Trading Commission (CFTC) communism China and Marx Soviet Union and in the United States Complex, The (True) Congressional Budget Office (CBO) Congress of Industrial Organizaitons (CIO) consumer debt. See subprime mortgage bubble (2000–2008) Consumer Financial Protection Agency Coolidge, Calvin Cooper, Keysha Cordesman, Anthony H. Coughlin, Father Charles Council of Economic Advisors credit default swaps Crocker, David Cuomo, Andrew Cuomo, Mario currency dollar pound sterling ruble trade deficit and yuan Daley, William Danner, Mark Davis-Bacon Act de Beauvoir, Simone Debs, Eugene Dell Corporation Democratic Party. See government spending; U.S. politics; individual names of Democratic politicians Democrats for Education Reform deposit insurance deregulation Bill Clinton and Carter and financial meltdown of 2008 and Reagan and derivatives Dodd, Christopher Dodd-Frank dollar “domino theory,” dot-com bubble (1990s) Dow Chemical drugs government spending and servant economy and economic austerity trade deficit and Duhigg, Charles Duncan, Arne Economic Policy Institute Economic Report of the President (Obama) economic security austerity austerity and servant economy Carter and Cold War and Great Society and institutionalists and Keynesians vs.

 

pages: 369 words: 94,588

The Enigma of Capital: And the Crises of Capitalism by David Harvey

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accounting loophole / creative accounting, anti-communist, Asian financial crisis, bank run, banking crisis, Bernie Madoff, Big bang: deregulation of the City of London, Bretton Woods, British Empire, business climate, call centre, capital controls, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, deskilling, equal pay for equal work, European colonialism, failed state, financial innovation, Frank Gehry, full employment, global reserve currency, Google Earth, Guggenheim Bilbao, illegal immigration, indoor plumbing, interest rate swap, invention of the steam engine, Jane Jacobs, joint-stock company, Joseph Schumpeter, Just-in-time delivery, land reform, liquidity trap, Long Term Capital Management, market bubble, means of production, megacity, microcredit, moral hazard, mortgage debt, new economy, New Urbanism, Northern Rock, oil shale / tar sands, peak oil, place-making, Ponzi scheme, precariat, reserve currency, Ronald Reagan, sharing economy, Silicon Valley, special drawing rights, special economic zone, statistical arbitrage, structural adjustment programs, the built environment, the market place, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, Thorstein Veblen, too big to fail, trickle-down economics, urban renewal, urban sprawl, white flight, women in the workforce

A new currency futures market formed in the 1970s in Chicago, but it was organised around strict rules of the game. Then, towards the end of the 1980s, to offset the volatility, the practice of hedging (placing two-way bets on currency futures) became more common. An ‘over the counter’ market arose outside of the regulatory framework and the rules of the exchanges. This was the kind of private initiative that led to an avalanche of new financial products in the 1990s – credit default swaps, currency derivatives, interest rate swaps, and all the rest of it – which constituted a totally unregulated shadow banking system in which many corporations became intense players. If this shadow system could operate in New York, then why not also in London, Frankfurt, Zurich and Singapore? And why confine the activity to banks? Enron was supposed to be about making and distributing energy but it increasingly merely traded in energy futures and when it went bankrupt in 2002 it was shown to be nothing but a derivatives trading company that had been caught out in high-risk markets.

The ‘shadow banking system’ emerges 1980 Currency swaps 1981 Portfolio insurance introduced; interest rate swaps; futures markets in Eurodollars, in Certificates of Deposit and in Treasury instruments 1983 Options markets on currency, equity values and Treasury instruments; collateralised mortgage obligation introduced 1985 Deepening and widening of options and futures markets; computerised trading and modelling of markets begins in earnest; statistical arbitrage strategies introduced 1986 Big Bang unification of global stock, options and currency trading markets 1987–8 Collateralised Debt Obligations (CDOs) introduced along with Collateralised Bond Obligations (CBOs) and Collateralised Mortgage Obligations (CMOs) 1989 Futures on interest rate swaps 1990 Credit default swaps introduced along with equity index swaps 1991 ‘Off balance sheet’ vehicles known as special purpose entities or special investment vehicles sanctioned 1992–2009 Rapid evolution in volume of trading across all of these instruments. Volume of trading, insignificant in 1990, rose to more then $600 trillion annually by 2008 Sources and Further reading I relied on news reports for much of the detailed information I cite throughout the text.

Index Numbers in italics indicate Figures; those in bold indicate a Table. 11 September 2001 attacks 38, 41–2 subject to perpetual renewal and transformation 128 A Abu Dhabi 222 Académie Française 91 accumulation by dispossession 48–9, 244 acid deposition 75, 187 activity spheres 121–4, 128, 130 deindustrialised working-class area 151 and ‘green revolution’ 185–6 institutional and administrative arrangements 123 ‘mental conceptions of the world’ 123 patterns of relations between 196 production and labour processes 123 relations to nature 123 the reproduction of daily life and of the species 123 slums 152 social relations 123 subject to perpetual renewal and transformation 128 suburbs 150 technologies and organisational forms 123 uneven development between and among them 128–9 Adelphia 100 advertising industry 106 affective bonds 194 Afghanistan: US interventionism 210 Africa civil wars 148 land bought up in 220 neocolonialism 208 population growth 146 agribusiness 50 agriculture collectivisation of 250 diminishing returns in 72 ‘green revolution’ 185–6 ‘high farming’ 82 itinerant labourers 147 subsidies 79 AIG 5 alcoholism 151 Allen, Paul 98 Allende, Salvador 203 Amazonia 161, 188 American Bankers Association 8 American Revolution 61 anarchists 253, 254 anti-capitalist revolutionary movement 228 anti-racism 258 anti-Semitism 62 après moi le déluge 64, 71 Argentina Debt Crisis (2000–2002) 6, 243, 246, 261 Arizona, foreclosure wave in 1 Arrighi, Giovanni: The Long Twentieth Century 35, 204 asbestos 74 Asia Asian Currency Crisis (1997–98) 141, 261 collapse of export markets 141 growth 218 population growth 146 asset stripping 49, 50, 245 asset traders 40 asset values 1, 6, 21, 23, 26, 29, 46, 223, 261 Association of South East Asian Nations (ASEAN) 200 Athabaska tar sands, Canada 83 austerity programmes 246, 251 automobile industry 14, 15, 23, 56, 67, 68, 77, 121, 160–61 Detroit 5, 15, 16, 91, 108, 195, 216 autonomista movement 233, 234, 254 B Baader-Meinhof Gang 254 Bakunin, Michael 225 Balzac, Honoré 156 Bangalore, software development in 195 Bangkok 243 Bank of England 53, 54 massive liquidity injections in stock markets 261 Bank of International Settlements, Basel 51, 55, 200 Bank of New England 261 Bankers Trust 25 banking bail-outs 5, 218 bank shares become almost worthless 5 bankers’ pay and bonuses 12, 56, 218 ‘boutique investment banks’ 12 de-leveraging 30 debt-deposit ratio 30 deposit banks 20 French banks nationalised 198 international networks of finance houses 163 investment banks 2, 19, 20, 28, 219 irresponsible behaviour 10–11 lending 51 liquidity injections by central banks vii, 261 mysterious workings of central banks 54 ‘national bail-out’ 30–31 property market-led Nordic and Japanese bank crises 261 regional European banks 4 regular banks stash away cash 12, 220 rising tide of ‘moral hazard’ in international bank lending practices 19 ‘shadow banking’ system 8, 21, 24 sympathy with ‘Bonnie and Clyde’ bank robbers 56 Baran, Paul and Sweezey, Paul: Monopoly Capital 52, 113 Barings Bank 37, 100, 190 Baucus, Max 220 Bavaria, automotive engineering in 195 Beijing declaration (1995) 258 Berlin: cross-border leasing 14 Bernanke, Ben 236 ‘Big Bang’ (1986) 20, 37 Big Bang unification of global stock, options and currency trading markets 262 billionaire class 29, 110, 223 biodiversity 74, 251 biomass 78 biomedical engineering 98 biopiracy 245, 251 Birmingham 27 Bismarck, Prince Otto von 168 Black, Fischer 100 Blackstone 50 Blair, Tony 255 Blair government 197 blockbusting neighbourhoods 248 Bloomberg, Mayor Michael 20, 98, 174 Bolivarian movement 226, 256 bonuses, Wall Street 2, 12 Borlaug, Norman 186 bourgeoisie 48, 89, 95, 167, 176 ‘boutique investment banks’ 12 Brazil automobile industry 16 capital flight crisis (1999) 261 containerisation 16 an export-dominated economy 6 follows Japanese model 92 landless movement 257 lending to 19 the right to the city movement 257 workers’ party 256 Bretton Woods Agreement (1944) 31, 32, 51, 55, 171 British Academy 235 British empire 14 Brown, Gordon 27, 45 Budd, Alan 15 Buenos Aires 243 Buffett, Warren 173 building booms 173–4 Bush, George W. 5, 42, 45 business associations 195 C California, foreclosure wave in 1, 2 Canada, tightly regulated banks in 141 ‘cap and trade’ markets in pollution rights 221 capital bank 30 centralisation of 95, 110, 113 circulation of 90, 93, 108, 114, 116, 122, 124, 128, 158, 159, 182, 183, 191 cultural 21 devalued 46 embedded in the land 191 expansion of 58, 67, 68 exploitations of 102 export 19, 158 fixed 191, 213 industrial 40–41, 56 insufficient initial money capital 47 investment 93, 203 and labour 56, 88, 169–70 liquid money 20 mobility 59, 63, 64, 161–2, 191, 213 and nature 88 as a process 40 reproduction of 58 scarcity 50 surplus 16, 28, 29, 50–51, 84, 88, 100, 158, 166, 167, 172, 173, 174, 206, 215, 216, 217 capital accumulation 107, 108, 123, 182, 183, 191, 211 and the activity spheres 128 barriers to 12, 16, 47, 65–6, 69–70, 159 compound rate 28, 74, 75, 97, 126, 135, 215 continuity of endless 74 at the core of human evolutionary dynamics 121 dynamics of 188, 197 geographic landscape of 185 geographical dynamics of 67, 143 and governance 201 lagging 130 laws of 113, 154, 160 main centres of 192 market-based 180 Mumbai redevelopment 178 ‘nature’ affected by 122 and population growth 144–7 and social struggles 105 start of 159 capital circulation barriers to 45 continuity of 68 industrial/production capital 40–41 inherently risky 52 interruption in the process 41–2, 50 spatial movement 42 speculative 52, 53 capital controls 198 capital flow continuity 41, 47, 67, 117 defined vi global 20 importance of understanding vi, vii-viii interrupted, slowed down or suspended vi systematic misallocation of 70 taxation of vi wealth creation vi capital gains 112 capital strike 60 capital surplus absorption 31–2, 94, 97, 98, 101, 163 capital-labour relation 77 capitalism and communism 224–5 corporate 1691 ‘creative-destructive’ tendencies in 46 crisis of vi, 40, 42, 117, 130 end of 72 evolution of 117, 118, 120 expansion at a compound rate 45 first contradiction of 77 geographical development of 143 geographical mobility 161 global 36, 110 historical geography of 76, 117, 118, 121, 174, 180, 200, 202, 204 industrial 58, 109, 242 internal contradictions 115 irrationality of 11, 215, 246 market-led 203 positive and negative aspects 120 and poverty 72 relies on the beneficence of nature 71 removal of 260 rise of 135, 192, 194, 204, 228, 248–9, 258 ‘second contradiction of’ 77, 78 social relations in 101 and socialism 224 speculative 160 survival of 46, 57, 66, 86, 107, 112, 113, 116, 130, 144, 229, 246 uneven geographical development of 211, 213 volatile 145 Capitalism, Nature, Socialism journal 77 capitalist creed 103 capitalist development considered over time 121–4 ‘eras’ of 97 capitalist exploitation 104 capitalist logic 205 capitalist reinvestment 110–11 capitalists, types of 40 Carnegie, Andrew 98 Carnegie foundation 44 Carnegie Mellon University, Pittsburgh, Pennsylvania 195 Carson, Rachel: Silent Spring 187 Case Shiller Composite Indices SA 3 Catholic Church 194, 254 cell phones 131, 150, 152 Central American Free Trade Association (CAFTA) 200 centralisation 10, 11, 165, 201 Certificates of Deposit 262 chambers of commerce 195, 203 Channel Tunnel 50 Chiapas, Mexico 207, 226 Chicago Board Options Exchange 262 Chicago Currency Futures Market 262 ‘Chicago School’ 246 Chile, lending to 19 China ‘barefoot doctors’ 137 bilateral trade with Latin America 173 capital accumulation issue 70 cheap retail goods 64 collapse of communism 16 collapse of export markets 141 Cultural Revolution 137 Deng’s announcement 159 falling exports 6 follows Japanese model 92 ‘Great Leap Forward’ 137, 138 growth 35, 59, 137, 144–5, 213, 218, 222 health care 137 huge foreign exchange reserves 141, 206 infant mortality 59 infrastructural investment 222 labour income and household consumption (1980–2005) 14 market closed after communists took power (1949) 108 market forcibly opened 108 and oil market 83 one child per family policy 137, 146 one-party rule 199 opening-up of 58 plundering of wealth from 109, 113 proletarianisation 60 protests in 38 and rare earth metals 188 recession (1997) 172 ‘silk road’ 163 trading networks 163 unemployment 6 unrest in 66 urbanisation 172–3 and US consumerism 109 Chinese Central Bank 4, 173 Chinese Communist Party 180, 200, 256 chlorofluoral carbons (CFCs) 74, 76, 187 chronometer 91, 156 Church, the 249 CIA (Central Intelligence Agency) 169 circular and cumulative causation 196 Citibank 19 City Bank 261 city centres, Disneyfication of 131 City of London 20, 35, 45, 162, 219 class consciousness 232, 242, 244 class inequalities 240–41 class organisation 62 class politics 62 class power 10, 11, 12, 61, 130, 180 class relations, radical reconstitution of 98 class struggle 56, 63, 65, 96, 102, 127, 134, 193, 242, 258 Clausewitz, Carl von 213 Cleveland, foreclosure crisis in 2 Cleveland, foreclosures on housing in 1 Clinton, Bill 11, 12, 17, 44, 45 co-evolution 132, 136, 138, 168, 185, 186, 195, 197, 228, 232 in three cases 149–53 coal reserves 79, 188 coercive laws of competition see under competition Cold War 31, 34, 92 Collateralised Bond Obligations (CBOs) 262 Collateralised Debt Obligations (CDOs) 36, 142, 261, 262 Collateralised Mortgage Obligations (CMOs) 262 colonialism 212 communications, innovations in 42, 93 communism 228, 233, 242, 249 collapse of 16, 58, 63 compared with socialism 224 as a loaded term 259–60 orthodox communists 253 revolutionary 136 traditional institutionalised 259 companies joint stock 49 limited 49 comparative advantage 92 competition 15, 26, 43, 70 between financial centres 20 coercive laws of 43, 71, 90, 95, 158, 159, 161 and expansion of production 113 and falling prices 29, 116 fostering 52 global economic 92, 131 and innovation 90, 91 inter-capitalist 31 inter-state 209, 256 internalised 210 interterritorial 202 spatial 164 and the workforce 61 competitive advantage 109 computerised trading 262 computers 41, 99, 158–9 consortia 50, 220 consumerism 95, 109, 168, 175, 240 consumerist excess 176 credit-fuelled 118 niche 131 suburban 171 containerisation 16 Continental Illinois Bank 261 cooperatives 234, 242 corporate fraud 245 corruption 43, 69 cotton industry 67, 144, 162 credit cards fees vii, 245 rise of the industry 17 credit crunch 140 Credit Default swaps 262 Crédit Immobilièr 54 Crédit Mobilier 54 Crédit Mobilier and Immobilier 168 credit swaps 21 credit system and austerity programmes 246 crisis within 52 and the current crisis 118 and effective demand problem 112 an inadequate configuration of 52 predatory practices 245 role of 115 social and economic power in 115 crises crises of disproportionality 70 crisis of underconsumption 107, 111 east Asia (1997–8) 6, 8, 35, 49, 246 financial crisis of 1997–8 198, 206 financial crisis of 2008 34, 108, 114, 115 general 45–6 inevitable 71 language of crisis 27 legitimation 217 necessary 71 property market 8 role of 246–7 savings and loan crisis (US, 1984–92) 8 short sharp 8, 10 south-east Asia (1997–8) 6, 8, 35, 49, 246 cross-border leasing 142–3 cultural choice 238 ‘cultural industries’ 21 cultural preferences 73–4 Cultural Revolution 137 currency currency swaps 262 futures market 24, 32 global 32–3, 34 options markets on 262 customs barriers 42, 43 cyberspace 190 D Darwin, Charles 120 DDT 74, 187 de-leveraging 30 debt-financing 17, 131, 141, 169 decentralisation 165, 201 decolonisation 31, 208, 212 deficit financing 35, 111 deforestation 74, 143 deindustrialisation 33, 43, 88, 131, 150, 157, 243 Deleuze, Gilles 128 demand consumer 107, 109 effective 107, 110–14, 116, 118, 221, 222 lack of 47 worker 108 Democratic Party (US) 11 Deng Xiaoping 159 deregulation 11, 16, 54, 131 derivatives 8 currency 21 heavy losses in (US) 261 derivatives markets creation of 29, 85 unregulated 99, 100, 219 Descartes, René 156