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Monday, September 22, 2008

FURTHER UPDATE - Creeping Socialism?

Independent of influencing my earlier post, here, but later found to be in parallel, Luigi Zingales [Robert C. Mc Cormack Professor of Entrepreneurship and Finance, University of Chicago] has expressed reservations about a capitalism that separates the chances of risk and reward.

He worries over the long-term consequences of a capatilism, where failure is socialized, but profits are kept as entrepreneurial or risk-based reward and, hence, where both the unwise financial decision makers and wise ones gain no differentiating reward to trend the system toward the latter, i.e., toward wisdom and prudence in decisions as being best for all.

And besides socializing the loss of mortgage backed debt securities (but not the gain), there is also possible yin and yang where one party's result can be "left holding the bag" through something besides asymmetry in public policy. Getting caught being stupid, for example.

There are those who bought mortgage backed debt from Fannie and Freddie. Some bought not that, but rather debt securities issued by the Wall Street firms who were portfolio-speculating in the mortgage backed debt, and upon choking on too big a loss from the speculation failed to be able to service their own debt issuance.

Finally, there were those who were cautious and "bought" debt "insurance" in the form of credit risk swaps, but without clear or sufficient awareness of and planning for counterparty default risk in their deliberations; see here, reporting on credit swap reliance and trading and noting that "Five years ago, billionaire investor Warren Buffett called them a 'time bomb' and 'financial weapons of mass destruction' and directed the insurance arm of his Berkshire Hathaway Inc to exit the business."

That Reuters article moreover clearly explains the credit risk swap counterparty situation as sometimes circus-like, in a costly and problematic way:

When historians write about the current crisis, much of the blame will go to the slump in the housing and mortgage markets, which triggered the losses, layoffs and liquidations sweeping the financial industry.

But credit default swaps -- complex derivatives originally designed to protect banks from deadbeat borrowers -- are adding to the turmoil.

"This was supposedly a way to hedge risk," says Ellen Brown, the author of the book "Web of Debt."

"I'm sure their predictive models were right as far as the risk of the things they were insuring against. But what they didn't factor in was the risk that the sellers of this protection wouldn't pay ... That's what we're seeing now."

Over the last three quarters, AIG suffered $18 billion of losses tied to guarantees it wrote on mortgage-linked derivatives.

Its struggles intensified in recent weeks as losses in its own investments led to cuts in its credit ratings. Those cuts triggered clauses in the policies AIG had written that forced it to put up billions of dollars in extra collateral -- billions it did not have and could not raise.

When the credit default market began back in the mid-1990s, the transactions were simpler, more transparent affairs. Not all the sellers were insurance companies like AIG -- most were not. But the protection buyer usually knew the protection seller.

As it grew -- according to the industry's trade group, the credit default market grew to $46 trillion by the first half of 2007 from $631 billion in 2000 -- all that changed.

An over-the-counter market grew up and some of the most active players became asset managers, including hedge fund managers, who bought and sold the policies like any other investment.

In one notorious case, a small hedge fund agreed to insure UBS AG, the Swiss banking giant, from losses related to defaults on $1.3 billion of subprime mortgages for an annual premium of about $2 million.

The trouble was, the hedge fund set up a subsidiary to stand behind the guarantee -- and capitalized it with just $4.6 million. As long as the loans performed, the fund made a killing, raking in an annualized return of nearly 44 percent.

But in the summer of 2007, as home owners began to default, things got ugly. UBS demanded the hedge fund put up additional collateral. The fund balked. UBS sued.

The dispute is hardly unique. Both Wachovia Corp and Citigroup Inc are involved in similar litigation with firms that promised to step up and act like insurers -- but were not actually insurers.

"Insurance companies have armies of actuaries and deep pools of policyholders and the financial wherewithal to pay claims," says Mike Barry, a spokesman at the Insurance Information Institute.

Another problem: As hedge funds and others bought and sold these protection policies, they did not always get prior written consent from the people they were supposed to be insuring. Patrick Parkinson, the deputy director of the Fed's research and statistic arm, calls the practice "sloppy."


If I talked faster but folksier and in a more wholesome appearing way, sort of like John McCain does, I suppose I might be able to sell tornado insurance on the Ramsey City Hall.

It would be profitable if I wrote and sold Ramsey the policy, and if there ever was a tornado destruction event there at City Hall, that, if I talked the situation well enough, would be the first time any question of sufficient solvency to make good on the promise might arise.

Not to say those people managing the hedge funds were frauds, just very busy people not good with nuance and detail.

On the upside making 44% annual profit IS sweet, and on the downside having only $4.6 million capital at risk and backing a $1.3 billion contingency - on mortgage backed debt loss which is more likely than tornado touchdown damage, that's sweet too, from the $4.6 million side if not so sweet from the $1.3 billion perspective.

I suppose it depends on how you look at things, and views differ.