Personally I can’t support anything done in the name of regulation that Paul Krugman and Duncan Black haven’t signed off on. They have been the ones who have been consistently right about the economy and I’m just not interested in people who have always been wrong.

Oh yeah…and Bill Kistol is a Douchenozzle. Pass it on.

I see Gretchen Morgenson is still after CDSs too. Here’s her column for today.

6. There is no evidence that benefits of swaps exceed their costs.

That is a very interesting point if they can’t make a case that benefits are greater than costs then bank shareholders should be asking WTF!

2. Trading in swaps isn’t like a real market.

I’m still reading, masaccio, but wanted to call this out because even I have a hard time explaining why this is true.

But we all hear about ‘swaps markets’, so we are all under the **false impression** that there is some legitimate market out there on which swaps are bought and sold.

I think this point is absolutely key to moving forward with solid solutions, and I also think — judging from Congressional comments thither and yon — that a lot of Congresscritters do **not** understand that this is not a legitimate market.

Now, to finish reading…

Massaccio has been right a bunch on this too:) Has Paul or Duncan Black said anything one way or another? Considering that this is Obama’s idea I expect everyone to weigh in on this soon so we might as well start to read up about this subject now.

3. Risk management for swaps is problematic.

Man, oh man!!

The best explanation that I’ve read is Bookstaber’s “Demons of Our Own Design”, and he explains things well, but unfortunately few people really have the time (and some don’t have the technical skills) to follow what he’s saying…

But basically, it’s about bad computer code.

An easier analogy might be: imagine trying to build a cathedral. A lot of early cathedrals came tumbling down, IIRC from my old history prof’s lectures.

If the medieval stonemasons put the rocks on ground that was solid in the summer, but turned mushy in winter, down came the arches!

Of if they didn’t build the weight ratios correctly — based on their calculations of what those weights would require to hold up the vaulting arches — stonemasons got smashed beneath granite.

So there is a plenty of human history about how good intentions come to error. But because the ‘swaps’ are all code, people’s eyes glaze over and they think it’s too complicated for them to get their heads around.

It’s **not** any more complicated, really, than if NASA had miscalculated the distance to the moon. If they’d done that then spaceships would have gone zooming toward Mars, because the **assumptions** that calculations were based on were erroneous.

And that’s part of what Bookstaber helped me understand.

(BTW: He’d be a great Book Salon guest sometime…)

5. Counterparty risk cannot be calculated accurately.

This is because of the secrecy involved, based on assumptions that ‘information’ is valuable and the swaps are some kind of ‘trade secret’ between parties, correct?

Or am I mistaken?

(FWIW, it sure seems to me that after the Greece disaster, and finding out that Goldman Sachs has been on BOTH sides of far too many swaps, there may now be international will to ensure more open markets for swaps. But that’s a random guess….)

What the hell does “spirit of Glass-Steagal” mean? These half-assed watered down bullshit measures are not the hope and change I voted for. This bill will go nowhere anyway because of douchebag Bluedogs and the pissants in the GOP. And Obama is an ineffectual leader who finds arm twisting so distasteful that he is willing to destroy the democratic party to avoid any confrontation. My 18 year old cat shows more agression and forcefulness.

This isn’t how real markets work. People aren’t talked into buying bread or TVs. When they do buy, they shop. They don’t wait for their grocer to “put them into” chicken thighs, the way brokers “put their customers” into ETFs or BBB corporate bonds. This is a business that only exists if traders can talk someone else into being a counterparty.

Well, that’ll teach me not to finish the entire post before starting my questions 8 – ((

But I’d never thought of it like this before.

‘putting them into’ chicken thighs is a service, just like my dry cleaner is a service.

But I don’t have to buy chicken thighs.
Nor do I have to buy them ONLY IF my broker tells me they’re a super-duper deal, so that I take all the risk for the chicken farm.

Correct?

The level of exposure would be reduced over time so that no bank would have more than 5% of the outstanding notional values of any of the various swaps.

But doesn’t that set things up so that parties (US or otherwise) would ‘game the system’ over the short term to try to get ahead of these fixes…?

The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms

What’s a liability? Loans, for example are considered assets, not liabilities. You can have offsetting CDS or other swaps, but what does this mean? In a general downturn, you can’t guarantee that the counterparties will be good for the offsets and so if you have a big hedged portfolio a lot of it could turn out to be trash. Then too financial institutions get to cook their books with gimmicks like mark to model, instead of mark to market. So on paper they can look like they are worth a lot more than they, in fact, are. This is what happened with Lehman when in a matter of days its balance sheet went from being hundreds of billions in the black to hundreds of billions in the red. And of course none of this even begins to touch on the massive amounts of fraud that permeated the system, and continues, to be honest, to do so. Finally, this doesn’t get to the amount of overall risk that can be introduced into the system. Even if you believed that the mechanics of this would work, that TBTF couldn’t get their bought politicians to go along with whatever they wanted to do, on the upside of a bubble, markets are tolerant of assuming unsustainable amounts of risk. This proposal might, might limit some concentration of that risk, but the system could still face collapse because the aggregate risk was too high.

Considering that this is Obama’s idea I expect everyone to weigh in on this soon so we might as well start to read up about this subject now.

Agreed. Doing that now. :-)

From masaccio’s link to Morgenstern at NYT today:

Congressional “reform” plans for credit default swaps are full of loopholes, guaranteeing that another derivatives-fueled financial crisis awaits us. According to the Bank for International Settlements, credit default swaps with a face value of $36 trillion were outstanding in the second quarter of 2009, the most recent figures available.

Credit default swaps are “a way to increase the leverage in the system, and the people who were doing it knew that they were doing something on the edge of fraudulent,” said Martin Mayer, a guest scholar at the Brookings Institution and author of 37 books, many of them on banking. “They were not well-motivated.”

I honestly do not think that Congress really understands the ratios involved in CDS’s.

It’s like having a dot the size of a period that you ‘own’.
And then ‘leveraging’ (i.e., ‘betting’) a sum that is the size of a dime.

Who doesn’t want a magnificent payout on a tiny wager?

First, no one goes to the grocery store for an apple and arrives home with a bushel of them; that is not a ‘market’. The apples don’t multiply on your drive home.

But with ‘leverage’, you wager an apple and you can win a bushel.

First, is my analogy accurate?
Second, if it is accurate, do you see any evidence that Congress ‘gets’ it?
Because I think Maria Cantwell (Wa, Dem) ‘gets it’, but I don’t see others articulating the problem…

This bill will go nowhere anyway because of douchebag Bluedogs and the pissants in the GOP.

I would respectfully point out to you that this is an (ahem) ‘opportunity’ for anyone running against a Congressional incumbent this year.

If you can show that the incumbent does not understand these problems, and/or is supporting the loophole-riddled legislation that Morgenstern describes, then you stand a reasonable chance of picking off an incumbent, IMVHO.

This mess ain’t going to be fixed with more govt involvement, basically started by FDR and then aided later by Carter, i.e. govt involvement has caused most of the problems we see today.

To borrow a quote from the racist Rev. Wright: America’s chickens are coming home to roost.

The Big Govt – and its supportive mentality – will have to collapse before any recovery can begin. Which means that Americans are going to suffer a lot more before this is over…

Then too financial institutions get to cook their books with gimmicks like mark to model, instead of mark to market. So on paper they can look like they are worth a lot more than they, in fact, are.

Yup.
It’s a big, big problem.

President Obama thinks that a good idea is a good idea, regardless of who comes up with it.

I agree with virtually all of what you wrote above on the substance. But I feel compelled to state that this one sentence refers to a conceit of Obama’s that I find particularly offensive.

I mean, how many good ideas have come from Rs in the last year? When one infrequently emerges, it’s usually because they don’t fully understand the implications. Once Rush points out the problem, they drop it quickly.

We’ve seen the disastrous results of Obama looking for “a good idea, regardless of who comes up with it.” Especially among folks who never would have put the programs in question in place to begin with.

To me, it is his least admirable quality. Rather than a formula for finding the best way forward, it usually amounts to negotiating with himself upfront and turning his back on supporters.

Plus, there are lots of good ideas out there among his supporters — some of yours in fact! — that he conveniently ignores.

Take a look at the financial statements of JPMorgan Chase. They book something called derivatives receivable as an asset, and derivatives payable as a liability. Here is the explanation from Page 3 of the OCC report that I linked:

The first step to measuring credit exposure in derivative contracts involves identifying those contracts where a bank would lose value if the counterparty to a contract defaulted today. The total of all contracts with positive value (i.e., derivatives receivables) to the bank is the gross positive fair value (GPFV) and represents an initial measurement of credit exposure. The total of all contracts with negative value (i.e., derivatives payables) to the bank is the gross negative fair value (GNFV) and represents a measurement of the exposure the bank poses to its counterparties.

If the proposal is interpreted to limit exposure at this level, banks would be forced to cut their involvement in this business. In addition, it would be very difficult to game the system, because no counterparty would know why the sale was occurring. If the proposal is interpreted to cover the gross amount of protection sold, which is the highest level of exposure, there will be unwinding on both sides of the ledger, so there should be limited ability to game the system.

Ask Greece and the EU how well that laissez-faire crap is working out for them as opposed to Goldman Sachs and other greedheads.

bankers will do what bankers will do to give you hidden and unrepayable debt with one hand and bet against you with the other:

http://www.nytimes.com/2010/02/25/business/global/25swaps.html?scp=1&sq=greece%20and%20index&st=cse

These contracts, known as credit-default swaps, effectively let banks and hedge funds wager on the financial equivalent of a four-alarm fire: a default by a company or, in the case of Greece, an entire country. If Greece reneges on its debts, traders who own these swaps stand to profit.

As Greece’s financial condition has worsened, undermining the euro, the role of Goldman Sachs and other major banks in masking the true extent of the country’s problems has drawn criticism from European leaders. But even before that issue became apparent, a little-known company backed by Goldman, JP Morgan Chase and about a dozen other banks had created an index that enabled market players to bet on whether Greece and other European nations would go bust.

We don’t disagree about this. Senator Corker is smart enough to come up with alternatives if better ones are available. He also has a pretty smart bunch of staffers. I continue to hope for the best.

Trading in swaps isn’t like a real market

I’m not even sure what a real market is anymore. The idea behind a market is that it will achieve price discovery, i.e. coming up with the value of what something is really worth. This then leads to the efficient deployment of capital. That is people won’t be buying overpriced investments, and investments won’t be sold at below their real value. But in our version of crony casino capitalism, we have seen massive gaming and fraud. Markets have been distorted, rigged, blown up into bubbles. Under such conditions, price discovery is impossible.

Add into this that mot CDS are specially written for a particular deal. How do you value something when you don’t have anything to compare it to? when it is poorly understood? or when fraud is involved? The answer is you can’t.

This was where the big vanilla swaps debate arose. The heavy action is in the non-vanilla varieties. Banks want to keep them off exchange because they are essentially private deals, one-offs. But the real question is why, if a bank can’t create a vanilla version, it should be allowed to write a non-vanilla, far more dangerous one, one whose value, and associated risk can’t be valued.

Good point about Big Govt Greece and EU! Too bad that America decided to become such a domino…so to speak.

Just another game plan at “Gaming The Entire System” I stand behind Obama through thick and thin, but that boys advisers need shot!

This is about right. However, you can also wager an apple and lose a bushel. I try to be careful about analogies, because there is a real danger that arises when you start to reason with them. Here’s an example. I had a Compton’s pictured encyclopedia when I was a kid. It had a illustration of the distance of electrons from the nucleus of an atom: if the electrons were as big as baseballs, the distances were on the order of the size of the US, so there was an outline map of the US with perhaps 8 baseball sized electrons. Years later someone else familiar with the picture asked why you couldn’t pack atoms closer together, since there was so much space inside of them. That is a pretty good example of reasoning with a metaphor or an analogy.

The first step to measuring credit exposure in derivative contracts involves identifying those contracts where a bank would lose value if the counterparty to a contract defaulted today

(my bold)

It all depends on how this is calculated and on which contracts. I would agree the simplest way is to take the gross amount of both derivaties payable and receivable and use that as the measure of liability. And I would prohibit SPVs. Everything would have to stay on a bank’s balance sheet, no exceptions.

Yes, thanks masaccio — I agree that analogies have a lot of danger, because they are often flawed. And I, too, had trouble with the distance of electrons (!).

But for just for a quick-and-dirty, do-I-understand-the-basic-dynamics-here, I try to use them.

But your point is very, very well taken and I certainly appreciate it.

This seems to be about reducing the size of banks (so no one is too big to fail) more than it’s about reducing the size of the overall swaps markets. We got into trouble because the size of the derivatives markets got too big and over leveraged. This proposal does not address that. While all the banks have significantly deleveraged for now, if there is no regulation of these instruments for aggregate exposure and appropriate use, we are encouraging bankers and traders to take even greater risks with our economy given the unprecedented expansion of our monetary base by the Fed.

The first step to measuring credit exposure in derivative contracts involves identifying those contracts where a bank would lose value if the counterparty to a contract defaulted today

Your knowledge of history is sadly deficient. It was the safeguards put in place by FDR which kept the system stable for nearly 70 years. Carter catches only a minimal amount of blame because the fixes Volcker introduced to wring out inflation should have been rescinded once that recession was over, but weren’t. Then Reagan came in and began the process of deregulation which produced the S&L scandal. Clinton gets a lot of blame for setting up the unregulated system which Bush than exploited to the hilt causing both the housing bubble and the financial meltdown. Obama is continuing his policies with similarly disastrous results.

But Hugh, here’s why I don’t think that could actually work (deferring, also, to masaccio’s views):

I would agree the simplest way is to take the gross amount of both derivaties payable and receivable and use that as the measure of liability. And I would prohibit SPVs. Everything would have to stay on a bank’s balance sheet, no exceptions.

As I understand these things, they’re all interlinked.

Consequently, I may have 10 derivatives as ‘liabilities’.
One may be created using the ‘value’ of 100 townhouses in Florida, but there are other ‘counterparties’ that may be selling their exposure – that I may not know about. So even over the course of a day or a week, the ‘value’ of that derivative is in constant flux, based on factors completely beyond my control.

Another may be ‘based on the underlying value’ of a commodity (maybe a metal) that is suddenly no longer needed because a cheaper alternative has been located; so again, how many counterparties are there? How well am I able to track the value of that ‘underlying asset’ over a week or a month?

Again, I’m falling into the very problem of inaccurate analogies that masaccio warns against, but also trying to think this through and understand the dynamics.

I really think it goes back to your earlier comment — people do NOT actually know the price-value of these things from one hour to the next, one day to the next, one week to the next because they are so ‘complex’ that it’s like watching a meter that requires 10 different thermometers, on 5 different continents, to track at any given moment.

It’s nuts.

What’s a liability? Loans, for example are considered assets, not liabilities.

a loan is both: an asset on the balance sheet of whoever made the loan and a liability on the balance sheet of the borrower.

or i need to go back to accounting 101.

This post got really long, so I cut a bunch out. I usually think of markets in that sense we learned in Econ 101; buyers and sellers under no compulsion to sell or buy, perfect information, reasonable substitutes, low barriers to entry and so on. I think this way because so much economic theory begins with assumptions like these, which are irrelevant to the real world, and I think a lot of economics depends on those assumptions when it constructs models.

From a more realistic point of view, markets are structures that allow people to buy and sell, without regard to what those structures are.

Most people think of buying stuff at the grocery as their starting point for understanding markets. Stock brokers, however, don’t. You have money and they want some, so they try to talk you into buying securities. People are on a scale ranging from indifferent to highly competent at investing, with most folks on the not good side. So, brokers talk about putting their clients into investments, that is, persuading people that their interests will be best served by buying a particular stock or mutual fund.

So, the shorthand I used in the post is designed to say that swaps markets act like your broker selling you stuff. It isn’t like you deciding you need chicken thighs for chicken chili (mmm, note to self, chicken chili).

I don’t know how economic models incorporate the chicken thigh analogy, but I can’t imagine how they would reasonably accomodate the real answer, which is that people make decisions for so many different reasons that it is nuts to think that models are likely to capture anything much more complicated that markets for chicken thighs.

That was a point I made above. This does not address the overall amount of risk in the system. Also I am not sure banks actually have deleveraged that much. Remember they all would be insolvent if mark to market accounting was used to value their book. They are madly trying to get back to solvency by overcharging their customers and dumping bad debt on to the government, but they have also gone back to bubble blowing, as with stocks and commodities. So their leverage in this areas has almost certainly not gone done.

I am very pessimistic on regulation as a way of preventing the next financial crisis. I think we just tested that approach and found that it doesn’t work. From a social, financial, and political engineering standpoint, it was a compelling and definitive experiment with an absolutely indisputable outcome. Regulation didn’t work.

IMHO, failing to reimpose Glass-Steagall, while failing also to enforce antitrust laws, guarantees another crisis. Debating the pros and cons of marginal efforts “in the spirit of Glass-Steagall” seems to me to be giving way too much analytical ground for political purposes.

I think we just saw in HCR the likely political results of setting aside the correct solution — Single-Payer — and arguing the pros and cons of a second-best solution — the Public Option. It leads inexorably to nowhere near a second-best solution, especially given Obama’s desire to reach “some” agreement.

I think we may be making the same mistake in responding to the financial crisis by debating the likely effects of marginal changes. The next thing we’ll hear about the change you refer to in your post above is that Geithner is opposed.

The anonymous administration person betrays a fundamental ignorance of Glass-Steagall. As the NYT reporters indicate, it didn’t have anything to do with concentration. It simply barred commercial banks from engaging in investment banking.

masaccio, i think there were also prohibitions against banks underwriting insurance in glass-steagall — or was that the bank holding act of 1956? (so maybe the reporter meant concentration of financial institutions generally and not just commercial banks? i’m thinking of the citi/travelers merger, for example.)

My comment was only about limiting market share. For this you would have to have some way of measuring what the total market was. And as I have said a couple of times now, total market risk is not addressed by any of this.

selise, yes, but this was ostensibly from the point of view of what a TBTF’s market share was.

Yes I see that. Though I do wonder where all that money from the Fed is going since no one seems to be lending. Throwing it at all those toxic assets probably.

This discussion is really helpful. I wanted to talk about one way in which swaps don’t operate like markets for chicken thighs. Then I would conclude that models for markets that do operate like markets for chicken thighs won’t work for swaps markets. I was not clear enough.

The business of calculating the net position on swaps is complicated. The material quoted above is the first step, and there are others. The point I wanted to make is that companies have offsetting positions on swaps, that is, for each protection sold CDS, there should be a protection bought CDS.

There is a spread between the two, either positive, which is an asset, or negative, which is a liability. That is the open door set up by the President’s proposal for limiting bank exposure to CDSs.

We certainly agree on this.

And as I have said a couple of times now, total market risk is not addressed by any of this.

Okay, I follow you.
And I heartily concur with the concern that the total market risk is not addressed.

As I read masaccio’s post here, I assume that shrinking allowable bank size would have the corresponding result of shrinking the risk pool.

That is something to worry about.

The level of exposure would be reduced over time so that no bank would have more than 5% of the outstanding notional values of any of the various swaps.

am i reading this correctly to think that this regulation doesn’t affect the overall amount of swaps traded?

I think that’s right, but I’d have to check to make sure.

This discussion is really helpful. I wanted to talk about one way in which swaps don’t operate like markets for chicken thighs. Then I would conclude that models for markets that do operate like markets for chicken thighs won’t work for swaps markets. I was not clear enough.

Very cool if it’s helpful for you. It’s definitely helpful for me.

I’ll try to write a longer comment, as a way of asking whether I understand this correctly. Perhaps you and Hugh could swing by later in the day to offer feedback as to whether my analysis is correct…?

(It’ll take me a bit to think through the comment and try to write clearly.)

this was ostensibly from the point of view of what a TBTF’s market share was.

i don’t understand.

I’ll take slight issue with Glass-Steagall not being a “concentration issue”. True, Glass-Steagall Act was not an antitrust law but the Glass-Steagall requirements for separating banking from investment banking were part of initial proposals for what became of the Clayton Act of 1914 aimed at breaking up the “Money Trust” and fincancial concentration in Wall Street. Brandeis who advocated for these reforms wished to have all corporate interlocks prohibited and particularly those which linked banks, insurance companies and investment banks.

As I previously reported, the top five bank holding companies are parties to 40% or more of the outstanding swaps.

According to the Office of the Comptroller of the Currency, which is linked above, JPMorgan Chase was a party to 26% of notional amount of credit default swaps outstanding at 9/30. At that date, the five largest banks were a party to 48% of notional amount of all CDSs. JPMorgan Chase was a party to 18.8% of notional amount of all interest rate swaps. At that date, the five largest banks were a party to 49% of notional amount of all interest rate swaps.

The bankers all say that there is a real market, so we should assume that someone else would step in if they got out. I don’t think so. Therefore, over time, I think the number of CDSs would shrink dramatically, and the number of interest rate swaps would drop.

i think it’s confusing also because the fed was already letting commercial banks participate in some limited securities underwriting prior to repeal of glass-steagall (this, iirc, was where volcker had been outvoted).

I didn’t know that; interesting.

Looking at both sides of trades is about the total risk to the system. My understanding of Obama’s proposal is that it looks only at market share, not how big the market (and the associated risks) are. So in this case we are only looking at the percent concentration of the liabilities of the TBTF, the derivatives receivable and payable. My point was only that for any particular deal, the counterparties are going to be different. Otherwise you are just dealing with yourself.

thanks – that helps a lot. hope you are right.

……

i think overall, i’d feel more comfortable if the regulation proposed was attempting to chance incentives — both incentives for financial institutions and individuals at those financial institutions to take so much risk.

rules about market share permitted, etc seem like an invitation for some smart people to, um, “innovate” around those rules, so long as there is the incentive to do so.

So in this case we are only looking at the percent concentration of the liabilities of the TBTF, the derivatives receivable and payable.

for an individual institution (your tbtf) i think receivable would be an asset, not a liability.

karmi, you’re carrying water for feudalism. A weak central government is controlled by oligopolies and cartels, who do not want to compete.

We need a vigorous Patent Office to protect the rights of those who come up with great idea.
Patents Pending: Patent office overseer quits agency

You need to go back and read Adam Smith.

Thanks to masaccio, and all, for a terrific thread.

(returning to post after many interruptions…)

Here’s how I think it may work, although this is preliminary.

Suppose we want to create a market for chicken thighs. We need:
** chickens
** a processing plant, with refridgeration
** shipping (chilled)
** seller (with a big fridge)
** buyers
And this is a LINEAR process with ‘coupling’ (interlocking processes that have to be done in sequence) at every stage in the process of growing to selling:
Grow chicken(s) > butcher chickens > chill chickens > ship chickens (chilled) > sell chickens > buyer purchases chickens.

Now, we could add a few ‘loops’ into this that would affect selling and buying, or ‘market behavior’:
– we could have a 1/2 price special (or a 2-for-1 sale)
– some new ‘Super Weight Loss Through Chicken Thighs’ diet could hit Oprah, the Today Show, and all of the USA, which increases the price of chicken thighs due to increased sales
– we could have spoilage, or a link to disease, thereby sharply reducing the sales of chicken thighs.

But sales, diets, or aversion to chicken thighs do not fundamentally alter THE PROCESS by which chicken thighs are exchanged between buyers and sellers.
The process is “tightly linked”, but it is linear.
And with the addition of freezing, maybe we just ship a few truckloads of thighs off to cold storage until the 4th of July, so even though the process is ‘coupled’, it is also ‘lose’ — in the sense that if something goes wrong at any stage, you can stop and fix it.

You don’t suddenly have trouble growing chickens simply because your freezers broke on the weekend; the solution is to feed those chickens until the freezer is fixed, and then recall the butchers to their jobs.

——————————

I will now seek to describe a ‘ChickenThighCDS’.

It will be complex.
It will also be ‘tightly coupled’.
Because it is both complex and also ‘tightly coupled’ it is guaranteed to fail. I don’t know how or when, but if I am a thief or a sociopath, this so-called design will enable me to find dark places to take advantage without ever being caught. Meanwhile, if I’m a reasonable, sane person who just likes to be in a market, then at some point it will all explode and I won’t know why, nor can I fix it.

So we begin with:
** chickens; however, the number of chickens is a super-secret piece of ‘information’
** a new chicken genome — designed to grow chickens with 4 thighs each (this is also super-duper secret and not even the SEC or the Fed knows about this trade secret).
** a processing plant, with refridgeration
** shipping (chilled)
** ChickenThighCDS inventor, supplier, and seller (me!)
** buyers, aka ‘idiots’
** taxpayers to foot the bill for my wild schemes (aka, even dumber idiots)
** regulators (who are underfunded, don’t have the spine God gave a donut, and are reined in by their politically appointed supervisors), who are mostly here for show so that the buyers think they are protected, so we might rename buyers ”SillyGeese”.

So first, buyersSillyGeese assume that chickens have 2 legs.

However, my ChickenThighCDS feathered cacklers have 4 legs apiece. Which means, that I have some secret info in my formula that no buyers SillyGeese understand.

My ChickenThighCDS is based on the underlying value of chicken thighs.

Well, actually I have 4 processing plants, 10 trucks, and 2 airplanes. Which gives us 4 x 10 x 2 = 80 possible permutations for ‘deriving’ the price of chicken thighs.

But now, I’m going to add more factors:
– Plant A is only open M, W, F.
– Plant B is open T, Th.
– Plant C is open M,T,W,Th,F.
– Plant D is open M, T, Th — but can only be serviced by airplanes.

So now, I have subclasses in the category:
“Days on which I can get chickens from the processing plants”: 13.

But now here’s another piece of info:
Plant A does 50% of the processing; Plant B does 15%, Plant C does 5%, and Plant D does 30%.

So we started with 80 factors, then added another 13 — for 1,040 possible permutations. Or 1,040 possible derivative prices/costs at any given moment.

Then I added on another layer of complexity: not all plants do the same amount of processing. Oh, and the plant that can only ship by air does 30% of the processing.

I can add on layers, and layers, and layers of complexity.
And for every layer of complexity, you get to pay me for ‘customizing’ your ChickenThighCDS.

And if we drew it out, it would be a map with lots of ‘feedback loops’, whereas simply selling chickens is a > linear > process.

Now, figure that with all that ‘tight coupling’, things are bound to go wrong: a plane will break down, a truck will need extra maintenance, a processing plant will break, an outbreak of disease will wipe out the supply of chickens for two of my growers…

All this complexity allows me to create more and more complex code.

But I’m not done yet!

—————————–

Because for every layer of complexity that I add — remember, it’s all tightly coupled, because I can’t ship chickens before they are butchered, nor before they are refridgerated — the coupling creates potential problems.

Because if I add in ‘feedback loops’, by which the percent of chickens at Plant B that are shipped by air result in changes to the amount of chicken thighs that have to be shipped by air from Plant D, well… when I put in those ‘feedback loops’ the quality of the data and the related ‘coupled’ processes also have to alter in response.

——————-

FWIW, your body does this constantly: eat veggies, it kicks out chemicals to break them down, extract the nutrients, pass the waste out of your system, yadda, yadda…

But despite all the research being done, no one can tell you every single thing that happens when you eat an orange. Because at the level of nutrients and activity within all your cells, it’s simply more information than we tend to be able to manage — okay, supercomputers can do it. But that’s a lot of resources to follow the metabolic breakdown of an orange — and your body will do it differently from my body, etc, etc, etc….

Well, in Chpt 8 of his book, Bookstaber makes a good case that when you have an extremely complex system, like the one that I created for ChickenThighCDS, adding more ‘regulations’ is often the wrong thing to do — because you are adding one more layer to an already overly complex, overly interactive tight-coupled system.

(I pretty well agree with him on this point.)’

Some systems are very well designed for regulation, because they are complex, but — unlike an assembly line where you can STOP the line to fix a problem without damaging the other widgets on the conveyor belt behind it — when the problem lies in overcomplexification, the best solution is to REQUIRE SIMPLIFYING THE SYSTEM.

That’s different from adding a layer of regulation, because when you add a layer of regulation onto an already overly complex system, you really increase the failure rates. (He draws from engineering, and from what I’ve seen of the world, I agree with his analysis on this point.)

Sometimes, ‘more regulations’ are the correct solution.

But when a system is ALREADY overly complex AND ALSO ‘tightly coupled’, your more astute to outlaw certain levels of complexity.

(There’s a whole additional layer about how socially complex an outfit like Citygroup is, that adds in whole other reasons to **insist** on simplifying these swaps, and turn a deaf ear to the wheedling moans of the MoneyCrowd. When you have overly complex products in a very complex social organization, you’re bound to fail — BUT when those organizations are POLITICALLY CONNECTED, there is no ‘cost’ to failure for those at the top of the heap, because they are now socially, economically, and politically protected from the consequences of their decisions and actions.)

Shorter: chicken thighs can be bought and sold in what most of us think of as a ‘market’.

ChickenThighCDS can’t.
This is a specialized market, built on complexity.
But the nature of the complexity, and the ‘system design’ involving both INTERACTION (i.e., altering data with ‘feedback loops’ so that information is in constant flux, but not predictable), and also with TIGHT-COUPLING between one phase of the process and another… those are **not** market activities.

A better analogy might be this: we don’t ‘market’ NASA projects.
Sending a rocket into space is a specialized process.
It takes a lot of resources.
It is complex, and the processes involved rely on:
– (a) feedback loops (is there enough fuel? Do the side launchers have to provide additional thrust in response to the speed of the rocket as it hits the ionosphere?)
– (b) tight coupling: the missile launch pad has to behave in a very specific way in response to ‘lift off’, but it can’t do that until A, B, C, D, and E have occurred.

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I sincerely hope that masaccio and Hugh get back to read this and let me know whether I’m on the right track here.

And I certainly hope that if you read this, you are not ‘bored to tears’ (of if you are, please be kind enough not to be too harsh).

Corker could get himself some street cred if he hopped on the whole Financial Reform issue. Anyone in Congress who is well-informed, articulate, and shows results could get a lot of political goodwill, IMVHO. (That’s my pragmatic read on it.)

Yeah, that’s the first thing that occurred to me too.

It’s like somebody doing a survey of Weight Watcher’s or Jenny Craig’s customers and discovering that more than not gained weight. It wouldn’t be long before the word would get out and they’d be out of business.

How are the CDS sellers staying in business with that kind of record. Shouldn’t they be advising Toyota or something?

I see two ideas at work here, maybe three.

1) Swaps are inherently risky as surveys show they’re not terribly beneficial.
2) Over concentration of them in one firm makes that firm a systemic risk.
3) Requiring additional reserves should deter firms from going overboard on them.

Perhaps a more hard-and-fast rule should apply — that no firm shall have a greater ratio of traditional asset/investment to swap than TA# : S# (where the numbers are calculated based on performance and risk in the real world).

It’s **not** any more complicated, really, than if NASA had miscalculated the distance to the moon. If they’d done that then spaceships would have gone zooming toward Mars, because the **assumptions** that calculations were based on were erroneous.

How about when computer programs measured distance or speed in feet in one place and in meters in another? It really happened and was a big disaster of course.

Anyone who has played poker, and many who have played other games like chess, understand that at some point risk is necessary and at other points just foolishness. In finance competition there’s probably some of that thinking and so a non-transparency is of some importance to keep your own degree of risk-taking unknown to your competitors. If you can do as G-S did, and appear to be taking great risk, but then hedge it privately, you can make your competitors think you’re vulnerable to pressure while in fact you’re solid.

Transparency is good for the public knowledge, but not useful to each competitor.

I suppose you should add as a factor in determining how risk a firm’s position is the degree to which their lobbyists can get Congress to produce law which favors that firm. For example, who would be hurt most by a law requiring all swaps to become public knowledge? Surely somebody would be more hurt and others helped by that. You’d have to give everyone prior knowledge of a law change coming up, so they can reposition quietly.

How about when computer programs measured distance or speed in feet in one place and in meters in another? It really happened and was a big disaster of course.

Indeed.

Now, a reasonable person does what they can to fix the errors.

And a sociopath, mobster, or thug profits from knowing there’s a problem in the code, and argues that ‘complexity is necessary’. Yeah, necessary so they can cream millions off errors.
Or make errors intentionally, and then say, ‘golly, whoops…’

Leveraging increases the inherent risk of a situation. If you have Glass-Steagall separation and banking reserves, then it’s pretty acceptable for investment firms right up to the point where it is still a disaster when they go down. That’s where we are and why G-S became a bank.

Using a CDS when you have no direct investment means two things: you’re betting and have no business doing so and you’re risking somebody’s huge assets inappropriately OR somebody else should be reserved to cover their CDS.

During the Bush era it was a casino because there were naked bettors and non-reserve-backed CDSs.

Forcing CDS holders to prove they’re hedging or have a direct interest in the asset they’re “insuring” is good.

Forcing reserves for CDS issuers, as for insurance, is also good.

Apparently Obama also wants to look at the concentration of CDS holdings or perhaps issuances of a firm as part of a risk-assessment and then ban too much riskiness in one or both of those cases.

Perhaps we should also consider different, and reality-based, reserve requirements for CDS issuers and holders based on how CDSs have really performed.

A huge part of determining risk is simply to make it all transparent by law, with penalties for not declaring all such trades. Then the market participants can decide more easily and quickly the worth of these deals.

to give you hidden and unrepayable debt with one hand and bet against you with the other:

I’m not positive where this originated, but the first I heard of it was when Ken Rogoff was promoting loans to 3rd world countries which couldn’t pay them back. When you want to control somebody it pays to see how loan sharks and bankers have been doing it for centuries.