Kevin Drum

Even Yet More on Credit Default Swaps

| Wed Nov. 12, 2008 7:09 PM EST

EVEN YET MORE ON CREDIT DEFAULT SWAPS....Admit it: you can't get enough of credit default swaps, can you? Well, after yesterday's post on the subject, a bunch of people insisted that I needed to read Michael Lewis's latest piece in Portfolio right away, and since I'm a big Michael Lewis fan I got right on it. As usual, it's great, so do yourself a favor and drink in the whole thing sometime soon.

For now, though, let's focus just on the CDS part of Lewis's piece. Here's the backstory: a hedge fund manager named Steve Eisman, who believed the entire subprime house of cards was due to implode, wanted a way to bet against the market. So he shorted the stocks of subprime originators like New Century and Indy Mac and then looked around for even more targeted ways to make money on the coming collapse. The Holy Grail came from Greg Lippman, a mortgage-bond trader at Deutsche Bank:

The smart trade, Lippman argued, was to sell short not New Century's stock but its bonds that were backed by the subprime loans it had made. Eisman hadn't known this was even possible — because until recently, it hadn't been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision....Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.

But why was a bond trader recommending that Eisman short bonds in his own market? The answer came after Eisman had a conversation at an industry dinner:

His dinner companion in Las Vegas ran a fund of about $15 billion and managed C.D.O.'s backed by the BBB tranche of a mortgage bond, or as Eisman puts it, "the equivalent of three levels of dog shit lower than the original bonds."....[But] not only did he not mind that Eisman took a dim view of his C.D.O.'s; he saw it as a basis for friendship. "Then he said something that blew my mind," Eisman tells me. "He says, 'I love guys like you who short my market. Without you, I don't have anything to buy.' "

That's when Eisman finally got it. Here he'd been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren't enough Americans with shitty credit taking out loans to satisfy investors' appetite for the end product. The firms used Eisman's bet to synthesize more of them....The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. "They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford," Eisman says. "They were creating them out of whole cloth. One hundred times over! That's why the losses are so much greater than the loans. But that's when I realized they needed us to keep the machine running. I was like, This is allowed?"

I still won't pretend that I fully understand this. In fact, every time I read a story like this, it seems to get right up to the good stuff — "They were creating them out of whole cloth. One hundred times over!" — and then suddenly moves on. But I want more! I want an entire 10,000 word piece on how the combination of CDOs and CDS allowed Wall Street to magnify their underlying subprime losses so catastrophically. Instead, I just get a teaser and then the story meanders off in a more colorful direction.

Better than nothing, I suppose. And you should read Lewis's entire piece regardless. But I still wish someone could explain in layman's terms what this all means.

UPDATE: Further explanation here on what Eisman was doing and how the swaps he bought "synthesized" subprime mortgages. It doesn't explain exactly how big CDS losses are or which sectors of the financial industry lost most of the money from them, but it does explain the mechanics a bit better.

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What Just Happened

| Wed Nov. 12, 2008 4:36 PM EST

WHAT JUST HAPPENED....Despite all the grief she's gotten, I continue to think that the selection of Sarah Palin as John McCain's running mate represents the breaking of a consensual cultural barrier far more fundamental than most people realize. It's not just that she was inexperienced (Spiro Agnew and John Edwards weren't much more experienced than Palin when they ran for VP) but that she was — obviously, transparently, completely — uninterested in and uninformed about national policy at nearly every level. We've simply never seen someone so completely unmoored from the normal requirements of national office before. She was chosen purely at the level of celebrity, and an awful lot of people seemed to be just fine with that.

Unfortunately, I've never really been able to find the words to describe just how corrosive I think her choice was. The whole affair just left me gobsmacked. So instead I'll turn the floor briefly over to Andrew Sullivan:

Let's be real in a way the national media seems incapable of: this person should never have been placed on a national ticket in a mature democracy....The impulsive, unvetted selection of a total unknown, with no knowledge of or interest in the wider world, as a replacement president remains one of the most disturbing events in modern American history. That the press felt required to maintain a facade of normalcy for two months — and not to declare the whole thing a farce from start to finish — is a sign of their total loss of nerve.

....This deluded and delusional woman still doesn't understand what happened to her; still has no self-awareness; and has never been forced to accept her obvious limitations. She cannot keep even the most trivial story straight; she repeats untruths with a ferocity and calm that is reserved only to the clinically unhinged; she has the educational level of a high school drop-out; and regards ignorance as some kind of achievement. It is excruciating to watch her — but more excruciating to watch those who feel obliged to defend her.

Andrew's obsession with Palin was often hard to take, and I sometimes wished I could reach through the screen and strangle him whenever he started talking about Trig Palin again. Still, aside from the "clinically unhinged" crack, I agree with all of this. Disturbing hardly begins to describe what we've gone though with Palin over the past two months.

UPDATE: Via email, here's an excerpt from Wolf Blitzer's interview today with Palin:

BLITZER: Another question. What are your new ideas on how to take the Republican Party out of this rut that it's in right now? Give me one or two new ideas that you're going to propose to these governors who have gathered here in this hotel.

PALIN: Well, a lot of Republican governors have really good ideas for our nation because we're the ones there on the front lines being held accountable every single day in service to the people whom have hired us in our own states and the planks in our platform are strong and they are good for America. It's all about free enterprise and respecting the ...

BLITZER: Does that mean you want to come up with a new Sarah Palin initiative that you want to release right now.

PALIN: Gah! Nothing specific right now. Sitting here in these chairs that I'm going to be proposing but in working with these governors who again on the front lines are forced to and it's our privileged obligation to find solutions to the challenges facing our own states every day being held accountable, not being just one of many just casting votes or voting present every once in a while, we don't get away with that. We have to balance budgets and we're dealing with multibillion dollar budgets and tens of thousands of employees in our organizations.

Should I laugh or should I cry? I think it depends on whether Palin disappears back into well-earned obscurity over the next few months.

Healthcare Update

| Wed Nov. 12, 2008 2:26 PM EST

HEALTHCARE UPDATE....Senator Max Baucus is outlining his healthcare reform proposal today, and naturally, now that Barack Obama is in town, he brings the socialism!

I don't think a single payer health care system makes sense in this country. We are America, we will come up with a uniquely American health care system that's a combination of public and private.

....I do believe we should not scrap the employer based system. We should maintain it. We should build upon it. But the current vision of the tax code has certain inefficiencies that I believe we can address while still building on the employer-based system.

Wait a second. That's not socialism at all. What the hell is going on here?

Hmmph. And here I thought the revolution had arrived. Jon Cohn provides a quickie look at the non-socialistic Baucus plan:

It look a lot like the plan Barack Obama touted on the campaign trail: Expanded Medicaid and S-CHIP for the poor; a pooling mechanism that allows individuals and the uninsured to buy coverage at group rates; a new public insurance plan, modeled vaguely on Medicare, that would be available to people buying coverage through the new pool; subsidies to offset the cost of insurance coupled with efforts to restrain the cost of medicine in the long term; and regulations that force insurers to sell to everybody, regardless of pre-existing condition.

But Baucus' plan will differ from Obama's in one intriguing, and important, way. According to the Wall Street Journal's Laura Meckler, it will include a requirement that all people obtain insurance. In other words, it will include an individual mandate. That was a major source of contention during the Democratic primaries. Obama opposed such a mandate, while Senator Hillary Clinton supported it. (As readers of this space know, I think Clinton was absolutely right about this.)

More later as details of his plan percolate through the capitol. (The full policy paper is here.) Overall, it sounds a lot like what we heard during the campaign, with an interesting addition that allows people to buy into Medicare at age 55 if they want, and I very much doubt that mandates will be a huge sticking point with Obama. In fact, he might very well breathe a sigh of relief that someone like Baucus is insisting on it, since it gives him an easy out on the issue.

Bottom line: Republicans will almost certainly try to filibuster whatever the final product turns out to be, but they're going to have a hard time making it stick. Unlike 1994, Baucus, Kennedy, Hillary Clinton, and the president are roughly on the same page, the liberal interest groups are interested in getting something done, not bickering, and even the business community is finally coming around to the need for dramatic action. I give serious healthcare reform an 80% chance of passing before June.

Chart of the Day (Oil Edition)

| Wed Nov. 12, 2008 1:55 PM EST

CHART OF THE DAY (OIL EDITION)....The International Energy Administration has released its latest projections for oil production over the next couple of decades. They report that the average annual decline in existing oil fields will accelerate to about 8.6%, a very high number, but that overall production will continue to increase anyway. No peak oil for these guys! — but only if we invest $13 trillion in drilling and exploration infrastructure between now and 2030, mostly in OPEC countries.

I have my doubts about that, but I really have my doubts about this:

These projections are based on the assumption that the IEA crude oil import price averages $100 per barrel (in real year-2007 dollars) over the period 2008-2015, rising to over $120 in 2030....In nominal terms, prices double to just over $200 per barrel in 2030.

I know that oil fell below $60 yesterday, but I'm still willing to take on all comers on a bet that oil will be selling for only $200 per barrel in 2030. I just don't believe that. Hell, I wouldn't be surprised if oil were selling for $1000 per barrel by then.

In any case, this report, which is paired up with another report about carbon emissions, makes our choice stark. We can invest many trillions of dollars in oil infrastructure, which might keep oil prices relatively low and greenhouse emissions high, or we can do the opposite: allow oil prices to rise, thus reducing demand, and spend trillions of dollars on green power generation instead. The IEA's preference seems to be for both, somehow, which must mean I'm misreading something. I'll try to give the report a more careful read later. In any case, their estimate is that a global program to limit CO2 to 450 ppm would cost a bit less than 1% of world GDP, which includes a cap-and-trade system that sets a price of $180 per ton of CO2. If that's really true, then hallelujah. That's really not such a big number. But as they say, "Time is running out and the time to act is now."

UPDATE: A correspondent emails to point out that in 2004 IEA projected oil demand in 2030 of 121 million bpd, in 2005 lowered that to 115 million bpd, and this year lowered it again to 106 million bpd. Likewise, in 2005 their projection for oil prices was $65 per barrel in 2030. Today it's $200.

Those are huge changes. Like my correspondent, I don't think IEA has fully faced reality yet, but they're getting there.

Rumors and Reports of Rumors

| Wed Nov. 12, 2008 1:05 PM EST

RUMORS AND REPORTS OF RUMORS....I'm a little torn about whether I should blog more about transition scuttlebutt. On the one hand, this stuff matters a lot for the future course of the administration. If Robert Gates is Secretary of Defense or Tom Vilsack is Secretary of Agriculture, that says a lot about the tone and direction of Obama administration policy.

On the other hand, I'd guess that about 99% of these rumors are completely bogus, just random guesses from people with only a tenuous connection to the transition team. In that sense, reacting to the rumors is just dumb. It's the kind of thing that makes us all stupider, not better informed.

Still, chatting about who might go where, and what it all means, isn't such a bad conversation to have, even if the spark is sort of random and poorly sourced. So I dunno. What do you all think of the possibility of Gates staying on as SecDef or Vilsack being appointed Secretary of Agriculture?

TARP is Dead, Long Live TARP

| Wed Nov. 12, 2008 12:15 PM EST

TARP IS DEAD, LONG LIVE TARP....Henry Paulson has apparently given up completely on buying up troubled assets, the original rationale for the $700 billion bailout fund, and instead wants to inject yet more capital into the banking system and expand the bailout program to other sectors:

U.S. Treasury Secretary Henry M. Paulson Jr. said he wants to expand the government's $700 billion bailout program to include credit card, student loan and car loan companies, part of an effort to ensure that households and businesses have access to a broad array of borrowing options.

...."This market, which is vital for lending and growth, has for all practical purposes ground to a halt," Paulson said.

But has this market ground to a halt because of capital losses among the lenders, or has it ground to a halt because there's no demand for new loans among consumers? If it's the latter, all the capital injections in the world won't make any difference.

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Chart of the Day - 11.12.2008

| Wed Nov. 12, 2008 2:27 AM EST

CHART OF THE DAY....According to a new CNN poll, 59% of the public thinks one-party rule by the Democrats is a dandy idea. Furthermore, 62% have a favorable view of the Democratic Party, vs. 38% for the Republican Party. "When has the Republican Party image ever been that bad?" asks CNN political analyst Bill Schneider. "Answer: when the Republican Congress impeached President Clinton at the end of 1998."

West Coast Offense

| Tue Nov. 11, 2008 6:49 PM EST

WEST COAST OFFENSE....Adam Serwer writes today about the pros and cons of class-based affirmative action (vs. race/gender-based AA), and Atrios offers some advice:

If, say, a left of center magazine or some other Washington institution wanted to engage in a bit of class-based affirmative action, I have a fairly simple suggestion. Just make sure you reach out beyond elite schools. I've attended and taught at a variety of institutions, and some excellent students can be found most places. And while I don't know the hiring practices of random left of center magazines, or for Congressional staffs, or for the Washington Post, it wouldn't surprise me if first round resume weeding is frequently done based on the college the applicants attended.

I'll second that. Sure, the East Coast centrism of opinion magazines is easy to understand, since they're almost all based on the East Coast. But while I can't say for sure that things haven't changed recently, a few years ago I was noodling around on this subject and was astonished at the hegemony of the Ivy League in the mastheads of most progressive magazines. I expected it to be heavy, but my recollection is that my (admittedly unscientific) sample was something like three-quarters Ivy League. Considering the number of top notch universities elsewhere in the country, that's pretty hard to defend.

So yeah: recruit on the West Coast. Lots of smart liberals out here! And at public universities, which might produce a wider range of sensibilities. It's true that East Coast weather sucks and us Californians are more than a little crybabyish about snow and sleet and whatnot, but Ezra Klein managed to make the transition. I'll bet plenty of others can too.

UPDATE: But not just California! Recruit from all the other states too!

Yet More on the CDS Market

| Tue Nov. 11, 2008 6:09 PM EST

YET MORE ON THE CDS MARKET....I've been meaning to link to yet another Felix Salmon post about credit default swaps, since I know what a fascinating subject they are for everyone, but one thing led to another and I haven't done it yet. Basically, "one thing and another" means that I spent several hours yesterday trying to understand the whole CDS issue better, but I failed miserably. So instead of pretending otherwise, I'm just going to link. Salmon conducted an IM conversation with Robert Waldmann about the CDS market, and part of it went like this:

Felix Salmon: So, have I brought you around to the idea that CDS really aren't a major cause of the current crisis?
As you know, Kevin Drum calls me "disturbingly persuasive"

Robert Waldmann: Ah well that is ambitious. You have convinced me that there is a perfectly legitimate reason which can explain why face value is so huge. As to the cause of the crisis, I remain confused. Stupid CDS tricks could have done it. So could stupid CDO tricks and what all.

Felix Salmon: I will concede that there were indeed stupid CDS tricks

Robert Waldmann: I mean the situtation is I don't understand the new financial instruments and it sure looks like the trader types didn't understand them as well as they thought.

Felix Salmon: But the stupidity was in understanding credit risk, not in understanding CDS.

Well....sure, but this seems like a bit of a dodge. After all, pretty much all financial bubbles are based on mispricing risk in some way or another. It seems like we need to dig a little deeper and try to figure out if there were specific aspects of the way modern financial markets are regulated that encouraged even more risk mispricing than usual.

The question, then, isn't whether credit default swaps are useful instruments. They are. The question is whether there's something about the way they're managed in real life that makes them potentially more dangerous than, say, stocks or pork belly futures. And if so, what can we do to limit "stupid CDS tricks"? Here's one possibility:

Robert Waldmann: OK a reform proposal. CDS must come with collateral even if you find a sucker willing to buy one without collateral (this is a regulatory restriction).

Felix Salmon: Yes yes yes.
That's why I'm so astonished Berkshire Hathaway is STILL writing CDS without collateral requirements.
But a move to an exchange would have the same effect.

If I understand this right, the benefit of requiring collateral is twofold. First, it keeps the CDS market from going too crazy, since CDS sellers can only sell protection if they have collateral to back their positions. Second, it reduces counterparty risk, since even if the CDS seller goes bust there's collateral that's been posted to make good on the swap. The big problem with AIG, for example, which has been the most spectacular example of a financial firm losing its shirt due to CDS exposure, is that they were writing CDS willy nilly without having to post collateral (thanks to their AAA rating). When their rating started going south, and they had to post collateral to make up for it, the company went down the toilet. If they'd had to post collateral in the first place, that wouldn't have happened.

So I guess that's a good start: make CDS exchange traded and insist on collateral posting requirements for all writers of CDS.

But what I still don't have a handle on is the scale of the losses in the CDS market. Clearly, AIG and the monoline insurers lost a ton of money. But Salmon suggests that the broader banking industry didn't. Partly this is because only a small segment of the financial industry were net sellers of CDS protection:

Felix Salmon: There's AIG, there's the monolines, and there's the synthetic CDOs bought by institutional investors.
Given the zero-sum nature of any derivatives market, that means that everybody else, on net, was a buyer of credit protection.

So far, this seems to be right: net losses in the broader financial industry on CDS trades seem to be pretty modest. So far. Unfortunately, though, that still leaves the CDOs, which we don't know much about yet, and it also leaves everyone else, who might be choosing not to settle CDS contracts yet that have big losses associated with them. I have a feeling we might need to wait a while longer to know for sure if the broader CDS market is as benign as Salmon thinks.

But it might be. Obviously it's cheating a bit to single out the particular areas where CDS sales caused big problems and then say, "well, aside from those areas everything was fine" — after all, it's always the case in every industry that aside from the problems there are no problems — but still, if it turned out that the big abuses came from noncollateralized CDS sales and synthetic CDOs, that would make me happy. After all, I'm already on record as thinking that CDOs are the devil's spawn. Anything that heaps more abuse in their direction is fine with me.

Bottom line: I'm still confused. For one thing, an awful lot of smart people seem to disagree with Salmon. I'd like to see some of them engage with his arguments. For another, the CDS market is so opaque that we still don't really know how much exposure is out there and who has it. At the very least, that seems unacceptable. And finally, even if there were only three segments of the financial market that were net sellers of CDS protection, just how much is it going to cost us to bail them out?

One way or another, the losses in the financial markets appear to be far wider than just subprime loans. After all, the size of subprime losses in the U.S. seems to be about half a trillion dollars, but in the past year banks have raised something like $300-400 billion in new private capital and another $200 billion so far in government capital. So that means their overall capitalization levels should be OK. But apparently that's not the case. So where are all the rest of the losses coming from? CDS? CDOs? Currency forwards? What? Does anybody actually know? And if not, what will it take to find out?

POSTSCRIPT: And one more thing. It's really annoying that the plural of CDS is CDS. "CDS market" is fine, and CDS when referring to an individual swap is fine, but why not CDSes when referring to multiple swaps? As in, "Sellers of CDSes should be required to post adequate collateral for each CDS they sell"? What does Wall Street have against plural acronyms?

Netbooks

| Tue Nov. 11, 2008 2:49 PM EST

NETBOOKS....As part of my mission to stay hopelessly behind the curve in technology matters, I just yesterday discovered the existence of a new class of notebook computers called netbooks. I guess they've been around for nearly a year, but my local Micro Center didn't carry any the last time I was there in August. Yesterday, though, they had half a dozen different models, all of them small enough to toss in a purse or tote without thinking twice, but with screens large enough (barely) to get real work done.

As it happens, I've always wanted something in exactly this form factor, so I almost bought one on the spot. But I didn't. After all, I just bought a Mac notebook on impulse a few months ago. And it's not like I compute mobile-ly very often anyway.

Still, they're pretty damn cute. And cheap. And I think I want one. So consider this an open thread. Should I buy one? What kind? Anyone have any personal experiences to share?