Wednesday, September 24, 2008

Interesting Take



Remember in math, when they gave you a very complex looking figure and told you to find the area. The grunts in class would try to figure out all the many angles and tally up the area inside the figure. This almost always leads to careless errors or too little time to solve the problem given a limited test-taking time. The implicit lesson was to draw a regular figure (most often a rectangle) around the complex figure, calculate its easy-to-compute area, and subtract the areas that constituted the difference between the two figures. Voila... easy, fast, elegant and accurate.

I think the same lesson can be applied to credit default swaps. Instead of asking the obvious, complex, and obscuring question, "What value DO they have?", one should ask the elegant and simple question, "What value COULD they have?" Even a cursory examination would seem to indicate that the answer is either zero or less-than-zero. This comes from the interaction between debts and fees. In practice the greater the debt serviced (again concocted as if it had value), the greater the fee that would accrue in real terms to servicers. (Again this debt is curiously cast as an asset, often in ways that were supported by nothing other than increasing ostensible future returns that assumed unlimited resources and continuing ability to pay. One would have hoped that the bubble would have laid to rest the notion of hyped future returns as a good basis to assign value. )

Now we go to the 70 trillion dollar credit default swap market of last year. If only 1 to 2 percent "service fee" were charged in these transactions (which are based on illusory assets), we're talking nearly three-quarters to one-and-a-half trillion dollars in real term fees being siphoned off (i.e. hijacked from) the global economy for no productive, but merely parasitic, purpose. If these fees are attached to phony assets, as I have propounded, than that means a net loss of, say, a trillion dollars of capital taken right out of the system. No wonder we have a liquidity crisis.

Here is how the scam seems to work. Insure credit default with inadequate capital, assuming the market will always go up. I've heard actual figures quoted in articles I've read that fly-by-night operations were insuring billions of dollars of debt in major banks with only millions of dollars of collateral. So we're talking a tenth of a percent reserve, not ten percent, and the more exotic instruments apparently had no reserve or used the reserve to leverage other risky investments. As the market goes up, everybody's happy. Everybody appears to be making a killing, much like a pyramid scheme... as long as you can get the next person to pay. So now someone defaults in real terms, make that several million people. There aren't anything but IOUs in the system that have been treated as assets and capital. There is no money.

This is why I say that toxic assets may be toxic, but they are not assets, and that they have zero value and likely actually less-than-zero value. If I have insured against loss with only a tenth-of-a-percent reserve, and yet I am charging a percent or two per year for my services, I'm actually charging ten times more than I can actually pay out in case of a default. I guarantee you that those fees were not going into the reserve but into the pockets of the servicers.

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