Behind The Bailout

All this recent shit with the market is really affecting my libertarian values about the economy and markets. It's been gradually shifting over the years, but the last nail has been pounded into the coffin of "markets regulate themselves". I first really learned about Adam Smith and the "invisible hand" in my high school AP European History class, and at the time I really did believe that, if left alone, markets would establish a fair and stable system, although I didn't believe that anything (like God) actively regulated it. I think now we have a good case study disproving that idea. However, I still don't necessarily disapprove of deregulation (try untangling those negatives!). What I want is an "open" economy, not in terms of free international trade, but in terms of complete disclosure (which is a loose form of regulation, I guess). Every day in the news I hear that banks aren't lending any money, and today I found out why. On the long drive up to the synchrotron, I listened to the podcast of this week's This American Life, which I really strongly advise everybody to take a listen because it does a pretty decent job of explaining what went wrong and why we need a bailout. Basically the problem is with the credit default swap market. A CDS is when I have a bond from, say, Lehman Brothers, which is basically a loan to the company, or my investment into the company. I don't like that Lehman Brothers is making risky investments into subprime mortgages, and I want to make sure I don't lose all my money if they tank, so I go to a bank or a hedge fund or some other wall street company and make a contract to pay 2% of the bond value every year and in return, if something happens to Lehman Brothers, I get my initial investment. So I'm paying $2k a year to make sure I can at least walk away with my initial $100k. Most wall street entities do this, and I see no problem with it. But I don't even have to have made an initial investment with Lehman Brothers! I can just go to AIG and pay them $2k a year for a CDS in the hopes that Lehman Brothers will tank and then I'll get $100k. Let's say 100 people all decide to do this. AIG is now raking in the dough, $200k a year, and the chances of Lehman Brothers failing is small. But Lehman Brothers did fail, and now they have to pay out $10 million, which is why the government had to bail them out. The CDS market is completely deregulated. There is no requirement to actually hold the bond you are buying the CDS for, and the estimate I heard today is that the value of the CDS market is ten times the total real value of the bonds in the contracts. When people hear this they want to regulate in two ways:

1. In order to buy a CDS, you must hold the bond in question. In other words, a CDS is solely an insurance policy and not a bet that a company will fail.
2. In order to sell a CDS, you must be able to pay the full amount in case of default. In other words, AIG has to stop selling CDSs when they run out of capital to pay out for them.

I don't think we need to go regulate CDSs in this way. Instead:

3. Buying and selling of CDSs will occur in an established market with full disclosure

You see, in the above example, when Lehman Brothers files for bankruptcy, all the CDSs have to be payed, and AIG goes under. End of story. This does not affect the economy as a whole, except for AIG customers. But there is a CDS network. All those people who bought a 2% Lehman Brothers CDS from AIG realize that simply paying $2k a year on a bet is not a smart investment, so they've resold their CDS to somebody else for 2.5% or 3% (as Lehman Brothers gets shakier and more likely to fail). So those people pay $2k to AIG, but get $3k from somebody else. If Lehman Brothers fails, they owe the third party $1ook, but they will get that from AIG. But this third party has sold the CDS to a fourth party, and so on. There is this giant chain or network of CDS buying and selling. And if AIG fails because they have to pay out so much, AIG can't pay the $100k, and nobody gets paid. Also, other people have bought and sold CDSs against AIG, so the failure of AIG would cause another massive payout. Remember, the total value of CDSs sold is 10 times the total real value of the bonds involved, so this would cause a systemic failure of wall street.

Here's why I think solution #3 is the best solution. Because the CDS market is undisclosed, nobody knows what companies or fund managers are buying and selling. Nobody knows how much CDSs AIG has sold, meaning nobody knows how much AIG is fucked if Lehman Brothers goes down. If they knew, they wouldn't buy another CDS from AIG (although they probably would buy a CDS against AIG). Also, we have no idea how interconnected the CDS network is. But if the CDS market was fully disclosed and public, then investors would have a much better idea which CDS investments are better than others.

This takes us back to Adam Smith. Markets will "self regulate" only when both the buyer and seller have equal knowledge. Let's say I want to buy a mineral from a dealer at a gem and mineral show. As a geologist, I know how rare certain minerals are, and both the dealer and I know how much the specimen is worth, and we bargain until we reach a fair price. If I don't know anything about geology or mineralogy, the dealer may exaggerate how rare this particular mineral is, and I may overpay. If the dealer is just a hippie into crystals and that kind of bullshit, I may be able to talk down the value of the mineral (or recognize it as something else altogether, which has happened to me). So supply and demand are not the only factors that determine price. Information and knowledge are very important. Let the American people and investors know how much potential debt a company is getting themselves into and how interconnected they are to others, and this will have a big effect on the market.

So that's the justification for the AIG bailout. Soon the CDS market will be regulated to some degree. However, what about the big $700 billion bailout just passed in Congress? That's more directly related to the housing crisis to keep more mortgage companies (and mortgage-backed securities companies) from going under, although it is affected somewhat by the CDS crunch and the commercial paper freeze. I'm still not sure what my feelings are on this one. On the one hand, I think it's stupid for the government to buy mortgages and mortgage backed securities to take them off the books because we will have a hard time selling them off later (and there's a chance the American taxpayers can get really screwed on this deal). On the other hand, the bailout bill allows the Secretary of the Treasury to invest in banks instead of buying securities, taking partial ownership like the bailout of AIG. I like this idea better, but I'm wary of the government getting too involved in business, and there's potential for the loss of a lot of taxpayer money that way.

OK so I know this post was long, but the bottom line for me is that I'm fine with wall street making their money by clever schemes, risky ventures, and confusing investments, but all that trading information should be public because it can apparently affect everything else. Open markets and open government, that's what I say.

Also, I want to mention that market "self regulation" cannot occur if bailouts are allowed. The current CDS situation is being "self regulated" out of existence because it is untenable, but the bailouts will allow it to continue, therefore we are obligated to regulate it.

OK, that's enough!