6 ms·

The contracts themselves are good in principle, they were just executed stupidly (and the stupidness was rewarded with a bailout). But there is no reason that

by smanek 18y ago

The contracts themselves are good in principle, they were just executed stupidly (and the stupidness was rewarded with a bailout). But there is no reason that I shouldn't be allowed to sell you a guarantee that "X" won't happen (for any value of "X"). But, you are responsible for making sure that I'm liquid enough to pay in case "X" does happen - because if I'm not I'll just go bankrupt and you can try to claim your share of my assets just like everyone else. These sort of contracts help hedge risk - as long as they are done responsibly. When they are done irresponsibly, the involved parties should be made to suffer, not bailed out with tax payer funds.

joe_the_user 18y ago
You mean that the contracts seem logical to you - when you just look at the relation between two companies. But you aren't really looking at the total effect of these contracts. Derivative contracts "spread risk" but, as we've seen, they don't avoid risk. So what they do is turn the individual risk of corporate bankruptcy into the risk of systemic collapse. That is called an "externality of production". Individual companies sometimes don't mind taking gambles that have a downside for people not otherwise involved with them. Much of governmental regulation is specifically for preventing these externalitie from impacting people - this is why banks are regulated, why companies must proper precautions handling toxic materials, why automobile drivers must have insurance, etc. So, ultimately, these kinds of contracts are bad. They need to be regulated in the same way that banks are regulated and for the same reasons.
- anamax 18y ago
  > So, ultimately, these kinds of contracts are bad. They need to be regulated in the same way that banks are regulated and for the same reasons. And they were, by several US govt agencies. (Since these contracts were used for banking purposes, specifically securing assets, banking regulators were involved. Insurance regulators were involved. The SEC too.) Yes, this includes the London groups. I am confused about how foreign banks got stung, what with all their superior regulation and all.
  - joe_the_user 18y ago
    Uh, Can you document that? My impression is Alan Greenspan specifically nixed regulation of CDOs around 1999. I suppose I am talking about derivatives in general, in fact. Everything I've ever read claimed they were entirely unregulated. I would like to hear if that's not the case.
    - anamax 18y ago
      > Uh, Can you document that? http://files.ots.treas.gov/87171.pdf http://files.ots.treas.gov/87171.pdf That report comes from the Office of Thrift supervision (OTS). They started regulating AIG in 1999 when AIG applied to become a "Federal Savings Bank". (The application wasn't approved until 2000.) OTS regulates and supervises both FSBs and their holding companies. The report also documents OTS cooperation with and the existence of AIG regulation by "a multitude of regulators in over 100 countries". As the report documents, AIG's problem is liquidity. One of the paragraphs that I found interesting says: "AIGFP's CDS provide credit protection to counterparties on designated portfolios of loans or debt securities. AITFP provided such credit protection on a 'second loss' basis, underwhich it repeatedly reported and disclosed that its payment obligations would arise only after credit losses in the designated portfolion exceeded a specified threshold amount or level of 'first losses.' Also known as 'super senior', AITFP provided protection the layer of credit risk superior to the AAA risk layer. The AIGFP CDS were on the safest portion of the security from a credit perspective. In fact, even today, there have not been credit losses on the AAA risk layer." FWIW, AIG became concerned about this biz in 2005 and stopped selling these instruments in late 2005 and started unwinding then. I'd agree that they did so too slowly. > My impression is Alan Greenspan specifically nixed regulation of CDOs around 1999. Greenspan wasn't ever in a position to make that call. > Everything I've ever read claimed they were entirely unregulated. I would like to hear if that's not the case. Yes, there are unregulated financial instruments. (Leases and ownership aren't regulated either.) However, the existence of such instruments does not imply that regulated institutions (such as AIG or its customers) can use them to escape supervision. For banks and insurance companies, regulators define what counts as an asset, how it is valued, and regulate exposure to different kinds of assets. That applies to all assets, whether they're "regulated" or not. Note that OTS says that the portfolios that AIG insured have not had losses, the asset valuation has held up even as the market cratered, so it's a little unclear why AIG is making payments. I suspect that they're caught in mark-to-market, which is a regulatory creation. (Assets that are throwing off cash are not worthless even if there are no buyers today.) Did AIG screw up - yes. But there's no evidence to show that more regulation would have done better. More to the point, it is simply wrong to argue for more regulation on the theory that lack of regulation was a factor. It wasn't. If anything, regulation failed.
rjurney 18y ago
Insurance is ok. Insurance is regulated. Credit default swaps are derivatives. They were deregulated in the http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000 http://en.wikipedia.org/wiki/Commodity_Futures_Modernization... so as to be completely unregulated. You can't insure 35 times your cash reserves, but you can issue just such a derivative. Insurance was ok. Insurance gone mad in the form of derivatives literally tanked our economy.
hardik 18y ago
IMHO, our understanding of ability to hedge risk is still in infancy. The idea of complete diversification of risk is only good on paper and a lot of mess is a result of companies naively (or greedily) thinking that they can achieve it. I recently attended a presentation by some very respected actuaries where they showed empirical evidence that while risk can be diversified in general (across assets as well as asset classes) in the tail end of economic scenarios all asset classes have strong positive correlation. In other words in general you can ensure consistent returns by diversification, when things go bad, you are screwed and nothing much you could have done would prevent that; writing derivative contracts which would save you from such scenario are contingent on counter-party not defaulting, which it did (until the US Gov. paid the counter party taxpayer money to prevent defaults). At the end of the day, yes, it feels right to not only AIG but those counterparties should also feel the pain.. at least they should not be given 100 cents on a dollar!

by smanek 18y ago

joe_the_user 18y ago

You mean that the contracts seem logical to you - when you just look at the relation between two companies. But you aren't really looking at the total effect of these contracts. Derivative contracts "spread risk" but, as we've seen, they don't avoid risk. So what they do is turn the individual risk of corporate bankruptcy into the risk of systemic collapse. That is called an "externality of production". Individual companies sometimes don't mind taking gambles that have a downside for people not otherwise involved with them. Much of governmental regulation is specifically for preventing these externalitie from impacting people - this is why banks are regulated, why companies must proper precautions handling toxic materials, why automobile drivers must have insurance, etc. So, ultimately, these kinds of contracts are bad. They need to be regulated in the same way that banks are regulated and for the same reasons.

anamax 18y ago
> So, ultimately, these kinds of contracts are bad. They need to be regulated in the same way that banks are regulated and for the same reasons. And they were, by several US govt agencies. (Since these contracts were used for banking purposes, specifically securing assets, banking regulators were involved. Insurance regulators were involved. The SEC too.) Yes, this includes the London groups. I am confused about how foreign banks got stung, what with all their superior regulation and all.
- joe_the_user 18y ago
  Uh, Can you document that? My impression is Alan Greenspan specifically nixed regulation of CDOs around 1999. I suppose I am talking about derivatives in general, in fact. Everything I've ever read claimed they were entirely unregulated. I would like to hear if that's not the case.
  - anamax 18y ago
    > Uh, Can you document that? http://files.ots.treas.gov/87171.pdf http://files.ots.treas.gov/87171.pdf That report comes from the Office of Thrift supervision (OTS). They started regulating AIG in 1999 when AIG applied to become a "Federal Savings Bank". (The application wasn't approved until 2000.) OTS regulates and supervises both FSBs and their holding companies. The report also documents OTS cooperation with and the existence of AIG regulation by "a multitude of regulators in over 100 countries". As the report documents, AIG's problem is liquidity. One of the paragraphs that I found interesting says: "AIGFP's CDS provide credit protection to counterparties on designated portfolios of loans or debt securities. AITFP provided such credit protection on a 'second loss' basis, underwhich it repeatedly reported and disclosed that its payment obligations would arise only after credit losses in the designated portfolion exceeded a specified threshold amount or level of 'first losses.' Also known as 'super senior', AITFP provided protection the layer of credit risk superior to the AAA risk layer. The AIGFP CDS were on the safest portion of the security from a credit perspective. In fact, even today, there have not been credit losses on the AAA risk layer." FWIW, AIG became concerned about this biz in 2005 and stopped selling these instruments in late 2005 and started unwinding then. I'd agree that they did so too slowly. > My impression is Alan Greenspan specifically nixed regulation of CDOs around 1999. Greenspan wasn't ever in a position to make that call. > Everything I've ever read claimed they were entirely unregulated. I would like to hear if that's not the case. Yes, there are unregulated financial instruments. (Leases and ownership aren't regulated either.) However, the existence of such instruments does not imply that regulated institutions (such as AIG or its customers) can use them to escape supervision. For banks and insurance companies, regulators define what counts as an asset, how it is valued, and regulate exposure to different kinds of assets. That applies to all assets, whether they're "regulated" or not. Note that OTS says that the portfolios that AIG insured have not had losses, the asset valuation has held up even as the market cratered, so it's a little unclear why AIG is making payments. I suspect that they're caught in mark-to-market, which is a regulatory creation. (Assets that are throwing off cash are not worthless even if there are no buyers today.) Did AIG screw up - yes. But there's no evidence to show that more regulation would have done better. More to the point, it is simply wrong to argue for more regulation on the theory that lack of regulation was a factor. It wasn't. If anything, regulation failed.

rjurney 18y ago

Insurance is ok. Insurance is regulated. Credit default swaps are derivatives. They were deregulated in the http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000 http://en.wikipedia.org/wiki/Commodity_Futures_Modernization... so as to be completely unregulated. You can't insure 35 times your cash reserves, but you can issue just such a derivative. Insurance was ok. Insurance gone mad in the form of derivatives literally tanked our economy.

hardik 18y ago

IMHO, our understanding of ability to hedge risk is still in infancy. The idea of complete diversification of risk is only good on paper and a lot of mess is a result of companies naively (or greedily) thinking that they can achieve it. I recently attended a presentation by some very respected actuaries where they showed empirical evidence that while risk can be diversified in general (across assets as well as asset classes) in the tail end of economic scenarios all asset classes have strong positive correlation. In other words in general you can ensure consistent returns by diversification, when things go bad, you are screwed and nothing much you could have done would prevent that; writing derivative contracts which would save you from such scenario are contingent on counter-party not defaulting, which it did (until the US Gov. paid the counter party taxpayer money to prevent defaults). At the end of the day, yes, it feels right to not only AIG but those counterparties should also feel the pain.. at least they should not be given 100 cents on a dollar!