They were shoveling huge piles of credit default swaps through one another.
So a massive internal netting out will be going on....?
It doesn't make the alleged option transactions any less manipulative, but it's a plausible scenario..... "Any economic unit can emit money. The serious problem is to get it accepted" Hyman Minsky
The problem arises when the reference entities start defaulting. The buyer finds the seller woefully undercapitalized, and the secondary market folks downstream from the buyer discover the same thing when they try to call the CDS (They know that if the CDS is no good, it is doubly futile to try to enforce the repo clause against the buyer.). On the other side, the seller finds it charged far too little for premiums, as do the folks it sold the premium stream to when someone knocks at their door with CDS in hand.
The best JPM could do was to keep Bear from presenting its CDSs by buying Bear, and then perhaps tangling all the secondary market claimants up in the internal bookkeeping of the newly merged JPM-Bear.
Alice takes out a $ 1 mil loan from Bob paying $ 10k in interest pr. year.
Bob knows that Alice likely can't re-pay the loan, so Bob insures insures the loan against default with Charlie for $ 3k a year.
Bob then sells the (now insured) loan to Dora for $ 1.1 million.
Alice got her loan and everyone else earns money so everyone is happy.
Then Alice defaults on her loan.
Bob now doesn't get the 10k, so he can't pay Dora the 7k/year that he has to pay her because she owns the loan.
So he tries to collect his 1 mil from Charlie to pay off the loan so he doesn't have to pay Dora the 7k.
Charlie underestimated the risk of Alice defaulting so he doesn't have the $ 1 mil. Charlie becomes insolvent and goes belly-up.
Bob has now lost the $ 1 mil. Bob doesn't have a fresh million in liquid assets, so Bob now also becomes insolvent and goes belly-up.
Now Dora doesn't get her $ 10k/year, so Dora lost $ 1.1 mil. Dora goes belly-up.
Everyone is bankrupt and everyone is sad.
Now back up to where Bob tries to collect his 1 mil from Charlie.
Instead, Charlie spreads the rumour that Bob has gone Hare Krishna and Bob's investors panic and Bob goes belly up.
Charlie buys Bob's assets (including the loan).
Charlie now doesn't have to pony up the million he doesn't have. He can get away with ponying up the 10k that he does have out of his own pocket for a couple of years until things wind down.
Everyone is happy? (Well, except Alice and Bob who both went bankrupt.)
As a bonus, Bernanke gives Charlie a lot of cash. Everyone is happy, except Alice, Bob and everyone who holds US$ but isn't Charlie.
Did I miss something?
- Jake If you only spend 20 minutes of the rest of your life on economics, go spend them here.
I understand that it would clearly be illegal for Charlie to spread rumours that Bob had gone Hare Krishna. But considering that in the real world, Bob is not a real person but a publically traded company, the only people who were losing out until the arrival of Helicopter Ben in the parable would be Alice (who lost out in both scenarios) and Bob's shareholders.
I am not sure that I understand why we are having any sympathy for Bob's shareholders. They gambled on the exchange. They lost. So what? If they lost because of illegal market manipulation then presumably they could get fines and compensation by way of a civil suit. They're big boys - I think they can take care of that part for themselves.
I don't think this ultimately can be stopped, but Bernanke has managed to stall it enough for the "people who matter" (i.e. rich buggers with "vacation homes" in Paraguay and private, sovereign islands) to bail out at public expense and for the creation of a diversion of skyrocketing commodities that will cover the tracks of the financiers who created this mess and the "regulators" who let them.
