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The problem is the nature of the speculation.  As I commented in Jerome's diary, they wrote the swaps like insurance policies and then handled them like securities, which just can't work.  It's too late to start handling them like insurance policies, so the banks need to stop booking them like insurance policies.  That these CDSes satisfy the regulatory requirements only shows how weak the Basel II framework is.
by rifek on Mon Mar 23rd, 2009 at 09:04:27 AM EST
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You stated the problem correctly: Basel II is a weak framework. Unfortunately, it is also the the worldwide framework upon which virtually every country now bases its banking policies.  That's one big reason why there is such a reluctance to nationalise right now, even though I think it will eventually happen.  Doing so without a good analysis of the impact first could very likely put most financial and insurance institutions in the world in violation of their countrys' banking regulations -- making them all outlaw entities and the idea of banking regulation of any kind an absurdity.  

Finally, it's not really the CDSs that are the problem for indirect effects on the rest of the banking system.  It's the interest rate swaps that are the issue. Banks can only lend long term if they can be assured that the interest they pay for money won't be higher in the future than the rate they committed to charge on long term loans.  They obtain that guarantee by a swap where a counterparty takes the other position.  None of these are in danger of default in and of themselves.  What's in danger is the ability of the coordinator of many of these complicated insurance policies -- AIG -- to continue to guarantee them and do the job of collecting and distributing payments from one counterparty to another.  Conceivably the government or other entity could do the job, but no one really knows how hard or costly this job is yet if performed by another party, so just showing up and declaring the Feds are in charge could very well cause more harm than good.  

The calculus is simple: If it costs less for the government to do it, then nationalisation is the answer.  But if the total costs of nationalisation to society are expected to be higher -- which is what Geitner now believes -- then the facts don't yet support nationalisation regardless of what everyone's gut feelings might be.

by santiago on Mon Mar 23rd, 2009 at 10:14:22 AM EST
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An interest rate swap is still an insurance policy that is traded like a security and is therefore on a collision course with itself.  Consequently there is no way the coordinators, including AIG, can guarantee them.  Trying to calculate the risk is like trying to bisect a sneeze.  Assets expended trying to continue the guarantees are wasted, and the effort is detracting from the resources available to actually fix the problem.
by rifek on Mon Mar 23rd, 2009 at 03:39:49 PM EST
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are not insurance - they are a series of simple forward sales - a future, unknown interest rate against a fixed one.

And the interest swap market is not at all organised by AIG - it's a assive multi-participant market, probably the deepest and most liquid in the world. The problems are not coming from interest rate swaps.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Mon Mar 23rd, 2009 at 05:42:44 PM EST
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AIG is one of the principal coordinators of IRS, but, yes, you are correct that IRS is not at all where the problem is coming from. Rather, IRS contracts are a likely unintended victim of an ill conceived nationalisation of the kinds of entities that are in the business of arranging them, with uncertain consequences throughout the financial system.  The market for IRS has actually largely collapsed along with the market for long term securitized debt because it is also highly dependent upon counterparty confidence which is at an all time low. However there are existing agreements in which major investment banks and insurers such as AIG provide counterparty guarantee services and payment transfers.

(And I disagree -- they certainly are insurance, as are all derivative instruments. They insure fixed rate lenders against the event of rate volatility for refinancing their own capital.)

by santiago on Mon Mar 23rd, 2009 at 06:16:26 PM EST
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I'm afraid we'll have to disagree on this.  Under the Basel II regime, they are being booked as insurance, even though they are certainly not being handled as insurance, which is my point.  Booking something as more secure than it is is inherently destabilizing and deflating.

I didn't say AIG organized it, just that it's a player, it's a problem, and it's in the spotlight.  And to say that the IRS market is the deepest and most liquid in the world is to damn with faint praise.  Any of these instruments is only as good as the parties along its trade trail, and how many of those parties are good?  That said, I agree that IRSes are not the source of the problem.  I believe that honor (at least in this aspect of a massive, multi-sourced mess) goes to the fact that the Basel II "standards" can be gamed by a drunken chimpanzee.

by rifek on Tue Mar 24th, 2009 at 12:24:05 AM EST
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