Bo Peng

Five Ways This Bubble May End

Ricard, I think I've answered your question of "bank fails then what" question before. I see that you're not convinced. ;>

Bank fails. Deposit is saved. Commercial banking part remains public if possible. Investment banking part is taken over by gov and then sold to private partners ASAP. We go back to the old Wall Street model that had worked quite well for about two centuries. Counterparty risk chain reaction is unlikely as demonstrated by the non-event of Lehman CDS settlement.

My point is, too big to fail means it's too big, therefore needs to be broken down. Instead, the gov (not just US gov) is making them even bigger.

Banking Solution: Reprivatization, Not Nationalization

mr fredo, I have to admit the market handled the Lehman CDS settlement much better than I (and LOT of others) feared, which is of course a fantastic thing. Counterparty risk management has proven to be one silver lining in this storm and it's definitely improved a lot during the course. This gives us some confidence that, if any of the big banks fail, at least CDS settlement wouldn't be a major source of chain reaction.

Loss for equity and debt investors would be painful. But how is this any different from Verasun investors? Never heard of Verasun? Exactly. Losers cry for help on the first sign of pain. But they've gradually hijacked our society over the last few decades, taking advantage of our collective goodwill and kindness. We have to break free from the losers, or else we end up losing together.

The critical issue is to get the banking system, the corporate governance structure, the regulatory structure back in solid footing. Guarantee deposits. Support the wave of unemployed following the failure. Help them start from scratch. All these would take just a small fraction of what the various bailouts have cost us so far.

Today I read Willem Buiter had made a "good bank" proposal that's very similar to what I proposed here. And I agree, as I said in the post, that the international complication would be very difficult to predict and deal with. But pain is the best motivator. I still don't see any motivation to get to the root of the problem. Instead, everybody is highly motivated to muddle through and get a piece of the bailout pork.

Solving the Financial Crisis When 1+1 Doesn't Equal 2

Hi Recard and Mr Freddo,
Thanks for your kind comments.

CDS settlement is indeed a zero-sum game. For every dollar someone pays, there's someone else receiving it. But considering the underlying bond default (and not considering the naked CDS for now), then it's not zero-sum anymore. Assuming all bond holders of a defaulted bond are fully protected via CDS and thus make even, then most likely the CDS sellers are the net payers because the premium is most likely less (and often MUCH less) than the payout on default.

As to the size of a derivative vs that of the underlying, there's no forced relationship between the two unless the derivative settlement must involve delivery of the underlying. Most CDS contracts are cash settled after Delphi default. Especially for naked CDS buyers, there's no economic reason to insist on physical settlement.

In my opinion, CDS and CDO and all other "financial weapons of mass destruction" all serve legitimate purposes. They're powerful, useful tools. We didn't use the tools properly. Some abused them. Basel II allowed banks to use them to lower capital requirement and increase leverage. Hedge funds used CDS as a cheap source of financing, which is as legitimate as selling insurance without any regulation. Rating agencies treated subprime backed CDOs the same way as those backed by real companies. While every player in the market shares some blame in this mess, including some home buyers, there's no doubt in my mind the fault first and foremost falls squarely on regulators and rating agencies. I'm surprised the media and even the blogosphere still haven't come to clarity on this regard.

Lehman Bankruptcy: Crisis Management Via Crisis Export?

Yes, mrfreddo, Lehman bankruptcy "paid out" for the US in many ways. But it'd give too much credit to our elected and politically appointed officials if we say they saw all these and then did it. Heavens no! Otherwise we would've had the housing bubble starting at least moderating in 04. I think they were just reacting like headless chickens, as they've always done.

From the global perspective and the European perspective in particular, however, it's a sad mistake that nobody was willing to chip in a joint effort until the pain undeniably spread everywhere. Everybody was enjoying the slowly unfolding US demise. So "screw'em" is ironic, sad, yet poetic justice for all.

Work, reward, pain -- all must be shared.

Lehman Bankruptcy: Crisis Management Via Crisis Export?

I should add one more point:

For a full year before Lehman bankruptcy, US had been struggling while "Old Europe" had been standing on the sideline enjoying the pathetic show. I believe Europe made a strategic mistake in not helping US more proactively and earlier. They took this as an opportunity to establish Europe as one pole in the new multi-polar world, but failed to see how fragile their own footing was -- perhaps the most vivid evidence of this attitude is ECB's decision to raise rate as late as July 08.

Without active European corporation, Lehman bailout would probably have been very damaging to USD and treasuries. Why should we (US) bear all the brunt saving their ass while they enjoy the benefits as the best opportunity in a lifetime?

IMO, it was a strategic decision in the framework of international politics to let Lehman fail. US had little choice in face of Europe's persistent, misguided judgment of the situation.

Lehman CDS Net Settlement Only $6B: What Does It Mean?

amicus, since I can't go back and correct my example, let's use it. A owes B $600B, B owes C $540B. The total net payment is easily understood by discarding payment flows, but focusing on total net POSITIONS. In this example, the total net position is worth $60B. In other words, all sellers together need to pay buyers $60B. But some sellers may need to pay much more because some other sellers are also buyers.

If some hedge funds fail on 10/21, their prime brokerages would be left holding the collateral. Whatever shortfall they have, they'll need to recover in bankruptcy court. This is consistent with the reported massive margin calls all big prime brokerages have issued recently.

Lehman CDS Net Settlement Only $6B: What Does It Mean?

amicus, thanks for the links. But in my three-party example, no amount of netting changes the fact that party A will go down with a liability of $600B, my rusty arithmetic notwithstanding. Note that C doesn't owe A anything.

Lehman CDS Net Settlement Only $6B: What Does It Mean?

User 278805, you're right on both accounts.

Preferred, Lehman's debt holders haven't even begun recovering their claims. Derivatives counterparties can go thought bankruptcy protection and force liquidation.

The Wonderful World of Self-Insurance

Thanks for the link, emerald! Do you know the date of the paper by any chance?

Effectively, so-called "senior debt" of all bond issuers who're derivatives counterparties are subordinated. I wonder if rating agencies and regulators have taken this into consideration when giving such bonds their seniority labels and credit ratings. I wonder when somebody will sue them on such ground...

Senior debt holders of Lehman have been wiped out, without ever knowing the risk they were taking nor getting the reward for taking such risk.

From now on, bond cost for banks should be much higher, if people have learned the Lehman lesson.

It's the Capital, Not Liquidity, Stupid

The government is in paralysis. They continue doing what's been proven ineffective and wrong repeatedly, injecting liquidity. This is getting pathetic.

Added Liquidity Part of the Problem, Not the Solution

No, Fanny and Freddie were not clean from subprime crime. I don't want to divert this thread into a postmortem of GSE's (many) ills. My point is, subprime and Alt-A were only a small portion of their asset pool. If things hadn't gotten ugly in prime, the conservatorship would not have been necessary.

Added Liquidity Part of the Problem, Not the Solution

Update: Fed is apparently getting ready to lend directly to lower rings of the money supply chain. It's a de facto admission of failure of the blind liquidity injection to the banks, exactly as I said above. I'm very tempted to suggest Fed start lending mortgages directly -- it would've been funny if it weren't so sad.

Banks are flooded with cash. But such short-term liquidity cash is of no use to most of them. What they need is capital injection. How many will fail before Paulson gets around implementing the bailout plan? It would've been so much faster if the government would follow Buffet's GS model.

Sell Into the Financials Rally - Morgan Stanley

The height of this sucker's rally, IMO, is WM and UBS. WM virtually eliminated dividend, diluted existing shares by over 50%, had a massive write-down. And the end is nowhere in sight with their substantially sub-par (which is already very low) subprime and alt-A holdings performance so far. Guess what happened? The stock has gone up.

UBS -- 30% dilution, massive write-down, fights over future directions going public. Stock goes up.

I understand the sucker's thinking -- private equities and Uncle Ben's safety net et al. I just think TPG paid a very expensive price at $8.25 for WM, which will not be rescued because

1. their depository base is relatively small, and
2. they're not nearly as weaved in to the counterparty risk web as BSC, so that their demise will not cause a significant systemic shock. They hold most of their originations.