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Capitalistic Cycles and Derivatives

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January 06, 2012 – Comments (1)

Board: Macro Economics

Author: PosFCF

The emergency actions of the Federal Reserve were unprecedented and (in my opinion) illegal -- though they worked to prevent collapse of the system. The Fed and Treasury are trying their best to get back to normal, terminating TALF and TARP and gradually stabilizing the money supply. I don't think they want or intend to continue the emergency programs any longer than they must.

Consider two issues: Capitalistic cycles and derivatives.

In the capitalistic cycle, during a contraction the fat is squeezed out of the system until we have a lean, mean, business machine that eventually starts the whole cycle over and more investments are made until the "more investments are made" turns into more money is spent but no real return is achieved and, actually the money spent is being (in essence) thrown away. Then the system tips into contraction mode. In contraction mode the bad decisions become publicly known, hearings are held, policy makers fingered who then lose their jobs, then more contraction happens. Companies with marginal operations in the boom times are bankrupted and put out of business because their models can't be sustained in tough times. The process works until all the fat is squeezed out of the system....and then it all starts over again.

The above is a condensed version of what we here at the Fool have learned over the years. Probably not a bad summation, all-in-all.

A subset of the above is that sometimes whole industries undergo a drastic reduction in the number and scope of the remaining enterprises (think of how many companies went belly-up in the technology industry in the dot com bust). That reduction is capitalism's way of weeding out the unproductive and makes the whole industry healthier.

Now, consider derivatives. Let's start with credit default swaps (CDS). In brief, a bank has a big loan to XYZ corp who is rated AAA by the world. However, due to capital reserve requirements that state that the bank must have a certain percentage of money held in reserve for the amount of loans outstanding, they want to offload the risk of that loan onto some other party so that the bank can then free up the reserves to lend to other enterprises.

To make this happen, the bank is willing to pay someone to assume the risk of that loan. But part of the nuance is that the bank wants to retain the loan itself because it wants the banking relationship with XYZ and all the benefits and extra business that relationship brings to the bank. Enter the CDS....a vehicle created by the "smart guys" to do just that very thing....offload the risk, retain the loan.

Now, let's say the bank is willing to pay a fee each month or year to whoever will assume that risk. Let's also say the idea is presented to a pension fund manager as a way to increase his return without, really, risking very much.

Let's, for argument's sake put a name on XYZ. Let's pretend it is....oh, I don't know....triple AAA rating.....let's say it's XOM.

The loan is $4 billion, and you, the pension manager know that there is no way XOM is going to default on any obligation. So, to you, if someone is guaranteeing to pay you a yearly amount to assume the risk on this loan, wouldn't you likely think that this is pretty much free money?

But, let's now warp and twist the world as we know it and say that somehow the business climate changed, the capitalistic cycle started to contract, and the loan to XOM was proven to be a really bad decision.

Who gets wrung out of the system? The bank manager who approved the loan or the pension fund who bought the risk? So far it appears as though the default seller is getting credit for being really smart, and everyone is keeping quiet about the fund manager.

Now, let's further assume that the XYZ example only started with companies like IBM but much later and in much more quantity included other, not so credit worthy companies whose paper was graded the same AAA. Let's say that the number got into the staggering levels....systemic failure levels.....but, if you let the system collapse, you don't wipe out the bad policy-makers but every else they offloaded the risk onto.

Would the capitalistic system still perform well in that scenario?

Now let's ratchet it up a bit and add to the equation that in order to sell the risk, you don't even need to own the loan in the first place.

In a free enterprise world, wouldn't there be sales of that kind of product until there were no more buyers?

Let's then have the central banks lower interest rates not only through monetary policy, but through actively buying debt itself in the "open" market. Wouldn't that create more pressure on fund managers to find some kind of "safe" (after all what's safer than AAA paper?) yield? Wouldn't those kind of Central Bank policies perhaps increase the market for those CDSs?

This is only the example of CDS and how it might be able to distort the natural correction cycle of the capitalistic model.

On the horizon are interest rate swaps and we don't hear much about them yet.

The notional value of the derivatives market is in excess of $250 trillion dollars.

The proponents of derivatives will, likely, hasten to point out that it is the "net exposure" that counts.

"Net exposure" is an interesting concept. At its heart it assumes that all counterparties are appropriately reserved such that in the event of the derivative needing to be triggered, the originating party will be made whole by the counterparty, thus only the amount of derivatives not covered will really be at risk. This is referred to (I think) as Value at Risk (VaR). The VaR model also assumes that if one sells the risk exposure that the sale eliminates the risk. But it doesn't, it just transfers it to someone else. This is important folks, because the risk still exists!

The questions this old redneck has about that whole "netting" thing are: 1). If that really worked as modeled, what happened in 2008? 2). If it is still working as planned what happened to Greece; 3). How do you know it will work as modeled?; 4). What happens if it doesn't?

Doesn't anyone wonder what news is so bad that world governments are being forced to the tables over and over again, even when they don't want to be there? Does it seem to anyone else but me that Germany does not want to be at the table? France?

Why is the US backstopping the European financial system on the order of magnitude that it is.....I mean what could be so bad that all of Europe isn't enough to handle it?

Is public debt private and private debt public?

I don't know....I have more questions than answers.....and more than a little trepidation about it all.....trepidation that isn't soothed by the number of zeros that keep being added onto commitments.

Poz

1 Comments – Post Your Own

#1) On January 06, 2012 at 4:47 PM, Mega (99.95) wrote:

http://en.wikipedia.org/wiki/Value_at_risk

VaR is a significantly different idea from Net Derivative Position.

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