Friday, January 30, 2009

Soros is wrong

Unless I'm misreading him, George Soros is just plain wrong about this:

Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.
Umm, no. Protection buyers' profit is limited to the notional amount insured. Similarly, protection sellers' risk is also limited to the notional amount insured.


Don said...

The whole post is off. He claims the following:

"Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other."

My understanding is that we are in Debt-Deflation. A Calling Run. The run started when there was a foreclosure tsunami based on fraudulent and poor loans. At that point, anyone who had the ability to call cash from the owner's of these loans started doing so, since it wasn't clear how many foreclosures there would be nor how low home prices would fall. CDSs and CDOs were only some of the investments effected. As for AIG, at the point of this tsunami, they were downgraded, and needed to get capital. The only way to do this would be to sell assets for huge losses, which they didn't want do. In essence, they came to the government for a bridge loan. That's what Liddy said in November.
I don't see shorting as the problem. It was an actual Calling Run based on the mortgages. What am I missing?

Don the libertarian Democrat

Economics of Contempt said...

We were definitely caught in a margin spiral in September/October. And to some extent, certain parts of the hedge fund world are still experiencing a margin spiral, albeit at a much slower pace, seeing as hedge funds can suspend redemptions.

The problem with AIG was that it was the biggest net seller of CDS protection in the world. Since banks get full regulatory capital relief when they buy CDS protection, an AIG default would have immediately reduced the amount of capital relief they were receiving (by how much is still unknown, and bitterly contested). That would have forced the money center banks to immediately raise hundreds of billions of dollars, which would have ratcheted up the intensity of the margin spiral, making it difficult to stop.

Oddly enough, when I saw Tim Geithner speak at the NY Economic Club a few years back, this is exactly what he talked about. He argued that a margin spiral that originated in the money center banks could quickly bring down the entire financial system, and that a more robust back-office infrastructure was therefore needed. He was right.

Anonymous said...

There is the possibility that intensive shorting plus buying of CDS on a few financials at the wrong time helped force those financials into capital erosion spirals, where rating agencies looked at the CDS level increases and stock prices and thought, there must be something wrong there, which made the company more likely to need capital, which made equity investors less likely to want to hold the stock. Kind of hard to extricate from that sort of situation when liquidity has evaporated, with almost nobody wanting to be long most anything, let alone step up and take on aggressive short sellers. In more typical times, guys on the long side would likely have just crushed the short sellers. -Mark

Don said...

“The collapse of Lehman caused the credit markets to freeze up. Had AIG gone, it would have been even more significant,” Mr Liddy said.

Mr Liddy pledged to press on with a wide-ranging programme of asset sales aimed at raising funds to repay the $100bn in capital injected by the government.

He said the extension of the duration of the main government loan from two to five years and the cutting of the loan’s value from $85bn to $60bn would ensure AIG did not have to dispose of businesses at fire-sale prices.

“We have more capital so we don’t have to sell good assets in bad markets,” he said. AIG has not announced a single major disposal so far, partly because potential buyers have not been able to get funding."

That's Liddy.

Via Justin Fox, another post from Timothy Geithner, this one called "Liquidity Risk and the Global Economy:

"Although there is much that is positive in the world today, there is little reason to believe we have entered a new era of permanent stability. Financial innovation and global financial integration do not offer the prospect of eliminating the risk of asset price and credit cycles, of manias and panics, or of shocks that could have systemic consequences."

I agree with you, except that AIG needed to come up with the money because of the downgrade. At that point, no one knew what the losses might be. That was the cause of the downgrade. I agree that they needed to be saved, precisely because of my being a follower of Irving Fisher. But as I raised on another post, the connection of Merrill to Lehman on the Sunday before Lehman fell signaled the possibility of Fisher's Debt-Deflation. As for Geithner, since he seems to understand that, I have no explanation of his views about Lehman.

Don the libertarian Democrat

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