Sunday, March 22, 2009
Hey Paul Krugman
Saturday, March 14, 2009
Nobody could have predicted this
Well, maybe someone could have:
The major force shaping economic dynamics over the coming decade is likely to be an unwinding of the extreme leverage that individuals, businesses, and the U.S. itself (via its record current account deficit) have accumulated.
More from later in the same article:
According to the Bank for International Settlements, the U.S. interest rate swap market is about $34 trillion in size, having nearly doubled in size in the past two years. The reason this figure is so enormous is that there are usually several links in the chain from borrower to investor. A risky borrower may enter a swap with bank A, which then takes an offsetting swap position with bank B (earning a bit of the credit spread as its compensation), and so on, with a cheerful money market investor at the end of the chain holding a safe, government backed security, oblivious to the chain of counterparty risk in between.
Picture a freight train.
Aside from the risk that any particular link in this chain might be weak (know thy counterparty), the U.S. financial system has gone one step further. In order to hedge against the risk of defaults, banks frequently lay credit risk off by entering “credit default swaps” with other banks or insurance companies. These swaps essentially act as insurance policies for credit risk.
Once again, however, the iron law of equilibrium is that every risk swapped away by someone is held by someone else. According to Bloomberg, over half of the world’s trading in the credit swaps market is concentrated among five banks: J.P. Morgan (26%), Citigroup (10%), UBS Warburg (9%), Bank of America (7%) and Deutsche Bank (7%). As Warren Buffett has noted, “Large amounts of risk, particularly credit risk, have been concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The trouble of one could quickly infect the others.”
Picture a freight train.
This diagnosis of the crisis sound familiar? Those bank names ringing any bells? This was written in mid-2003. This wasn’t some weird crisis that nobody could have seen coming. Nobody wanted to see it coming. With every bubble, nobody wants to believe that it will pop, and everybody manages to act surprised when it finally does, just like every bubble before it.
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