Economy: Who wants a fairly accurate history . . .

[Skandery]

I understand.  Basically the judgement call to buy Credit Default Swaps could have been made with or without the regulations in place under Glass-Steagall.  That's new information for me. 

Eloquent explanation for how systemic risk is wildly different when you're talking CDS as opposed to regular insurance.  Basically a self-propagating, self-accelerating process once the market destabilizes, and very plausible in retrospect.  Large scale failures were happening before most knew what was happening.

My question becomes: economically, is their a tangible benefit to the public for the creation and market trade of some of these higher order financial instruments?

[Lurker]

Skander, ziggy did a great job of explaining CDS.  There are a couple more points I would like to add. 

The value assigned to the CDS's were several times the value of the underlying mortgages.  In simple terms they basically sold the same $1 of mortgage payments several times over.  This also contributed to the cascading effect once the first mortgage "dies".

The other piece of information that shows it was judgement (or lack thereof) is that Goldman Sach started unwinding their positions in these derivatives more than a year ago.  Other banks/financial institutions chose to not get deeply involved in buying these products.  Outside of AIG name another major insurance player (I think there is one in Europe - Fortis, I believe) that was sunk by this crisis?

As far as your question of whether these derivatives provided tangible benefit...that depends.  If you rode the market upwards and were lucky/smart enough to take some of the profits off the table then you benefited.  The other tangible benefit was the huge amount of easy credit that floated around the globe.  People in the US...as well as most developed nations...have run up massive amounts of debt.  The world's entire economy is built on there being an ever growing supply of credit.  Consumption, fueled by easy debt, has been the engine driving the world's economy.  When people stop spending...whether their choice or not...then companies stop making profits.  Then those companies cut costs (layoff workers) which adds to the economic pressure because there are fewer "consumers".  This is part of why I am strongly against any bailouts and/or stimulus checks from our government.  It is just a way of collectively borrowing as opposed to individual borrowing...but it does encourage consumption.  The best thing our government could do is reduce govt debt.  This would then free up capital to be used by companies and individuals.  Part of the lack of credit is because the "lenders" are all buying US Govt debt.  If you had an extra million lying around would you lend it (buy commercial paper) to some company that could be hitting a downturn in their cycle?  Or would you lend it to Uncle Sam (buy treasuries)?

[ziggy]

I understand.  Basically the judgement call to buy Credit Default Swaps could have been made with or without the regulations in place under Glass-Steagall.  That's new information for me. 

Eloquent explanation for how systemic risk is wildly different when you're talking CDS as opposed to regular insurance.  Basically a self-propagating, self-accelerating process once the market destabilizes, and very plausible in retrospect.  Large scale failures were happening before most knew what was happening.

My question becomes: economically, is their a tangible benefit to the public for the creation and market trade of some of these higher order financial instruments?

Skander I haven't ignored you.  Been very, very busy of late.  I saw this thought I would post.  Once again I am not against sensible regulation, but all regulation will have unintended consequences.  How severe those unintended consequences are in difficult times can have significant reverberations.

Basically this article is pointing to the fact that with the Investment banks now Commercial bank holding companies, the hedge fund sector has lost its major funding source, which is causing massive de-leverage in the hedge fund industry, which is what is driving the markets around the world into the tank.  Just to put into perspective as bad as the US markets are, they have outperformed Europe the last 12 months by 15% +/-, and Asia and the emerging markets by 25%-40%+/-.  Now is the unwinding of the hedge fund sector a bad thing?  It could be argued both ways, and I happen to think that the hedge fund sector and the shadow banking system are directly in the middle if the mess we have today, so I believe this correction is a needed thing.  At the same time people around the globe are losing trillions, because a regulatory requirement is sucking funding out of markets.  That could be considered a good thing, and I am not proposing that it is bad, but it is an unintended consequence.



Emerging Markets Capital Flight Exacerbated By Goldman and Morgan Stanley Becoming Banks

I somehow managed to fail to connect the dots on this one. When Morgan Stanley and Goldman, the far and away two biggest prime brokers (as in lenders to hedge funds) became banks, tougher regulatory requirements forced them to curtail hedge fund lending significantly.

To give you an idea of the concentration in this business, Morgan, Goldman, and number three (until late 2007) prime broker Bear Stearns had among them 70% market shares, with some sources saying as high as 75%. So with all three now regulated as banks, the reduction in credit availability, even absent adverse market conditions, margin calls, and redemptions, is considerable.

From Roger Peston at the BBC (hat tip reader Doc Holiday):

    As for this most recent phase of the withdrawal of credit, which has caused financial crises for a series of emerging economies in eastern Europe, Asia and South America (see "Now there are runs on countries") and also global falls in share prices, it was in a way wholly foreseeable.

    It was caused, to a large extent, by an exceptional and unprecedented shrinkage in the prime brokerage industry, which in turn led to a serious reduction in the volume of credit extended to hedge funds, which in turn forced hedge funds to sell assets, especially those perceived as higher risk.

    This contraction in loans provide through prime brokers was the inevitable consequence of the collapse of Lehman, but also - far more importantly - of the recent conversion into banks of Morgan Stanley and Goldman Sachs.

    Morgan Stanley and Goldman are - by far - the biggest prime brokers, with Morgan Stanley the number one.
    But as banks, they're prevented by regulators from lending as much relative to their capital resources as they had been as securities firms.

    So the US authorities should have known - and presumably did know - that by allowing Morgan Stanley and Goldman to become banks they were in effect forcing a serious contraction in the hedge-fund industry, which in turn would lead to sales of all manner of assets held by hedge funds and precipitate turmoil throughout the financial economy.

    Which, as if you needed telling, only goes to show that regulatory intervention carried out with the best of intentions can have consequences that - in the short term at least - can be very painful.