credit default swaps / collateralized debt obligations

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pages: 459 words: 118,959

Confidence Game: How a Hedge Fund Manager Called Wall Street's Bluff by Christine S. Richard

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activist fund / activist shareholder / activist investor, Asian financial crisis, asset-backed security, banking crisis, Bernie Madoff, cognitive dissonance, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, family office, financial innovation, fixed income, forensic accounting, glass ceiling, Long Term Capital Management, market bubble, money market fund, moral hazard, old-boy network, Ponzi scheme, profit motive, short selling, statistical model, white flight, zero-sum game

Butler, Jack “Buying the Farm” (Gotham Partners / Ackman) Cadbury PLC, Cahn, Jordan Caldwell and Raymond Caliendo, Charles Callen, Michael Calyon Canadian Imperial Bank of Commerce Cantor, Richard Capital Asset Research Management business described “Caulis Negris” (“Black Hole”) deal Lehman Brothers and Moody’s and NYS attorney general’s office and NYS Insurance Department and Pershing Square / Ackman and SEC and videotape of board meeting Wall Street Journal and Capital Markets Management LLC, Capuano, Michael Carina CDO Limited Carpenter, Ben Cartwright, Brian Casey, Kathleen Cassano, Joseph Catholic University of America “Caulis Negris” (“Black Hole”) deal financial details Pershing Square / Ackman and properties described CDOs. See collateralized-debt obligations CDS Delivery Option (Boberski) CDSs. See credit-default swaps certificates of participation (COPS) Chadbourne & Parke Channel Reinsurance Chanos, Jim Chaplin, Chuck MBIA’s mark-to-market explained by “Charlie Munger on the Psychology of Human Misjudgment” (Munger) Cholnoky, Thomas CIFG Moody’s and mortgage crisis and rescue proposals for bond insurers and triple-A rating Citigroup Ambac, proposed investment in ARS and CDOs and CDSs and MBIA downgraded by mortgage crisis and Pershing Square / Ackman and rescue proposals for bond insurers and Class V Funding IV, CNBC Mad Money Squawk Box CNN collateralized-debt obligations (CDOs) ACA Capital and AIG and Ambac and Assured Guaranty and “BISTRO,” Broderick Buffett comments on Carina CDO Limited catastrophe bonds, similiarity to CDO-squareds Citigroup and Class V Funding IV, collateral not required commutations, defined Congress and defined 888 Tactical Fund Limited FGIC and Fitch Ratings and FSA and IKB and JPMorgan Chase and Lehman Brothers and MBIA and Merrill Lynch and mezzanine Moody’s and Morgan Stanley and mortgage crisis and Octonion CDO Limited Open Source Model (Credit Suisse) and Pinnacle Peak CDO Limited rating fees Ridgeway Court Funding II Ltd.

Although the company never disclosed what assets it funded through the SPVs, Gotham had been able to identify about half of the $8 billion in loans. Companies selling assets to the SPVs included Onyx Acceptance Corporation, which made loans to credit-impaired borrowers to purchase used cars, and American Business Financial Services, a company that originated home-equity loans in the subprime market. Gotham also pointed out that MBIA was now entering into credit-default-swap (CDS) contracts as a way to guarantee collateralized-debt obligations (CDOs), despite a New York state prohibition on bond insurers backing derivatives. “LaCrosse transforms obligations that MBIA cannot guarantee directly into ones it believes it can guarantee indirectly,” the report said. A statement in MBIA’s most recent filing with the New York State Insurance Department, saying the company has not entered into any transactions classified as derivative instruments, “obscures the company’s true credit derivative exposure,” the report said.

The story Ackman presented was complex. He was deconstructing MBIA’s entire business, and regulators had no idea how to deal with that. Just getting everyone in the group up to speed on bond insurance was hugely time consuming, as one person involved in the MBIA investigation recalls. Insurance is mind-numbingly complicated even before one considers the municipal finance, asset-backed securities, collateralized-debt obligations, and credit-default swaps (CDSs) that made up MBIA’s business. “Ackman,” he says, “had been marinating in it.” “He comes across as very smart, with an unusually intense affect,” explains the person who attended a number of Ackman’s presentations. “He’s leaning in, staring fixedly, talking for long periods of time. He’s bright. And he knows he’s bright.” At his best, Ackman had a way of making others in the room feel like they were as smart as he was.


pages: 257 words: 64,763

The Great American Stickup: How Reagan Republicans and Clinton Democrats Enriched Wall Street While Mugging Main Street by Robert Scheer

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banking crisis, Bernie Madoff, Bernie Sanders, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, facts on the ground, financial deregulation, fixed income, housing crisis, invisible hand, Long Term Capital Management, mega-rich, mortgage debt, new economy, old-boy network, Ponzi scheme, profit motive, Ralph Nader, Ronald Reagan, too big to fail, trickle-down economics

However, some years before Glass-Steagall was dismantled, Phil’s wife played a key role, as a member of both the Reagan and the Bush I administrations, in shaping the rapid changes in the financial markets brought about by internationalization, computer-driven trading, and the introduction of a whole new discipline of “risk management,” whereby Wall Street wizards deployed complex mathematical models to create a vast array of new financial products, such as the now infamous credit default swaps and collateralized debt obligations. As was seen throughout the Reagan and later the Bush I and Bush II administrations, the Republicans had realized they could impose de facto deregulation of Big Business by appointing to influential federal commissions and agencies “watchdogs” who were sympathetic to the corporations they were supposed to be monitoring. Of course, this end run around congressional authority was probably not as satisfying or foolproof as wiping out the regulation altogether, yet it proved quite effective in pleasing CEOs, who had spent the 1970s complaining about red tape and overzealous government investigators.

And if he really wanted to educate the president he served, and the Democratic one who came before him, Paulson should have pointed out that the reason he, one of the nation’s leading investment bankers as well as the Treasury secretary, was so in the dark as to what was going on is that he didn’t really have a grasp on what his old company or AIG actually owned. Those credit default swaps and the collateralized debt obligations they pretended to cover had developed into the biggest financial bubble in human history because of the law pushed by Republican Phil Gramm and signed by Democratic president Bill Clinton to the cheers of Wall Street lobbyists, including most prominently those representing Goldman Sachs, that categorically freed all such financial packages from any regulatory supervision.

Bush, Republicans by Enron, Goldman by financial services industry by Ken Lay to candidates linked to international projects, trade missions by lobbyists to Obama from private, Wall Street, funds to Phil Gramm from Enron by Wall Street Capitalism and government restraint on corporate actions Carpenter, Michael A. Causey, Richard A. CDO liquidity put CDOs. See Collateralized debt obligations CDS. See Credit default swaps Center for Economic and Policy Research Center for Responsive Politics CFMA. See Commodity Futures Modernization Act CFTC. See Commodity Futures Trading Commission Cheney, Richard “Dick,” Chinese walls Cho, David Citi Residential Citibank merged with Travelers to form Citigroup and Weill-Clinton phone conversation Citicorp-Travelers Group merger CitiFinancial Citigroup as creditor of Enron as heavy underwriter of CDOs bailout deal created by Geithner, Paulson, Rubin bailout expansion endorsed by Obama in business with ACC Capital Holdings buys predatory subprime mortgage lenders conglomerate created -Enron relations expands CDOs, risks, under Rubin formation forces Glass-Steagall repeal influences New York Federal Reserve regulatory inquiries, class action lawsuits as too big to fail CitiMortgage Clinton, Hillary Clinton, William Jefferson “Bill” allied with Republican drafters of FSMA cancels government officials lobbying restriction covered by Jesse Jackson’s FSMA endorsement on derivatives advice from Rubin and Summers -Gramm compromise weakens CRA -Greenspan agreement defines economic policy and Rubinomics supports passage of CFMA triangulation political strategy validates Citigroup merger, legislation Clinton administration boom benefits wealthiest Americans economic policy defined ignores, condemns, Born’s derivatives warnings as instrumental in FSMA passage with Raines as Fannie Mae CEO role in deregulation, Glass-Steagall repeal with roots of economic collapse trade missions linked to Enron Clinton bubble CLUES system Collateralized debt obligations (CDOs) Citigroup as heavy underwriter created by math models described packaged as securities after deregulation Commercial Credit company Committee to Save the World Commodity Futures Modernization Act (CFMA) of 2000 bans regulations on derivatives benefits Fannie Mae-Countrywide relations blamed as cause of economic crisis by Obama created by Phil Gramm Enron loophole measures written by Enron passage and Robertson conflict of interest Rubin’s role in legislation stifles CFTC reform efforts supported by Jesse Jackson Commodity Futures Trading Commission (CFTC) chaired by Born (1996-1999) chaired by Goldman-alum Gensler chaired by Wendy Gramm (1988-1993) described prohibited from studying, regulating, derivatives Community Reinvestment Act (CRA) described weakened by Clinton- Gramm compromise Competitive Equality Banking Act of 1987 Computerized banking Computerized mathematical trading models “Concept release” document (Born) Conflicts of interest between public service and private sector reward for Geithner and Friedman for Goldman alumni for Paulson for Robertson Rubin-Fisher phone call Rubin’s government-Citi-Enron roles Summers hedge fund payment Congress, U.S.


pages: 322 words: 77,341

I.O.U.: Why Everyone Owes Everyone and No One Can Pay by John Lanchester

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asset-backed security, bank run, banking crisis, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black-Scholes formula, Celtic Tiger, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversified portfolio, double entry bookkeeping, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial innovation, fixed income, George Akerlof, greed is good, hindsight bias, housing crisis, Hyman Minsky, intangible asset, interest rate swap, invisible hand, Jane Jacobs, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, laissez-faire capitalism, light touch regulation, liquidity trap, Long Term Capital Management, loss aversion, Martin Wolf, money market fund, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, negative equity, new economy, Nick Leeson, Norman Mailer, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative easing, reserve currency, Right to Buy, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, South Sea Bubble, statistical model, The Great Moderation, the payments system, too big to fail, tulip mania, value at risk

As chance would have it, it was insurance against those very counterparty insolvencies which was to destroy AIG. This is a gigantic insurance company, worth $200 billion at its peak and definitely “too big to fail.” It was AIG which was, in effect, the Joneses. It was the company which underwrote all the insurance: it was the single biggest player in the CDS market. Entertainingly for fans of financial acronyms, AIG was done in by CDSs on CDOs. That’s to say, it took part in credit default swaps on collateralized debt obligations, the pools of subprime mortgages whose dramatic collapse in value in 2008 was the proximate cause of the financial crisis. When the investment bank Lehman Brothers imploded in September 2008, done in by its exposure to bad assets, there was a generalized panicked scramble to see who else was carrying similar risk. When it turned out that AIG was—and worse, that it was valuing those assets at much higher prices than Lehman Brothers had—investors freaked out and the company’s credit rating collapsed.

., 77, 100, 204 regulation and, 184–86 risk and, 142–43, 164–66 conservatism, housing and, 98 correlation, correlations: CDOs and, 115–16, 158, 167 risk and, 74, 148–49, 158–59, 165, 167 credit, 8, 169–73 banks and, 24–26, 37, 41, 43, 209, 211 bubbles in, 42, 60, 109, 170, 176, 216–17, 221, 223 CDOs and, 114–15, 119–20, 172 crunch in, 37, 41, 43, 54n, 77, 84–86, 92–93, 94n, 136, 163–64, 169, 171–73, 182, 193, 201–2, 215–16, 218–19 histories and ratings on, 85, 100, 123–26, 158, 163, 165, 208–11 housing and, 84–86, 92–93, 94n, 100, 109, 112, 125, 129–30, 132, 163–64 Iceland’s economic crisis and, 10–12 interest rates and, 172–73, 175, 209 risk and, 136, 158, 165 see also banking-and-credit crisis Crédit Agricole, 36 credit cards, 27, 217 credit ratings and, 123–24 Iceland’s economic crisis and, 9, 11–12 risk and, 158–59, 163 credit default swaps (CDSs), 20, 63, 65–80, 117, 158–59, 183–86 AIG and, 75–78, 201 attractive aspects of, 72–74 examples of, 57–58 Exxon deal and, 67–70, 121 over-the-counter trading of, 184–85, 201 regulation and, 68, 70, 73, 184–86 risk and, 58, 66–70, 72–75, 78–80, 212 securitized bundles of, 69–70, 74 streamlining and industrializing of, 68–69 unfortunate side effect of, 74–75 Credit Suisse, 36, 227 Cuomo, Andrew, 99 Cutter family, 126–27 Darling, Alistair, 172, 220 debt, debts, 27–29, 34, 59–63, 118, 172n, 179, 216, 229 in balance sheets, 27–28, 30–31 benefits of, 59–61 bonds and, 59, 61–63, 208, 210 credit and, 123–26, 221 derivatives and, 52, 67, 69–72 housing and, 93, 100, 132, 176 paying the bill and, 220–22 personal, 221–22 regulation and, 181, 190 Russian default on, 55–56, 162, 164–65 see also collateralized debt obligations default, defaults, default rates, 162–65 CDOs and, 114–15 on mortgages, 159–60, 163, 165, 229 risk and, 154, 159–60, 163 of Russia, 55–56, 162, 164–65 see also credit default swaps Demchak, William, 69 democracy, democracies, 15–18, 108–9, 179, 213 free-market capitalism and, 15, 17, 23 housing and, 87, 98 DePastina, Anthony, 85 Depository Institutions Deregulation and Monetary Control Act (DIDMCA), 100 deregulation, see regulation, deregulation derivatives, 45–58, 63–80, 86, 210–12 in balance sheets, 30–31, 70 banks and, 20, 51–54, 57–58, 63–71, 74–75, 77, 79, 115–17, 120–21, 132, 183–84, 200, 205–6, 211 Black-Scholes formula and, 48, 54, 116–17, 151 bonds and, 58, 63–67, 112, 114, 118–19, 210–11 Buffett and, 56–57, 78 and City of London, 56–57, 79, 201 complexity of, 52–54, 56–57 Enron and, 56, 105–6, 185 futures and, 46–47, 49n, 51–52, 54, 184 Greenspan on, 166, 183–84 in history, 45–48, 147 mathematics and, 47–48, 52–54, 115–17, 166 offshore companies and, 70, 72 options and, 46–47, 50–52, 151, 174, 184 over-the-counter trading of, 184–85, 201, 205–6 prices and, 38, 46–52, 54, 56, 75, 158–59, 166 regulation and, 68, 70, 73, 153, 183–86, 200–201 risk and, 46–47, 49–52, 54–55, 57–58, 66–75, 78–80, 114–15, 117–22, 151, 153, 158–60, 163, 166–67, 184–85, 205, 212 size of market in, 48, 56, 80, 117, 201 see also collateralized debt obligations; credit default swaps Detroit, Mich., 81–82 Deutsche Bank, 36, 77, 83, 227 diversification, 146–48, 177 dividends, 101, 147–48 Doctorow, E.

., 77, 100, 204 regulation and, 184–86 risk and, 142–43, 164–66 conservatism, housing and, 98 correlation, correlations: CDOs and, 115–16, 158, 167 risk and, 74, 148–49, 158–59, 165, 167 credit, 8, 169–73 banks and, 24–26, 37, 41, 43, 209, 211 bubbles in, 42, 60, 109, 170, 176, 216–17, 221, 223 CDOs and, 114–15, 119–20, 172 crunch in, 37, 41, 43, 54n, 77, 84–86, 92–93, 94n, 136, 163–64, 169, 171–73, 182, 193, 201–2, 215–16, 218–19 histories and ratings on, 85, 100, 123–26, 158, 163, 165, 208–11 housing and, 84–86, 92–93, 94n, 100, 109, 112, 125, 129–30, 132, 163–64 Iceland’s economic crisis and, 10–12 interest rates and, 172–73, 175, 209 risk and, 136, 158, 165 see also banking-and-credit crisis Crédit Agricole, 36 credit cards, 27, 217 credit ratings and, 123–24 Iceland’s economic crisis and, 9, 11–12 risk and, 158–59, 163 credit default swaps (CDSs), 20, 63, 65–80, 117, 158–59, 183–86 AIG and, 75–78, 201 attractive aspects of, 72–74 examples of, 57–58 Exxon deal and, 67–70, 121 over-the-counter trading of, 184–85, 201 regulation and, 68, 70, 73, 184–86 risk and, 58, 66–70, 72–75, 78–80, 212 securitized bundles of, 69–70, 74 streamlining and industrializing of, 68–69 unfortunate side effect of, 74–75 Credit Suisse, 36, 227 Cuomo, Andrew, 99 Cutter family, 126–27 Darling, Alistair, 172, 220 debt, debts, 27–29, 34, 59–63, 118, 172n, 179, 216, 229 in balance sheets, 27–28, 30–31 benefits of, 59–61 bonds and, 59, 61–63, 208, 210 credit and, 123–26, 221 derivatives and, 52, 67, 69–72 housing and, 93, 100, 132, 176 paying the bill and, 220–22 personal, 221–22 regulation and, 181, 190 Russian default on, 55–56, 162, 164–65 see also collateralized debt obligations default, defaults, default rates, 162–65 CDOs and, 114–15 on mortgages, 159–60, 163, 165, 229 risk and, 154, 159–60, 163 of Russia, 55–56, 162, 164–65 see also credit default swaps Demchak, William, 69 democracy, democracies, 15–18, 108–9, 179, 213 free-market capitalism and, 15, 17, 23 housing and, 87, 98 DePastina, Anthony, 85 Depository Institutions Deregulation and Monetary Control Act (DIDMCA), 100 deregulation, see regulation, deregulation derivatives, 45–58, 63–80, 86, 210–12 in balance sheets, 30–31, 70 banks and, 20, 51–54, 57–58, 63–71, 74–75, 77, 79, 115–17, 120–21, 132, 183–84, 200, 205–6, 211 Black-Scholes formula and, 48, 54, 116–17, 151 bonds and, 58, 63–67, 112, 114, 118–19, 210–11 Buffett and, 56–57, 78 and City of London, 56–57, 79, 201 complexity of, 52–54, 56–57 Enron and, 56, 105–6, 185 futures and, 46–47, 49n, 51–52, 54, 184 Greenspan on, 166, 183–84 in history, 45–48, 147 mathematics and, 47–48, 52–54, 115–17, 166 offshore companies and, 70, 72 options and, 46–47, 50–52, 151, 174, 184 over-the-counter trading of, 184–85, 201, 205–6 prices and, 38, 46–52, 54, 56, 75, 158–59, 166 regulation and, 68, 70, 73, 153, 183–86, 200–201 risk and, 46–47, 49–52, 54–55, 57–58, 66–75, 78–80, 114–15, 117–22, 151, 153, 158–60, 163, 166–67, 184–85, 205, 212 size of market in, 48, 56, 80, 117, 201 see also collateralized debt obligations; credit default swaps Detroit, Mich., 81–82 Deutsche Bank, 36, 77, 83, 227 diversification, 146–48, 177 dividends, 101, 147–48 Doctorow, E. L., 64 Dorgan, Byron, 188 dot-com bust, 3, 104–7, 109, 142, 175 Dow Jones Industrial Average, 152 Drake, Sir Francis, 214 Dunfermline Building Society, 40 Dutch tulip bubble, 47, 104, 136 Ebbers, Bernie, 105 “Economic Possibilities for Our Grandchildren” (Keynes), 213–15 economics, economy, economists: booms in, 2–4, 14, 16, 23, 81, 108–9, 214, 216 contractions in, 170–71, 222–23 crises in, 4–6, 9–12, 16, 23–24, 39–40, 57, 73, 76–79, 142, 150–52, 160–62, 164–67, 170–72, 175–76, 182–83, 185–87, 189, 191–96, 199, 201–2, 205–7, 211, 213, 215–21, 223, 225–28, 230–31 ignorance of, 5–6, 23 liberalism in, 136 rationalism in, 136–38 Economist, The, 3, 170, 193, 202–3 education, 4–5, 9, 13, 17, 21, 198, 200, 217, 222 efficient portfolio, 149 Elizabeth I, Queen of Great Britain, 214 Ellis, William Webb, 201 employment, employees, 8, 28, 40, 51, 171, 179, 203–4, 217 banks and, 206, 229 economic contractions and, 222–23 Enron and, 106, 226 and financial vs. industrial interests, 197–98 free-market capitalism and, 15–17, 19 housing and, 86, 88–89, 94, 96–97, 99–100, 126–27, 131, 163 interest rates and, 102, 172–73, 221 Marxist analysis of, 15–16 paying the bill and, 221–23 Enron: collapse of, 105–7, 175, 226, 231 derivatives and, 56, 105–6, 185 equality, inequality, 15–17, 21, 164 in free-market capitalism, 15–16, 23 in mortgage market, 99–101 equity, 27–31, 34–37, 41–42, 55, 190 leverage and, 35, 41, 60 negative, 28–29, 42 return on (ROE), 36–37 selling of, 58–59 Europe, European Union, 177, 180, 191 banks of, 8, 35–36, 40, 51, 77, 83, 92, 120, 227 comparisons between U.S. and, 17 contracting economies in, 222–23 housing in, 40, 83–84, 91–95, 110 European Bank for Reconstruction and Development (EBRD), 68–70 Exxon, 67–70, 121 Failure of Capitalism, A (Posner), 174 fair value theory, 147–48 Fannie Mae, 39, 95, 99–100, 113, 124 Federal Reserve (Fed), 40, 102, 142, 173–74, 183, 189 Ferguson, Niall, 177 FICO scores, 123–24 films, film industry, 1–2, 198–99 finance, financial industry: favored treatment of, 19–21 gap between world of general public and, 5–6 industrial interests vs., 196–99 power of, 164 Financial Services Authority (FSA), 180–82, 194–95, 201 Financial Times, 193, 227 Flanders, Stephanie, 37 Florida, 10, 59, 83, 115 Fooled by Randomness (Taleb), 53 Fool’s Gold (Tett), 121 foreclosure rescue, 129–31 Fortis, 36, 40 Fortune, 105 4:15 report, 152 France, French, 36, 156, 229 housing in, 92–94 Nazi occupation of, 138–39 Freddie Mac, 39, 95, 99–100, 113, 124 Friedman, Thomas, 208 front running, 192 Fuld, Richard, 204, 206 funny smells, 169–73, 208, 211 and banking-and-credit crisis, 194, 201 credit crunch and, 169, 171–72 Galway’s water and, 169–71 Greenspan and, 173, 176 regulation and, 169, 192, 201, 211 futures, 46–47, 49n, 184 how they work, 47, 51–52 losing money on, 51–52, 54 Galway, 169–71 Garn–St.


pages: 422 words: 113,830

Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism by Kevin Phillips

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algorithmic trading, asset-backed security, bank run, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, collateralized debt obligation, computer age, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency peg, diversification, Doha Development Round, energy security, financial deregulation, financial innovation, fixed income, Francis Fukuyama: the end of history, George Gilder, housing crisis, Hyman Minsky, imperial preference, income inequality, index arbitrage, index fund, interest rate derivative, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, large denomination, Long Term Capital Management, market bubble, Martin Wolf, Menlo Park, mobile money, money market fund, Monroe Doctrine, moral hazard, mortgage debt, Myron Scholes, new economy, oil shale / tar sands, oil shock, old-boy network, peak oil, Plutocrats, plutocrats, Ponzi scheme, profit maximization, Renaissance Technologies, reserve currency, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, Satyajit Das, shareholder value, short selling, sovereign wealth fund, The Chicago School, Thomas Malthus, too big to fail, trade route

Using 2007 data, the Bank for International Settlements first broke out the notional values: a total of $596 trillion split between interest rate derivatives ($393 trillion), credit default swaps ($58 trillion), and currency derivatives ($56 trillion) with the remainder put into an unallocated category. Then, to assess real-world vulnerability, the BIS set what they called net risk at $14.5 trillion, and put a plausible gross credit exposure at $3.256 trillion.14 Abstract as these trillion-dollar references may seem to laypeople, global fears of a second wave of exotic financial implosions took shape during 2008. In 2007, mortgage-backed securities and mortgage-linked packages of collateralized debt obligations (CDOs), contaminated by subprime mortgage ingredients, had been the top sources of heartburn. By autumn 2008, financial institutions had already written off some $700 billion of these products. In the meantime, credit default swaps (CDSs), as well as the so-called Synthetic CDOS in which credit swaps also figured, had become the new front burner of crisis management.

With regulation all but suspended, competition to innovate, experiment, and return to the collusions of the 1920s became intense. And before the wax attaching their wings melted Icarus-like in 2007-2008, most of the top fifteen to twenty institutions had bet their fortunes on a host of new financial vehicles and instruments—structured investment vehicles (SIVs), special purpose acquisition companies (SPACs), mortgage securitization, collateralized debt obligations (CDOs), credit default swaps (CDSs), and the like. Although bountiful in their own right, fees for mergers and acquisitions soon paled alongside the larger benefits of bull markets, assets bubbles, and the uber-profitability of exotic financial instruments. Back in the late 1980s, Goldman Sachs estimated that a major portion of that decade’s stock market upsurge had come from anticipation of takeover bids or buyouts, and other analysts would make the same point about the later M&A floodtides in 2000 and 2006 (see p. 77).

One 2006 BusinessWeek article spotlighted the new secretary as a high-roller: “Think of Paulson as Mr. Risk. He’s one of the key architects of a more daring Wall Street where securities firms are taking greater and greater chances in their pursuit of profits.” That, the magazine added, “means taking on more debt . . . it means placing big bets on all sorts of exotic derivatives and other securities.” 31 Those were items like collateralized debt obligations (CDOs) and credit default swaps (CDSs), arcane U.S. innovations we now know to have spread toxicity, opacity, and paralysis. Economics professor Ben Bernanke, before he replaced Alan Greenspan as Federal Reserve Board chairman in early 2006, had served almost three years as the Chairman of George W. Bush’s Council of Economic Advisers. There he had been an enthusiast of Bush economic policies, including upper-bracket tax cuts, Social Security privatization, “securitization” of assets, and “safe” financial derivatives.


pages: 543 words: 157,991

All the Devils Are Here by Bethany McLean

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Asian financial crisis, asset-backed security, bank run, Black-Scholes formula, break the buck, call centre, collateralized debt obligation, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Exxon Valdez, fear of failure, financial innovation, fixed income, high net worth, Home mortgage interest deduction, interest rate swap, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, market fundamentalism, Maui Hawaii, money market fund, moral hazard, mortgage debt, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative trading / quantitative finance, race to the bottom, risk/return, Ronald Reagan, Rosa Parks, shareholder value, short selling, South Sea Bubble, statistical model, telemarketer, too big to fail, value at risk, zero-sum game

See Kurland, Stanford; Sambol, Dave profitability of refinancings by SEC fraud charges Spitzer investigation stock, decline of subprime mortgages underwriting guidelines, loosening Cox, Christopher Cox, Prentiss Credit default swaps AIG-FP BISTRO as precursor to first mortgage-based. See Collateralized debt obligations (CDOs) profitability of relationship to subprimes risk-management features tradable market, lack of Credit enhancements Credit risk, minimizing. See Derivatives Cribiore, Alberto Cuomo Andrew Currency swaps Dallas, Bill Dallavecchia, Enrico Daurio, Jon Davis Square III Defaults, on subprimes Depository Institutions Deregulation and Monetary Control Act (1980) D’Erchia, Peter Derivatives of AIG Financial Products CDOs CDOs, multisector CDOs, synthetic credit default swaps currency swaps danger and warning about futures classification defeat high ratings, reasons for interest rate swaps of J.P.

Once this risk-based methodology took hold, banks had an enormous incentive to move into assets that would require less capital—or to invent new products that would have the same effect. Lo and behold, along came the product that would soon be the greatest capital reducer of them all: the credit default swap. In simplest terms, a credit default swap is designed to accomplish the same task as an interest rate or currency swap—move risk from a party that doesn’t want it to one that does. The risk in this case, however, is credit risk. A credit default swap is essentially an insurance policy against the possibility of default—credit protection, it came to be called. One party—a bank—would buy credit default swaps to protect against a default in its loan portfolio. A counterparty would sell the bank the credit default swap in return for a fee. So long as there was no default, the counterparty would keep collecting fees. But in the event of a default, the counterparty would have to pay the full amount of the loss to the bank.

“We were extending credit,” says one member of the credit derivative team, “and nobody was putting a price on it.” A tradable market for credit default swaps would change that. Traders buying and selling credit protection would allow the market to gauge the riskiness of a loan. If the cost of the credit default swap increased, that meant the chance of a default was rising; if it decreased, then the odds were decreasing. Even before a tradable market existed, J.P. Morgan’s quants began using credit default swaps internally, to put a price on the risk of its own commercial loans. The old-line commercial lenders hated it, but this was exactly the kind of approach to risk that Weatherstone favored. And the second reason the bank wanted to make credit default swaps a reality? If a tradable market developed, J.P. Morgan would certainly be a dominant player.


pages: 430 words: 109,064

13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson, James Kwak

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Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, banking crisis, Bernie Madoff, Bonfire of the Vanities, bonus culture, break the buck, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, commoditize, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Edward Glaeser, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, financial intermediation, financial repression, fixed income, George Akerlof, Gordon Gekko, greed is good, Home mortgage interest deduction, Hyman Minsky, income per capita, information asymmetry, interest rate derivative, interest rate swap, Kenneth Rogoff, laissez-faire capitalism, late fees, light touch regulation, Long Term Capital Management, market bubble, market fundamentalism, Martin Wolf, money market fund, moral hazard, mortgage tax deduction, Myron Scholes, Paul Samuelson, Ponzi scheme, price stability, profit maximization, race to the bottom, regulatory arbitrage, rent-seeking, Robert Bork, Robert Shiller, Robert Shiller, Ronald Reagan, Saturday Night Live, Satyajit Das, sovereign wealth fund, The Myth of the Rational Market, too big to fail, transaction costs, value at risk, yield curve

In his memoir, former trader Frank Partnoy described how Morgan Stanley earned $75 million on a single trade.3 In addition to pure derivatives such as interest rate swaps, currency swaps, and credit default swaps, asset-backed structured products were a mainstay of Wall Street derivatives desks in the early 1990s. The Repackaged Asset Vehicles that played a starring role for Morgan Stanley were structured products, in which a special-purpose vehicle (SPV, a new company that exists only on paper) bought a set of existing securities (say, bonds issued by the state electric utility of the Philippines) and paid for them by selling investors a new set of custom-designed securities.4 Asset-backed structured products became Wall Street’s new cash cows, in the form of mortgage-backed securities (MBS) and their cousins, collateralized debt obligations (CDOs). The original mortgagebacked securities created by Ginnie Mae in the late 1960s were “pass-through” securities: mortgages were combined in a pool, and each security had an equal claim on the mortgage payments from that pool, spreading the risk evenly.

Before 2008, they benefited from the general expectation that the government would step in if necessary to prevent a catastrophic failure. That expectation did not save Lehman Brothers. But since then, the idea that certain banks are “too big to fail” has virtually become government policy; as a result, they can take on more risk than their competitors, since creditors and counterparties know that the government will clean up after them. Subprime lending, mortgage-backed securities, collateralized debt obligations (CDOs), and credit default swaps all flowed naturally from this business model, and absent fundamental reform, there is no reason to believe bankers will refrain from inventing new toxic products and precipitating another crisis in the future. What’s more, given the growth in the size of the leading banks, the next crisis is likely to be even bigger. As The Financial Times’ Martin Wolf wrote in September 2009, “What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees.

Orange County lost almost $2 billion on inverse floaters and similar trades that treasurer Robert Citron clearly did not understand; real-economy companies such as Procter & Gamble and Gibson Greetings similarly lost tens or hundreds of millions of dollars.75 But these transactions generated large fees for the dealers; Merrill Lynch alone made $100 million on deals with Orange County.76 One crucial innovation in the recent history of derivatives, which played an important role in creating the latest financial crisis, was the credit default swap. A credit default swap is a form of insurance on debt; the “buyer” of the swap pays a fixed premium to the “seller,” who agrees to pay off the debt if the debtor fails to do so. Typically the debt is a bond or a similar fixed income security, and the debtor is the issuer of the bond. Historically, monoline insurance companies provided insurance for municipal bonds, and Fannie Mae and Freddie Mac insured the principal payments on their mortgage-backed securities. With credit default swaps, however, now anyone could sell insurance on any fixed income security. Credit default swaps were invented in the early 1990s by Bankers Trust, but were popularized by J.P. Morgan later in the decade as a way for banks to unload the default risk of their asset portfolios; this enabled them to lower their capital requirements, freeing up money that could be lent out again.77 Credit default swaps also provide a way for a bond investor to hedge against the risk of default by the bond issuer.


pages: 280 words: 79,029

Smart Money: How High-Stakes Financial Innovation Is Reshaping Our WorldÑFor the Better by Andrew Palmer

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Affordable Care Act / Obamacare, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, Black-Scholes formula, bonus culture, break the buck, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Graeber, diversification, diversified portfolio, Edmond Halley, Edward Glaeser, endogenous growth, Eugene Fama: efficient market hypothesis, eurozone crisis, family office, financial deregulation, financial innovation, fixed income, Flash crash, Google Glasses, Gordon Gekko, high net worth, housing crisis, Hyman Minsky, implied volatility, income inequality, index fund, information asymmetry, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, loss aversion, margin call, Mark Zuckerberg, McMansion, money market fund, mortgage debt, mortgage tax deduction, Myron Scholes, negative equity, Network effects, Northern Rock, obamacare, payday loans, peer-to-peer lending, Peter Thiel, principal–agent problem, profit maximization, quantitative trading / quantitative finance, railway mania, randomized controlled trial, Richard Feynman, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, short selling, Silicon Valley, Silicon Valley startup, Skype, South Sea Bubble, sovereign wealth fund, statistical model, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

In derivatives transactions, more collateral (or “margin”) can be demanded as the values of specific contracts go up and down. Collateralized-debt obligations: The next step in the securitization process after the creation of asset-backed securities is the CDO. CDOs are instruments made up of the riskier slices of a lot of ordinary asset-backed securities. They are then sliced into different tranches: the most senior tranches of CDOs of mortgage-backed securities were given high ratings during the most recent US housing boom because the performance of all the different mortgages in the pool was thought to be diversified. Counterparty risk: The risk that the other party to a contract will not live up to its obligations. The counterparty risk in an interest-rate swap is that one of the parties to the swap will not pay up. Credit-default swap: A credit-default swap is a form of insurance against default by a bond issuer.

See Drug-development megafund Capital, forms of, 6–7, 163 Capital One, 189 CareerConcept, 166 Cash-surrender value, 142 Castle Trust, 69, 81, 83–84 Catastrophe insurance catastrophe bonds, 224–227 importance of to economy, 224–225 Catastrophes, risk modeling of catastrophes, calculation of, 227–228 finance, use of in, 233–239 Monaco, earthquake risk in, 227 terrorist attack on 2006 World Cup, risk of, 221–222 See also Lethal pandemic Catastrophist, 221 CDS. See Credit-default swap Cecchetti, Stephen, 79 Church-tower principle, 207 Cigarettes, as means of payment, 5 Clark, Geoffrey Wilson, 144 Clearinghouse, 39 ClearStreet, 210 Clinical drug trials, indemnification of, xii–xiii Coates, John, 116 Code, simplification of, 63 Cohen, Ronald, 91–95, 97, 106, 108, 112 Coins, history of, 4 Collateral, xiv, 7, 38, 65, 76, 150, 177, 185, 204–206, 215 Collateralized-debt obligations (CDOs), 43, 234–235 Collective Health, 104 College graduates, earning power of, 170–171 Commenda, 7–8, 19 Commercial paper, 185 Commodity Futures Trading Commission, 54 CommonBond, 182, 184, 197 Confusion de Confusiónes (de la Vega), 24 Congressional Budget Office, 99, 169 Consumer Financial Protection Bureau overdraft fees and prepaid cards, concern about, 203–204 report on reverse mortgages, 141 survey on payday borrowing, 200 CoRI, 132 Corporate debt, in United States, 120 Corporate finance, 237–238 Correlation risk, 165 Cortisol and testosterone, effect of on risk appetite and aversion, 116 Counterparty risk, 22 Credit, industrialization of, 206 Credit Card Accountability, Responsibility, and Disclosure (Credit CARD) Act of 2009, 203 Credit cards, 203 Credit-default swap (CDS), 37, 64–65, 75, 124, 169, 238 Credit ratings, 24, 120–121, 233–236 Credit-reporting firms, 24 Credit risk, 200, 201, 237, 238 Credit scores, 47–49, 201, 216–217 Creditworthiness, xiv, 10, 12, 47, 121, 197, 202, 204, 216 Crowdcube, 152–155, 158–159, 162 Damelin, Errol, 208 Dark Ages, banking in, 11 Dark pools, 60 DCs (defined-contribution schemes), 129, 131 DE Shaw, 163 Debit cards, 204 Debt, 6, 7, 70, 149, 164 Decumulation, 138–139 Defined-benefit schemes, 129, 131 Defined-contribution (DC) schemes, 129, 131 Dependent variable, 201 Deposit insurance, 13, 43–44 Derivatives, 3, 9–10, 29–32, 38, 40 Desai, Samir, 189 Development-impact bonds, 103 Diabetes, cost of in United States, 102 Dimensional Fund Advisors, 129 Direct lending, 184 Discounting, 19 Disposition effect, 25 Diversification, 8, 12, 20, 117–119, 196, 236 Doorways to Dreams (D2D), 213–214 Dot-com boom, 148 Dow Jones Industrial Average, 40 Dow Jones Transportation Average, 40 Drug development, investment in, vii-viii, 114–115 Drug-development megafund adaptive market hypothesis and, 115–117 Alzheimer’s disease, 122 credit rating, importance of, 120–121 diversification and, 117, 119–120, 122 drug research, improvement of economics of, 114–115 financial engineering, need for, 119 guarantors for, 121 orphan diseases and, 118–119, 122 reactions to, 118 securitization and, 117–119, 122 Dumb money, comparison of to smart money, 155–158 Dun and Bradstreet, 24 Durbin Amendment (2010), 204 Dutch East India Company (VOC), 14–15, 38 E-Mini contracts, 54–55 Eaglewood Capital, 183–184 Ebola outbreak (2014), mortality rate of, 230 Ebrahimi, Rod, 210–211 Ecology, finance and, 113 Economist 2013 conference, xv on railways, 25 on worth of residential property, 70 Educational equity adverse selection in, 174, 175, 182 CareerConcept, 166 differences in funding rates, 176 enforceability, 177 in Germany, 166 Gu, Paul, 172, 175–176 income-share legislation, US Senate and, 172 information asymmetry, 174 Lumni, 165, 168, 175 Oregon, interest in income-share agreements, 172, 176 Pave, 166–168, 173, 175, 182 peer-to-peer insurance, 182 problems with, 167–168, 173–174 providers and recipients, contact between, 160, 175 risk-based pricing model, 176 student loans, 169–171 Upstart, 166–168, 173, 175, 182 Yale University and, 165 Efficient-market hypothesis, 115 Endogeneity, 239 Epidemiology, finance and, 113 Eqecat, 222 Equity, 7–8, 149–150, 186–187 Equity-crowdfunding in Britain, 154 Crowdcube, 152–155, 158–159, 162 Friendsurance, 182–183 Equity-crowdfunding in Britain (continued) herding, 159–160 social insurance, 182–183 Equity-derivatives contracts, 29 Equity-sharing, 7–8 Equity-to-assets ratio, 186 Eren, Selcuk, 73 Eroom’s law, 114 Essex County Council, 95 Eurobond market, 32 European Bank for Reconstruction and Development, 169 Exceedance-probability curve, 231–232, 232 figure 3 Exxon, 169 Facebook, 174 Fair, Bill, 47 False substitutes, 44 Fama, Eugene, 115 Fannie Mae, 48, 78, 85, 168 Farmer, Doyne, 60, 63 Farynor, Thomas, 16 FCIC (Financial Crisis Inquiry Commission), 50 Federal Deposit Insurance Corporation (FDIC), 186, 200 Federal Reserve Bank of New York, 170, 204, 205 Feynman, Richard, 115 Fibonacci (Leonardo of Pisa), 19 FICO score, 47–49 Films to rent, study of hyperbolic discounting, 133–134 Finance bailouts, 35–36 banks, purpose of, 11–14 collective-action problem in, 62 computerization of, 31–32 democratization of, 26–28 economic growth and, 33–34 fresh ideas, need for, xviii, 38–39, 80, 85–86 globalization and, 30, 225 heuristics, use of in, 45–50 illiteracy, financial, 134–135 importance of, 10 information, importance of, 10–11 inherent failings in, 241 misconceptions about, xiii–xvi panic, consequences of, 44 regulatory activity, results of, 33 risk assessment, 24, 45, 77–78 risk management, 55, 117–118, 123 as solution to real-world problems, 114 standardization, 39–41, 45, 47, 51 unconfirmed trades, backlog of, 64–65 use of catastrophe risk modeling in, 233–239 See also High-frequency trading (HFT); Internet Finance, history of bank, derivation of word, 12 Book of Calculation (Fibonacci), 19 call options, 10 Code of Hammurabi, 8 coins, 4 commodity forms of exchange, 4–5 credit and debt, 5–7 in Dark Ages, 11 democratization, 26–28 deposits, 6 derivatives, 29–32, 38 Dutch East India Company (VOC), 14–15, 38 early financial contracts, 5 early forms of finance, 3 equity contracts, 7–8 fire insurance, 16–17 first futures market, 29, 39–40 forward contracts, 38 in Greece, 11 industrialization and, 3, 27–28 inflation-protected bonds, 26 insurance, 8–10, 16–17, 20–22 interest, origin of, 5 in Italy, 9, 14 life annuities, 20–22 maritime trade and, 7–8, 14, 17, 23 payment, forms of, 4–5 put options, 9–10 railways, effect of on, 23–25 in Roman Empire, 7, 8, 11, 36 securities markets, 14 stock exchanges, 14, 24–25 Finance, innovation in absence of, xvi–xvii credit and debt, 5–7 derivatives, 9–10, 29–32 diffusion, pattern of, 45 drivers of, 22–26 equity, 7–8 importance of, 66, 242–243 insurance, 8–9, 16–17, 20–22 lessons from, 32–34 mathematical insights, 18–20 payment, forms of, 4–5 risks of, 145 stock exchanges, 14–16 Finance and the Good Society (Shiller), 242 Financial Crisis Inquiry Commission (FCIC), 50 Financial crisis of 2007–2008 causes of, xv, 34, 69 effects of, xx–xi future of finance, effect on, 243 mortgage debt, role of in, 69–70 new regulations since, 185, 187 Financial Times, quote from Chuck Prince in, 62 Fire insurance, early, 16–17 Fitch Ratings, 24 Flash Boys (Lewis), 57 Flash crash, 54–56, 63 Florida, hurricane damage in, 223, 225 Florida, new residents per day in, 225 Foenus nauticum, 8 Forward contracts, 38 Forward transactions, 15 France collapse of Mississippi scheme in, 36 eighteenth century life annuities in, 20–21 government spending in, 99 Freddie Mac, 48, 85 Fresno, California, social-impact bond pilot program in, 103–104 Friedman, Milton, 165 Friendsurance, 182–183 Fundamental sellers, 54–55 Funding Circle, 181–182, 189, 197 Futures, 29, 39–40 Galton Board, 17, 18 figure 1 Gaussian copula, 235 Geithner, Timothy, 64–65 Genentech, xii General Motors, bailout of, xi Geneva, Switzerland, annuity pools in, 21–22 Gennaioli, Nicola, 42, 44 Ginnie Mae, 168 Girouard, Dave, 166 Glaeser, Edward, 74 Globalization, finance and, 30, 225 Goldman Sachs, 61, 98, 156, 235 Google Trends, 218 Gorlin, Marc, 218 Government spending, rise in, 99–100 Governments, support for new financial products by, 168–169 Grameen Bank, 203 Greece, forerunners of banks in, 11 Greenspan, Alan, 236 Greenspan consensus, 236 Grillo, Baliano, 9 Gu, Paul, 162–164, 166, 172, 175–176 Guardian Maritime, 151 Haldane, Andy, 188 Halley, Edmund, 19–20 Hamilton, Alexander, 35–36 Hammurabi, Code of, 5, 8 Health conditions, SIB early detection programs for, 102–104 Health-impact bonds, 103–104 Hedge funds, 123, 158, 183 Hedging, 30–31, 54, 124, 129, 131, 156, 206, 227 Heiland, Frank, 73 Herding, 24, 159–160 Herengracht Canal properties, Amsterdam, real price level for, 74 Heuristics, 45–50 HFRX, 157–158 High-frequency trading (HFT) benefits of, 58 code, simplification of, 63 flash crash, 54–56 latency, attempts to lower, 53 pre-HFT era, 59–61 problems with, 56–58, 62–63 Hinrikus, Taavet, 190–191 HIV infection rates, SIB program for reduction of, 103 Holland, tulipmania in, 33, 36 Home equity, 139–140 Home-ownership rates, in United States, 85, 170 Homeless people, SIB program for, 96–97 Housing boom of mid-2000s, 148–149 Human capital contracts, 165, 167, 173–174, 176, 177 defined, 6 as illiquid asset, 177 Hurricane Andrew, effect of on insurers, 223–224, 225 Hurricane Hugo, 223 Hyperbolic discounting, 133–134, 211 IBM, 169 If You Don’t Let Us Dream, We Won’t Let You Sleep (drama), 111 IMF (International Monetary Fund), 125–126 Impact investing, 92 Implied volatility, 116 Impure altruism, 109–110 Income-share agreements, 167, 172–178 Independent variables, 201 Index funds, 40 India, CDS deals in, 37 India, social-impact bonds (SIBs) in, 103 Industrialization, effect of on finance, 3, 27–28 Inflation-protected Treasury bills, 131 Information asymmetry, 174 Innovator’s dilemma, 189 Instiglio, 103 Insurance, 8–10, 16–17, 142, 223–225 Insurance-linked securities, 222 Interbank markets, x Interest, origin of, 5 Interest-rate swaps, 29 International Maritime Bureau Piracy Reporting Centre, 151 International Monetary Fund (IMF), 125–126 International Swaps and Derivatives Association (ISDA), 40 Internet, role of in finance creditworthiness, determination of, 172–173, 202, 218 direct connection of suppliers and consumers, xviii, 32 equity crowdfunding, 152–155 income-share agreements, 172–173 ROSCAs, 210 small business loans, 216 speed and ease of borrowing, 189 student loans, 166–167 Intertemporal exchange, 6 Intuit, 218 Investment grade securities, 121 Ireland, banking crisis in, xiv–xv, 69 Isaac, Earl, 47 ISDA (International Swaps and Derivatives Association), 40 ISDA master agreement, 40 Israel, SIBs in, 97 Italy discrimination against female borrowers in, 208 financial liberalization and, 34 first securities markets in, 14 maritime trade partnerships in, 7–8 J.

Big jumps in US interest rates in the early 1980s, as then Federal Reserve chairman Paul Volcker battled inflation, gave people more reason to hedge against interest-rate volatility. Globalization increased the complexity of multinational companies’ operations, and the Asian debt crisis in the late 1990s drove home the risks of operating in emerging markets. Credit-default swaps promised a way for banks to reduce the impact of defaults, in the aftermath of a wave of bank failures experienced during America’s savings-and-loan crisis in the 1980s, because the sellers of a swap promised a payout if the borrower in question was unable to pay. Needs are not always so noble, of course. By making their lending seem less risky, credit-default swaps also meant that regulators were happy to allow banks to fund themselves with less equity capital. That in turn made banks more attractive propositions to equity investors, who would have to put up less money in order to get a return.


pages: 311 words: 99,699

Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett

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accounting loophole / creative accounting, asset-backed security, bank run, banking crisis, Black-Scholes formula, break the buck, Bretton Woods, business climate, collateralized debt obligation, commoditize, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, easy for humans, difficult for computers, financial innovation, fixed income, housing crisis, interest rate derivative, interest rate swap, locking in a profit, Long Term Capital Management, McMansion, money market fund, mortgage debt, North Sea oil, Northern Rock, Renaissance Technologies, risk tolerance, Robert Shiller, Robert Shiller, Satyajit Das, short selling, sovereign wealth fund, statistical model, The Great Moderation, too big to fail, value at risk, yield curve

Why did the bankers, regulators, and ratings agencies collaborate to build and run a system that was doomed to self-destruct? Did they fail to see the flaws, or did they fail to care? This book explores the answer to the central question of how the catastrophe happened by beginning with the tale of a small group of bankers formerly linked to J.P. Morgan, the iconic, century-old pillar of banking. In the 1990s, they developed an innovative set of products with names such as “credit default swaps” and “synthetic collateralized debt obligations” (of which more later) that fall under the rubric of credit derivatives. The Morgan team’s concepts were diffused and mutated all around the global economy and collided with separate innovations in mortgage finance. These then played a critical role in both the great credit bubble and its subsequent terrible bursting. The J.P. Morgan team were not the true inventors of credit derivatives.

Morgan’s proprietary name for the idea of creating CDOs out of credit derivatives. It was first launched in 1997 and was the forerunner of the synthetic CDO structure that later became widespread. Collateralized Debt Obligations (CDOs): A form of asset-backed security. They are typically created by bundling together a portfolio of fixed-income debt (such as bonds) and using those assets to back the issuance of notes. Such notes usually carry varying levels of risk. Cash CDOs are created from tangible bonds, bonds, or other debt; synthetic CDOs sare created from credit derivatives. Collateralized Debt Obligations of Asset Backed Securities (CDO of ABS): CDOs built out of asset-backed securities, which are usually (but not always) types of mortgage-backed bonds. Collateralized Loan Obligations: CDOs built out of loans, which are usually “leveraged loans” (those extended to companies whose debt is rated noninvestment grade).

After all, for every buyer in a market there must be a seller; a market in any commodity—be it equities, art, or synthetic CDOs—can operate only if there are parties on both sides of the trade. Feldstein and some others putting their money on the contrarian view helped to make a lively new business of trading in default swaps take off. By 2005 there were more tools available to conduct such trading, too. In the early years, bankers who wanted to trade credit default swaps generally used only contracts that related to single names. From 2004 onward, though, indices of credit default swaps sprang up, known as “CDX” in the US and “iTraxx” in Europe. They tracked the cost of insuring against default on a basket of companies, offering a handy way for investors to evaluate trends in pricing, in the same way that the S&P 500 shows how the whole equity market is moving. They could also be traded as contracts in their own right.


pages: 566 words: 155,428

After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead by Alan S. Blinder

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Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, banks create money, break the buck, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, conceptual framework, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Detroit bankruptcy, diversification, double entry bookkeeping, eurozone crisis, facts on the ground, financial innovation, fixed income, friendly fire, full employment, hiring and firing, housing crisis, Hyman Minsky, illegal immigration, inflation targeting, interest rate swap, Isaac Newton, Kenneth Rogoff, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, market clearing, market fundamentalism, McMansion, money market fund, moral hazard, naked short selling, new economy, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, price mechanism, quantitative easing, Ralph Waldo Emerson, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, statistical model, the payments system, time value of money, too big to fail, working-age population, yield curve, Yogi Berra

Never Again: Legacies of the Crisis Notes Sources Index LIST OF ACRONYMS AND ABBREVIATIONS ABCP: asset-backed commercial paper ABS: asset-backed securities AIG: American International Group AIG FP: AIG Financial Products AMLF: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility ANPR: Advance Notice of Proposed Rulemaking ARM: adjustable-rate mortgage ARRA: American Reinvestment and Recovery Act (2009) BofA: Bank of America CBO: Congressional Budget Office CDO: collateralized debt obligation CDS: credit default swaps CEA: Council of Economic Advisers CEO: Chief Executive Officer CFMA: Commodity Futures Modernization Act (2000) CFPA: Consumer Financial Protection Agency CFPB: Consumer Financial Protection Bureau CFTC: Commodity Futures Trading Commission CME: Chicago Mercantile Exchange CP: commercial paper CPFF: Commercial Paper Funding Facility CPI: Consumer Price Index CPP: Capital Purchase Program DTI: debt (service)-to-income ratio ECB: European Central Bank EMH: efficient markets hypothesis ESF: Exchange Stabilization Fund FCIC: Financial Crisis Inquiry Commission FDIC: Federal Deposit Insurance Corporation FHA: Federal Housing Administration FHFA: Federal Housing Finance Agency FICO: Fair Isaac Company FOMC: Federal Open Market Committee FSA: Financial Services Authority (UK) FSLIC: Federal Savings and Loan Insurance Corporation FSOC: Financial Stability Oversight Council G7: Group of Seven (nations) GAAP: generally accepted accounting principles GAO: Government Accountability Office GDP: gross domestic product GLB: Gramm-Leach-Bliley Act (1999) GSE: government-sponsored enterprise H4H: Hope for Homeowners HAFA: Home Affordable Foreclosure Alternatives Program HAMP: Home Affordable Modification Program HARP: Home Affordable Refinancing Program HAUP: Home Affordable Unemployment Program HHF: Hardest Hit Fund HOLC: Home Owners’ Loan Corporation HUD: Department of Housing and Urban Development IMF: International Monetary Fund ISDA: International Swaps and Derivatives Association LIBOR: London Interbank Offer Rate LTCM: Long-Term Capital Management LTRO: Longer-Term Refinancing Operations LTV: loan-to-value (ratio) MBS: mortgage-backed securities MOM: my own money NBER: National Bureau of Economic Research NEC: National Economic Council NINJA (loans): no income, no jobs, and no assets NJTC: new jobs tax credit OCC: Office of the Comptroller of the Currency OFHEO: Office of Federal Housing Enterprise Oversight OMB: Office of Management and Budget OMT: Outright Monetary Transactions OPM: other people’s money OTC: over the counter OTS: Office of Thrift Supervision PDCF: Primary Dealer Credit Facility PIIGS: Portugal, Ireland, Italy, Greece, and Spain QE: quantitative easing Repo: repurchase agreement S&L: savings and loan association S&P: Standard and Poor’s SEC: Securities and Exchange Commission Section 13(3): of Federal Reserve Act SIFI: systemically important financial institution SIV: structured investment vehicle SPV: special purpose vehicle TAF: Term Auction Facility TALF: Term Asset-Backed Securities Loan Facility TARP: Troubled Assets Relief Program TBTF: too big to fail TED (spread): spread between LIBOR and Treasuries TIPS: Treasury Inflation-Protected Securities TLGP: Temporary Liquidity Guarantee Program TSLF: Term Securities Lending Facility UMP: unconventional monetary policy WaMu: Washington Mutual PREFACE When the music stops . . . things will be complicated.

There is no agreed-upon definition of the shadow banking system, but the institutions involved on the eve of the crisis included nonbank loan originators; the two government-sponsored housing agencies, Fannie Mae and Freddie Mac; other so-called private-label securitizers; the giant investment banks (who were often securitizers, too); the aforementioned SIVs; a variety of finance companies (some of which specialized in housing finance); hedge funds, private equity funds, and other asset managers; and thousands of mutual, pension, and other sorts of investment funds. The markets involved included those for mortgage-backed securities (MBS), other asset-backed securities (ABS), commercial paper (CP), repurchase agreements (“repos”), and a bewildering variety of derivatives, including the notorious collateralized debt obligations (CDOs) and the ill-fated credit default swaps (CDS). (Sorry about the alphabet soup—explanations to come.) By most estimates, the shadow banking system was far larger than the conventional banking system. Imagine leaving all that financial activity almost totally unregulated—like a bunch of wild animals running around without zookeepers. Well, actually, you don’t have to imagine it. We did it. In the case of derivatives, a little history is instructive.

See Democrats; Republicans stimulus package in, 225–28, 232 TARP in, 181–84, 187–93, 200 Conrad, Kent, 397 Consumer Financial Protection Agency (CFPA), 301, 312 Consumer Financial Protection Bureau (CFPB), 278–79, 308 Dodd-Frank provisions, 312–13 Consumer Price Index (CPI) house price deflation by, 31, 33–34 medical care costs in, 390 Consumer protection CFPB creation for, 278–79, 308 Dodd-Frank provisions, 308, 312–13 reform needs, 277–79, 296, 301, 437 Contagion, financial, 141–42 avoiding, Bagehot principal, 94, 97, 104 and European crisis, 420 rational and irrational, 141–42 Cordray, Richard, 317 Corporate bonds default risk of, 41 fundamental value of, 41 Council of Economic Advisers (CEA), 215 Countrywide Financial, 164, 305, 330 Credit, interest-rate spreads, 237–43 Credit default swaps (CDS), 61, 65–68 AIG as seller, 66–67, 131–35 features of, 66–67, 132 as gamble versus hedge, 66, 67, 280 naked CDSs, 66, 67–68, 280, 302 notional value of, 67 origin of, 65 in shadow banking system, 60 and subprime mortgages, 68 as synthetic leverage, 66–67 Credit-rating agencies, 79–81 AAA to collateralized debt obligation (CDO), 74, 76 compensation of, 80 Dodd-Frank provisions, 311 failure, reasons for, 79–81 free-riding problem, 285–86 negotiating rating by issuer, 80, 285 regulatory needs for, 81, 285–86, 295 Currency swaps, as liquidity solution, 95–96 Darling, Allistair, 124 Davidson, Paul, 326 Davis, Michelle, 193 Dealers, derivatives, role of, 61, 67 Default risk adjustable-rate (ARMs), 70–71, 321–22 and bond bubbles, 40–42 bonds, 40–42 and interest-rate spreads, 41–42 subprime mortgages, 57, 70–71, 84 Deficit, federal.


pages: 402 words: 110,972

Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber

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AI winter, algorithmic trading, asset allocation, banking crisis, barriers to entry, Big bang: deregulation of the City of London, butterfly effect, buttonwood tree, buy low sell high, capital asset pricing model, citizen journalism, collateralized debt obligation, corporate governance, Craig Reynolds: boids flock, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, en.wikipedia.org, experimental economics, financial innovation, fixed income, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, intangible asset, Internet Archive, John Nash: game theory, Kenneth Arrow, Khan Academy, load shedding, Long Term Capital Management, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, Metcalfe’s law, moral hazard, mutually assured destruction, Myron Scholes, natural language processing, negative equity, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, quantitative hedge fund, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Renaissance Technologies, Richard Stallman, risk tolerance, risk-adjusted returns, risk/return, Robert Metcalfe, Ronald Reagan, Rubik’s Cube, semantic web, Sharpe ratio, short selling, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, too big to fail, transaction costs, Turing machine, Upton Sinclair, value at risk, Vernor Vinge, yield curve, Yogi Berra, your tax dollars at work

This is informative on how responsible use of market technology might have avoided the crisis and can help avoid an even more dreadful sequel in the future. Technology errors of omission and commission have contributed to our present woes. Stock markets are almost perfectly transparent, with full information available to all, and the best electronic clearing and settlement in history. These technologies were omitted in building the skyscraper of cards (“house of cards” seems too mild) out of collateralized debt obligations (CDOs), credit default swaps (CDSs), synthetic collateralized debt obligations (SCDOs), and the rest. The Hall of Shame for those guilty of incompetent engineering features collapsing bridges, flaming dirigibles, exploding spacecraft, and melting reactors. We can add a new wing for overly complex derivatives, modeled in exquisite detail by myopic nerds with Ph.D.’s who got lost in the ever more complex simulations but ignored the basic principles, and their lavishly paid bosses who ignored the warnings from the best of them so they could be even more lavishly paid.

See also data mining capital asset pricing model, 98–99 “Barr’s better beta”, 98–101 Bill Sharpe, 38 CAPM. See capital asset pricing model CDO. See collateralized debt obligation CDS. See credit default swaps Center for Innovative Financial Technology, 311 CERN, 37, 104 CFTC. See Commodity Futures Trading Commission Chicago Mercantile Exchange, 6–9, 72, 286 Chriss, Neil, 76–77 chromosome, 155, 184–186, 192–193 CI. See collective intelligence CIFT. See Center for Innovative Financial Technology CME. See Chicago Mercantile Exchange Codexa, xxxiv, 221, 235–249 GUI, 246–249 message counting, 237–241 whisper numbers, 241–246 collateralized debt obligation, 61, 318, 279, 283, 289 Fannie Mae, 295–298 lack of transparency, 284 collective intelligence, xl, 227–251 collective investing, 229–234 See also counting messages, whisper numbers collective investing, 229–234 iExchange, 230–231 Marketocracy, 232 Index Commodity Futures Trading Commission, 283–284 common factor analysis, 127 Computer Assisted Execution System, 66 computerized investing active management, 115–124 finding alpha, 124–128 indexing, 110–115 market neutral portfolios, 120–124 trading costs, 128–130 computers on Wall Street, early, 22–26 counting messages, 237–241, 261 Cox, Christopher, 60, 106, 218 credit default swaps, 61, 279 NABI on, 322–323 PWG on, 285–286 crossover in chromosomes, 184, 186, 192 D.E.

Algorithmic trading is almost entirely about stocks. There is tremendous transparency in the stock market. Look at the bottom of any business television channel or web site. You can see the details of every trade in every stock, within seconds. Regulators can track down parties involved in suspicious trades via automated clearing systems. In marked contrast, we see absolutely nothing at all about trading in the collateralized debt obligations (CDOs), credit default swaps (CDSs), and mortgage-backed securities (MBSs) that created this mess, even though the total size of those markets is a multiple of the size of the stock market. Trades and quotes in these securities, holdings, and holders are all unknown and largely unknowable, even in today’s electronic markets. If the level of regulation, reporting, and transparency we have in the equity markets were in effect for the toxic garbage that is being laid off on the U.S. taxpayers, we wouldn’t be in the bind we are in.


pages: 353 words: 88,376

The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett by Jack (edited By) Guinan

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Albert Einstein, asset allocation, asset-backed security, Brownian motion, business process, capital asset pricing model, clean water, collateralized debt obligation, computerized markets, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, equity premium, fixed income, implied volatility, index fund, intangible asset, interest rate swap, inventory management, London Interbank Offered Rate, margin call, market fundamentalism, money market fund, mortgage debt, Myron Scholes, passive investing, performance metric, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, statistical model, time value of money, transaction costs, yield curve, zero-coupon bond

See Current ratio Cash conversion cycle (CCC), 39 Cash flow, 39-40, 109-111, 182-183, 198-199, 208 Cash flow statement, 40-41, 208 Cash ratio. See Current ratio C-CPI-U. See Chained urban consumers, CPI (C-CPI-U) CDO. See Collateralized debt obligation (CDO) CDS. See Credit default swap (CDS) Certificate of deposit (CD), 41 Chained dollar GDP. See Nominal GDP Chained urban consumers, CPI (C-CPI-U), 48-49 Chapter 11, Bankruptcy Code, 19, 42 Characteristic line. See Security market line (SML) Chicago Board Options Exchange, 316 Churning, 307 CINS number, 63 Closed-end fund, 42-43, 195-196 CML. See Capital market line (CML) Coefficient of variation (CV), 43 COGS. See Cost of goods sold (COGS) Collateral, 43-44, 127 Collateralized debt obligation (CDO), 44, 290 Collateralized mortgage obligation (CMO), 44-45, 303 Commercial paper, 45 Commissions. See Load fund Commodity, 45-46, 107-108.

For example, if a person gets a mortgage, the collateral would be the house. In margin stock trading, the securities in the account act as collateral against the margin loan. 44 The Investopedia Guide to Wall Speak Related Terms: • Asset • Margin • Regulation T • Asset-Backed Security • Margin Call Collateralized Debt Obligation (CDO) What Does Collateralized Debt Obligation (CDO) Mean? An investment-grade security that is backed by a pool of bonds, loans, and other assets. CDOs represent various debt obligations but are often nonmortgage loans or bonds. Investopedia explains Collateralized Debt Obligation (CDO) Similar in structure to a collateralized mortgage obligation (CMO) or a collateralized bond obligation (CBO), CDOs are unique in that they represent different types of debt and credit risk. In the case of CDOs, these different types of debt often are referred to as tranches or slices.

A credit crunch makes it nearly impossible for companies to borrow money because lenders are scared of bankruptcies or defaults and charge higher interest rates because of that fear. The result is a slowdown in growth that leads to a prolonged recession (or slower recovery), which is compounded as banks hold tight to the banking reserves. Related Terms: • Bankruptcy • Debt • Subprime Meltdown • Bear Market • Recession Credit Default Swap (CDS) What Does Credit Default Swap (CDS) Mean? A swap designed to transfer the credit exposure of fixed-income products between parties. Investopedia explains Credit Default Swap (CDS) The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the creditworthiness of the product. When this is done, the risk of default is transferred from the holder of the fixed-income security to the seller of the swap. For example, the buyer of a credit swap still is entitled to the par value of the bond from the seller of the swap if the bond defaults in its coupon payments. 58 The Investopedia Guide to Wall Speak Related Terms: • Bond • Fixed Income Security • Swap • Credit Derivative • Interest Rate Swap Credit Derivative What Does Credit Derivative Mean?


pages: 265 words: 93,231

The Big Short: Inside the Doomsday Machine by Michael Lewis

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Asperger Syndrome, asset-backed security, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, facts on the ground, financial innovation, fixed income, forensic accounting, Gordon Gekko, high net worth, housing crisis, illegal immigration, income inequality, index fund, interest rate swap, John Meriwether, London Interbank Offered Rate, Long Term Capital Management, medical residency, money market fund, moral hazard, mortgage debt, pets.com, Ponzi scheme, Potemkin village, quantitative trading / quantitative finance, Robert Bork, short selling, Silicon Valley, the new new thing, too big to fail, value at risk, Vanguard fund, zero-sum game

How do you explain to an innocent citizen of the free world the importance of a credit default swap on a double-A tranche of a subprime-backed collateralized debt obligation? He tried, but his English in-laws just looked at him strangely. They understood that someone else had just lost a great deal of money and Ben had just made a great deal of money, but never got much past that. "I can't really talk to them about it," he says. "They're English." Twenty-two days later, on August 31, 2007, Michael Burry lifted the side pocket and began to unload his own credit default swaps in earnest. His investors could have their money back. There was now more than twice as much of it as they had given him. Just a few months earlier, Burry was being offered 200 basis points--or 2 percent of the principal--for his credit default swaps, which peaked at $1.9 billion.

The deals with Goldman had gone down in a matter of months and required the efforts of just a few geeks on a Goldman bond trading desk and a Goldman salesman named Andrew Davilman, who, for his services, soon would be promoted to managing director. The Goldman traders had booked profits of somewhere between $1.5 billion and $3 billion--even by bond market standards, a breathtaking sum. In the process, Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation. Like the credit default swap, the CDO had been invented to redistribute the risk of corporate and government bond defaults and was now being rejiggered to disguise the risk of subprime mortgage loans. Its logic was exactly that of the original mortgage bonds. In a mortgage bond, you gathered thousands of loans and, assuming that it was extremely unlikely that they would all go bad together, created a tower of bonds, in which both risk and return diminished as you rose.

Only now did he fully appreciate the central importance of the so-called mezzanine CDO--the CDO composed mainly of triple-B-rated subprime mortgage bonds--and its synthetic counterpart: the CDO composed entirely of credit default swaps on triple-B-rated subprime mortgage bonds. "You have to understand this," he'd say. "This was the engine of doom." He'd draw a picture of several towers of debt. The first tower was the original subprime loans that had been piled together. At the top of this tower was the triple-A tranche, just below it the double-A tranche, and so on down to the riskiest, triple-B tranche--the bonds Eisman had bet against. The Wall Street firms had taken these triple-B tranches--the worst of the worst--to build yet another tower of bonds: a CDO. A collateralized debt obligation. The reason they'd done this is that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce 80 percent of the bonds in it triple-A.


pages: 342 words: 99,390

The greatest trade ever: the behind-the-scenes story of how John Paulson defied Wall Street and made financial history by Gregory Zuckerman

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1960s counterculture, banking crisis, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, financial innovation, fixed income, index fund, Isaac Newton, Long Term Capital Management, margin call, Mark Zuckerberg, Menlo Park, merger arbitrage, mortgage debt, mortgage tax deduction, Ponzi scheme, Renaissance Technologies, rent control, Robert Shiller, Robert Shiller, rolodex, short selling, Silicon Valley, statistical arbitrage, Steve Ballmer, Steve Wozniak, technology bubble, zero-sum game

Pellegrini’'s bright ideas kept coming, though. He developed a new method to use “"statistical arbitrage”" to trade stocks, though he couldn’'t make much money with it. A stint at Tricadia Capital, a hedge fund founded by Michaelcheck’'s Mariner Investment Group, Inc., gave Pellegrini an education in the world of securitized debt and credit-default swaps (CDS), which the firm was heavily involved in. But Pellegrini didn’'t make many friends at Tricadia when he suggested that the firm find ways to short collateralized-debt obligations, even as others at the firm were buying and creating versions of these debts. After a derivative-focused company that Pellegrini hoped to set up for Tricadia failed to get off the ground, he began searching for a job once again. It was that development that led him to the interview that Paulson set up for him with two of Paulson’'s executives, Andrew Hoine and Michael Waldorf.

Paulson had examined shorting shares of some financial-service companies, but some companies in that business recently had received takeover offers, sending the stocks racing higher, burning those who shorted them with deep losses. Was there any better insurance? One day in October 2004, Pellegrini, still nervous about his standing at the firm, got up the nerve to approach Paulson in the hallway to tell his boss that there might be a better way to protect the firm’'s portfolio. Why not buy credit-default swaps? Paulson and his team weren’'t very familiar with the world of credit-default swaps, beyond a vague understanding that these instruments provided insurance against losses from debt investments. Though trading of CDS contracts had soared in volume in recent years, it was a complicated, esoteric world. Paulson was one of many investors who shied away from using these “"derivative”" investments, described as such because their value derives from the change in some underlying asset.

But Paulson liked to encourage his staff to develop novel approaches to problems, and he seemed intrigued, a small smile forming on his face. He asked Pellegrini to research how the firm could buy CDS contracts on financial companies, which Paulson was especially worried about due to all their borrowed money. In truth, Pellegrini didn’'t know that much about how credit-default swaps were traded, other than watching others do it at Tricadia. So he arranged for tutorials by various brokerage firms on the ins and outs of credit-default swaps. The fund made its first purchase of CDS protection on a company called MBIA, Inc., which insured all those mortgage bonds backed by aggressive loans. The annual cost of insuring $100 million of MBIA’'s debt was a puny $500,000. In other words, if MBIA ran into problems and its debt became worthless, Paulson would get paid $100 million thanks to CDS protection that cost just $500,000 annually.


pages: 1,073 words: 302,361

Money and Power: How Goldman Sachs Came to Rule the World by William D. Cohan

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asset-backed security, Bernie Madoff, buttonwood tree, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, fear of failure, financial innovation, fixed income, Ford paid five dollars a day, Goldman Sachs: Vampire Squid, Gordon Gekko, high net worth, hiring and firing, hive mind, Hyman Minsky, interest rate swap, John Meriwether, Kenneth Arrow, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, mega-rich, merger arbitrage, moral hazard, mortgage debt, Myron Scholes, paper trading, passive investing, Paul Samuelson, Ponzi scheme, price stability, profit maximization, risk tolerance, Ronald Reagan, Saturday Night Live, South Sea Bubble, time value of money, too big to fail, traveling salesman, value at risk, yield curve, Yogi Berra, zero-sum game

At this moment, Greenberg said, Sullivan should have pretty much shut down the credit-default swap operation at AIGFP: “When the AAA credit rating disappeared in spring 2005, it would have been logical for AIG’s new management to have exited or reduced its business of writing credit-default swaps,” he explained. With little effort, Greenberg ticked off in rapid fire the litany of mistakes then made by Sullivan, Cassano, and company: Rather than curtailing the selling of credit-default swaps, AIGFP ratcheted up exponentially its issuance of them, and no longer just on corporate debt but on a whole new explosion of risk that Wall Street was madly underwriting through the issuance of increasingly risky mortgage-backed securities tied to so-called subprime and Alt-A mortgages. Then there were the credit-default swaps written on collateralized debt obligations, or CDOs, with huge exposures to subprime mortgages.

For instance, in the second half of 2006 and the first quarter of 2007, Goldman “reduces CDO [origination] activity” and “residual assets marked down to reflect market deterioration.” Then, the board was told, “GS reverses long market position through purchase of single name CDS”—credit-default swaps—“and reductions of ABX.” The gross revenues of Goldman’s mortgage business reflected the changing dynamics as well. In 2005, the firm made $885 million in revenues on the mortgage desk, mostly from the origination of residential and commercial real-estate securities. In 2006, Goldman underwrote $29.3 billion of subprime mortgage securities, a ranking of sixth overall, and underwrote close to $16 billion in collateralized debt obligations, ranking fifth. That year, the mortgage-related revenues increased 16 percent with the origination business staying essentially flat, but with Birnbaum’s group generating $401 million in revenue, up 64 percent from the $245 million generated the year before.

One of the more intriguing opportunities that Birnbaum spied in the market by the end of 2005 was the increasing use of credit-default swaps, or CDS—a form of insurance that could be bought on whether a debt would in fact be paid—in the mortgage or any other debt market. Increasingly, insurance companies, such as AIG, or other Wall Street firms were willing to sell protection on whether the mortgages that went into mortgage-backed securities would in fact be paid. To get the insurance, buyers had to pay premiums to the issuers, as they did to obtain any other form of insurance. Instead of buying life insurance, or fire insurance on your house, or auto insurance on your car, buying a credit-default swap allowed investors to make bets on whether people ended up paying their mortgages. There were a number of reasons that the markets for mortgages and for credit-default swaps started to intersect in the summer of 2005.


pages: 430 words: 140,405

A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers by Lawrence G. Mcdonald, Patrick Robinson

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asset-backed security, bank run, collateralized debt obligation, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, diversification, fixed income, high net worth, hiring and firing, if you build it, they will come, London Interbank Offered Rate, Long Term Capital Management, margin call, money market fund, moral hazard, mortgage debt, naked short selling, negative equity, new economy, Ronald Reagan, short selling, sovereign wealth fund, value at risk

And as the years went by, Dick Fuld had tightened his circle, shutting out more and more key people from the downstairs floors where the daily action seethed, where the trading battles ebbed and flowed, where more critical information flew around than anywhere else in the city. That was the place from which he had, to all intents and purposes, removed himself. In the process, he had become separated from the most modern technology and the ultramodern trading of credit derivatives—CDO (collateralized debt obligations), RMBS (residential mortgage-backed securities), CLO (collateralized loan obligations), CDS (credit default swaps), and CMBS (commercial mortgage-backed securities). Stories about long-departed commanders were legion. There were mind-blowing tales of the Fuld temper, secondhand accounts of his rages, threats, and vengeance. It was like hearing the life story of some caged lion. Tell the truth, I ended up feeling pretty darn glad I wasn’t meeting him.

Because this one was already clambering halfway over the ramparts, its ass pointing up toward the sun. I refer, of course, to the CDOs, which had swiftly developed into a major disaster area. On a bright June day, we all gathered for a crisis meeting in the trading floor conference room. In the chair was Jason Schechter, senior vice president and global head of cash CDO trading, who had supervised the construction of a hybrid collateralized debt obligation comprising credit default swaps on ninety high-yield rated companies. It was perhaps the most dangerous junk bond ever invented. In attendance were Pete Schellbach, Joe Beggans, Pete Hammack, Ashish Shah, Eric Felder, Jeremiah Stafford, who was a trader in high-yield indexes, and Jane Castle. I was sitting with my buddy John Gramins, a good-looking and fast-talking trader in leveraged loans, and a nine-year Lehman veteran.

Back home, where it was impossible to make money in bank accounts with a 2 percent rate, high-yield bonds were plainly the answer, and they became as fashionable as stock in dot-com companies had once been. But Wall Street had outsmarted everyone, and instead of the old-fashioned regular reliable bonds, investors now stampeded for residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), and structured investment vehicles (SIVs), paying around 5 to 8 percent. Securitization. What a stroke of pure genius. Turning those mortgage debts into tangible entities. Hardly anyone noticed the minor flaws that would, in time, bankrupt half the world. The year 2003 turned into 2004, and still the flame of my ambitions burned as strongly as ever.


pages: 246 words: 74,341

Financial Fiasco: How America's Infatuation With Homeownership and Easy Money Created the Economic Crisis by Johan Norberg

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accounting loophole / creative accounting, bank run, banking crisis, Bernie Madoff, Black Swan, capital controls, central bank independence, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Brooks, diversification, financial deregulation, financial innovation, helicopter parent, Home mortgage interest deduction, housing crisis, Howard Zinn, Hyman Minsky, Isaac Newton, Joseph Schumpeter, Long Term Capital Management, market bubble, Martin Wolf, Mexican peso crisis / tequila crisis, millennium bug, money market fund, moral hazard, mortgage tax deduction, Naomi Klein, new economy, Northern Rock, Own Your Own Home, price stability, Ronald Reagan, savings glut, short selling, Silicon Valley, South Sea Bubble, The Wealth of Nations by Adam Smith, too big to fail

W.) administration, 19-21 on bailout, 116-17, 128 expanded homeownership, 23-24, 37-38, 41-42 "G.S.E.s-We Told You So," 36 "Hoover myth" of deregulation, 133 business cycle, government manipulation, 153-55 "Buttonwood" prediction, 14-15 buyer education program participation, 31 Calomiris, Charles, 65 "capitalism of adventures," 119 Cassel, Gustav, 103 Cayne, James, 56-57, 72, 80 CDOs. See collateralized-debt obligations (CDOs) central banks, 49-51, 152 role of, 10-15, 142 Chanos, James, 111 China, 16-17 Chrysler, 125 Cisneros, Henry, 23-25, 29-36 Citigroup, 57-58, 74, 76, 85 Klios, 57 citizens' and consumer groups, monitoring of loans, 34, 35 Clarkson, Brian, 60 Clinton, Bill, 20-21, 79, 85, 86 bureaucracy and, 132 expanded homeownership, 23-24, 26 real estate capital gains tax and, 6 Cole, Harold, 106 collateralized-debt obligations (CDOs), 48, 71 CDO-squared and CDO-cubed packages, 48-49 notching, 64 community lending cash-back opportunities to borrowers, 127-28 Community Reinvestment Act and, 26-28 creditworthiness requirements, 29-30 flexible underwriting of loans, 31-32, 43 housing bubble and, 70-75 housing policy and, 25-28 See also specific lenders Community Reinvestment Act, 26-28 constant-proportion debt obligation, 59-60 consumer spending, 9 increase in consumption, 11-12 Coolidge, Calvin, 102 Cooper, George, 14 Countrywide, 29, 41, 71-72, 83, 148 Cisneros scandal and corruption and, 32 special privileges for, 30 Cox, Christopher, 112 Cramer, Jim, 72, 113-14, 148 credit counseling program participation, 31 credit-default swaps, 86-91 credit ratings and credit-rating agencies, 46-49, 58-68, 141 faith in, 73 junk designation, 59 legislation, 65 mislabeling, 73 notching, 64 rating committees, 63-64 regulatory responsibilities, 133 Subprime XYZ package, 65-68 supervision, 141-42 creditworthiness requirements, 29-30 flexible underwriting of loans and, 31-32, 40, 43 low- and moderate-income earners, 70-71 crisis, current.

It goes without saying that this attracted players to the market like flies to a lamp. Increasingly sophisticated varieties of securitization also began to evolve. When large bunches of mortgages have been resold as securities, other investors can buy a few hundred such securities of different origins, for example medium-risk ones, and repackage them once more into a new kind of security, a "collateralized-debt obligation," or CDO. That will also be split into tranches depending on the level of risk that buyers are willing to take. The original idea of CDOs was to spread risk by including a wide variety of assets, but in 2003, Wall Street firms started to create CDOs backed exclusively by mortgages. Similar to an ordinary mortgage-backed security, the buyer who picks the riskiest tranches gets paid the most but also has to suffer the first loss if the CDO investments fail.

It is better for the bank to have someone living in the house, who may be able to pay back the loan in the longer term, than to be forced to take over the house and try to sell it just when prices are lowest. But the securitization of mortgages had led to an unexpected consequence: The original lender no longer owned the loan, because it had been repackaged and sold and then chopped up and sold as part of a collateralized-debt obligation. Households in default no longer had an individual lender to negotiate with, which made more and more of them just abandon their homes and either buy something cheaper or start renting. On July 24, 2007, the mortgage giant Countrywide held one of its regular conference calls with investors and analysts from Bear Stearns, Merrill Lynch, Morgan Stanley, and the rest of the Wall Street elite.


pages: 545 words: 137,789

How Markets Fail: The Logic of Economic Calamities by John Cassidy

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Albert Einstein, Andrei Shleifer, anti-communist, asset allocation, asset-backed security, availability heuristic, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black-Scholes formula, Bretton Woods, British Empire, capital asset pricing model, centralized clearinghouse, collateralized debt obligation, Columbine, conceptual framework, Corn Laws, corporate raider, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Daniel Kahneman / Amos Tversky, debt deflation, diversification, Elliott wave, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, global supply chain, Gunnar Myrdal, Haight Ashbury, hiring and firing, Hyman Minsky, income per capita, incomplete markets, index fund, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, John Nash: game theory, John von Neumann, Joseph Schumpeter, Kenneth Arrow, laissez-faire capitalism, Landlord’s Game, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, Mikhail Gorbachev, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Myron Scholes, Naomi Klein, negative equity, Network effects, Nick Leeson, Northern Rock, paradox of thrift, Pareto efficiency, Paul Samuelson, Ponzi scheme, price discrimination, price stability, principal–agent problem, profit maximization, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, RAND corporation, random walk, Renaissance Technologies, rent control, Richard Thaler, risk tolerance, risk-adjusted returns, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, technology bubble, The Chicago School, The Great Moderation, The Market for Lemons, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, unorthodox policies, value at risk, Vanguard fund, Vilfredo Pareto, wealth creators, zero-sum game

Later in the 1990s, many fast-growing Asian countries, including Thailand, Indonesia, and South Korea, endured serious financial blowups. In 2007–2008, it was our turn again, and this time the crisis involved the big banks at the center of the financial system. For years, Greenspan and other economists argued that the development of complicated, little-understood financial products, such as subprime mortgage–backed securities (MBSs), collateralized debt obligations (CDOs), and credit default swaps (CDSs), made the system safer and more efficient. The basic idea was that by putting a market price on risk and distributing it to investors willing and able to bear it, these complex securities greatly reduced the chances of a systemic crisis. But the risk-spreading proved to be illusory, and the prices that these products traded at turned out to be based on the premise that movements in financial markets followed regular patterns, that their overall distribution, if not their daily gyrations, could be foreseen—a fallacy I call the illusion of predictability, the third illusion at the heart of utopian economics.

Center for Public Integrity Center for Responsible Lending Central Intelligence Agency (CIA) World Factbook Champernowne, David Chase Home Finance Chase Manhattan Bank; see also JPMorgan Chase Cheney, Dick Chevalier, Judith Chevron Corporation Chicago, University of Booth School of Business Chilean economists at Committee on Social Thought Economics Department efficient market hypothesis developed at Friedman at Hayek at Lange at Lucas at Law School Chicago Board Options Exchange Chicago School Chicago Tribune Chile China Christianity Chrysler Corporation Churchill, Winston Cicero Cisco Systems, Inc. Cisneros, Henry G. Citigroup Associated First Capital purchased by compensation of CEOs of credit default swaps of dereguation and disaster myopia of Federal Reserve and government safety net for reduction in assets of risk-management system at shadow banking system and suprime mortgage securities issued by Citron, Bob City College classical economics new Clayton Antitrust Act (1914) climate change Clinton, Bill CLSA Emerging Markets CNBC television network Coase, Ronald Coase theorem Cobden, Richard Coca-Cola Corporation Cohen, Jonathan collateralized debt obligations (CDOs) collateralized mortgage obligations (CMOs) Columbia Broadcasting System (CBS) Columbia University Earth Institute Columbine massacre Columbus, Christopher Commerce Department, U.S.

Greenspan later acknowledged that the fall of Long-Term Capital, which prior to its troubles had been lionized in the media, was “a major failure of counterparty surveillance.” However, it didn’t prevent him, in the period after 1998, from repeating his previous arguments to head off efforts to regulate derivatives trading. Brooksley E. Born, the then-head of the Commodity Futures Trading Commission (CFTC), tried to bring credit default swaps, which offered investors protection against the possibility of a bond defaulting, under the regulatory jurisdiction of the CFTC. Such a move would have involved establishing some minimal capital requirements for Wall Street firms that bought and sold credit default swaps, and forcing them to disclose more information. “Recognizing the dangers . . . was not rocket science, but it was contrary to the conventional wisdom and certainly contrary to the economic interests of Wall Street at the moment,” Born told Stanford Magazine in early 2009.


pages: 435 words: 127,403

Panderer to Power by Frederick Sheehan

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Asian financial crisis, asset-backed security, bank run, banking crisis, Bretton Woods, British Empire, call centre, central bank independence, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, deindustrialization, diversification, financial deregulation, financial innovation, full employment, inflation targeting, interest rate swap, inventory management, Isaac Newton, John Meriwether, Long Term Capital Management, margin call, market bubble, McMansion, Menlo Park, money market fund, mortgage debt, Myron Scholes, new economy, Norman Mailer, Northern Rock, oil shock, Paul Samuelson, place-making, Ponzi scheme, price stability, reserve currency, rising living standards, rolodex, Ronald Reagan, Sand Hill Road, savings glut, shareholder value, Silicon Valley, Silicon Valley startup, South Sea Bubble, supply-chain management, supply-chain management software, The Great Moderation, too big to fail, transaction costs, trickle-down economics, VA Linux, Y2K, Yom Kippur War, zero-sum game

The GrammLeach-Bliley Act (its formal name: The Financial Services Modernization Act) became law on November 12, 1999.57 Rubin had left his treasury post to join Citicorp.58 Larry Summers, treasury secretary when the act passed, claimed: “This historic legislation will better enable American companies to compete in the new economy.”59 Greenspan, Rubin, and Summers played a major role ensuring that the wildest derivatives remained unregulated. To thrive, the mortgage machine needed such developments as collateralized debt obligations (CDO) and credit default swaps (CDS). The trio led the offense against regulation of over-the-counter derivatives. Deputy Treasury Secretary Larry Summers told Congress that any oversight would cast “a shadow of regulatory uncertainty over an otherwise thriving market.”60 Without the contributions of Greenspan, Rubin, and Summers, the credit bubble might have been a muted affair. Timothy Geithner, secretary of the treasury in 2009, served under both Robert Rubin and Larry Summers as undersecretary of the treasury for international affairs.

., 247, 278, 308, 339 BusinessWeek, 52–53, 54, 55, 60, 81, 209–210, 233 Butz, Earl, 56 C California real estate, 63, 86–87, 88–91, 165, 273, 274, 279, 289, 292, 293, 295, 331 Campbell, Kirsten, 233 Capital, 364 Capitalism, 362–364 Carlyle Group, 323 Carry trade, 125–126, 128, 162 in 2006, 313 in late 1990s, 166 Carter, Jimmy, 62–63, 67, 77 Casey, William, 69 CDOs (collateralized debt obligations), 313–314 CDS (credit default swaps), 314–316 CEA (see Council of Economic Advisers) Central banks, 126 1998 rate cuts by, 195 and bubbles, 203, 204 currencies degraded by, 305–306 and price stability, 287, 298 (See also specific banks) Centrust Savings Bank (Miami, Florida), 89 CEOs (see Chief executive officers) Chambers, John, 235 Chase Manhattan Bank, 112 Chemical Bank, 35 Chicago, Ill, 45, 295 Cheney, Richard “Dick,” 54, 300 Chief executive officers (CEOs), 128, 235, 318 Chinese central bank, 308–310 Chrysler, 62, 246 Churning, in mortgage markets, 262 Cisco Systems, 177, 207, 216, 235, 237, 238, 243, 248 Citicorp (Citigroup), 78, 79, 114–115, 275, 276, 347n.48, 354 Clark, Jim, 141 Clinton, Bill, 136–138, 142, 143, 216–217, 323, 339 Clinton, Hillary, 339 CMBS (commercial mortgagebacked security) market, 273–274 CMOs (collateralized mortgage obligations), 130 CNBC, ix, 55n.33, 64, 104, 119, 193, 198, 212–213, 297, 322, 342 Cohen, Abby Joseph, 174–175, 208, 232, 248–249 Cohen, Steve, 324 Collateral, LTCM failure and, 185 Collateralized debt obligations (CDOs), 313–314 Collateralized mortgage obligations (CMOs), 130 The Collective, 14–15 Columbia Savings and Loan (Beverly Hills, California), 89, 90, 93 Columbia University, 12, 27, 28, 333 Commercial banks: bailouts of, 72, 78–79 derivative contracts held by, 312 in early 1990s, 125 mortgages held by, 312 Commercial mortgagebacked security (CMBS) market, 273–274 Commercial paper 90, 117, 306 Community Reinvestment Act (1995), 273, 277 Computer industry: in 1997–1998, 197–198 in 1999, 207 profit losses in, 218 Computer prices, adjustment of, 153, 230 Conference Board, 13 Conglomerates, 33–36, 349 Consumer debt, 251–258 in early 2000s, 271 in mid–1990s, 134 renewing economic growth through, 311 (See also Mortgages) Consumer Price Index (CPI): in 1960s, 39 calculation of, 147–152 changes to, 50 and inflation of asset prices, 170–171 Consumer spending, economic growth and, 291, 292, 311 Consumerism, 22, 51, 52, 63 Continental Illinois National Bank and Trust, 78–79, 306 Cooper, Sherry, 344 Coraine, Richard, 355 Corporate bonds, yields on, 72 Corporate (business) debt, 99, 134 Corporate executives, priorities of, 209–210 Corporate growth, 77 Corporate profits: as measure of productivity, 197 and price of stocks, 175, 177–178, 194, 216 Council of Economic Advisers (CEA): under Carter, 61 under Ford, 5, 47, 50, 52–57, 97 under Kennedy, 26 Counterparty risk, 182 Countrywide Bank, 334 Countrywide Credit, 165, 279 Countrywide Financial, 271, 273, 277, 347n.48 CPI (see Consumer Price Index) Cramer, Jim, 208 Cranston, Alan, 85 Credit: in 1960s, 34, 37 in 1970s, 48 in 1980s, 77 in 1990s, 166 in 1999, 209 in 2001, 245 from 2005–2007, 312 consumer, 252–257 expanded access to, 296 and Great Depression, 352 and house prices, 290 inflation in, 173 from investment banks, 125 as liquidity, 363 at mid-century, 21, 22 and recession of early 1990s, 124 and rise in corporate/consumer debt, 134 worldwide bubble in, 302, 319 Credit default swaps (CDS), 314–316 Credit-rating agencies, 270, 271, 314 Crime, inflation of 1970s and, 44–45 Crime, appraisal fraud, 280 Crocker, Donald, 86, 87 D Dallas Federal Reserve Bank, 288 The Darwin Awards, 236 Daily Telegraph (London), 341, 344 Davis Polk & Wardwell, 116 Day trading, 169, 211 D.E.

It included 7,212 first-and second-lien mortgages when it was issued.23 Some of these CDOs owned pieces of millions of mortgages, sometimes owning the same mortgage three or four times, since one layer of a CDO might be owned by another layer and so on. One other growing class of derivatives deserves mention, especially since Alan Greenspan sang its praises into 2008: credit default swaps (CDS). These were originally designed to hedge against losses should a company enter bankruptcy. The purchaser pays a premium for bankruptcy protection. Credit default swaps would appeal to General Motors bondholders who wanted to hedge—hold an “insurance” policy— against General Motors declaring bankruptcy. The original intention expanded. Credit default swaps were written for other derivatives, such as CDOs. The complications of credit default swaps written on CDOs that combined several CDOs (CDOs squared) were recreational mathematics played with other people’s money. 21 Gillian Tett, “The Unease Bubbling in Today’s Brave New Financial World,” Financial Times (London edition), January 19, 2007, p. 36.


pages: 374 words: 114,600

The Quants by Scott Patterson

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Albert Einstein, asset allocation, automated trading system, beat the dealer, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buttonwood tree, buy low sell high, capital asset pricing model, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, Gordon Gekko, greed is good, Haight Ashbury, I will remember that I didn’t make the world, and it doesn’t satisfy my equations, index fund, invention of the telegraph, invisible hand, Isaac Newton, job automation, John Meriwether, John Nash: game theory, law of one price, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, merger arbitrage, money market fund, Myron Scholes, NetJets, new economy, offshore financial centre, old-boy network, Paul Lévy, Paul Samuelson, Ponzi scheme, quantitative hedge fund, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Sergey Aleynikov, short selling, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise

Quants use Brownian motion mathematics to predict the volatility of everything from the stock market to the risk of a multinational bank’s balance sheet. Credit default swap: Created in the early 1990s, these contracts essentially provide insurance on a bond or a bundle of bonds. The price of the insurance fluctuates depending on the riskiness of the bonds. In the late 1990s and 2000s, more and more traders used the contracts to make bets on whether a bond would default or not. At Deutsche Bank, Boaz Weinstein was a pioneer in the use of CDS as a betting instrument. Collateralized debt obligation: Bundles of securities, such as credit-card debt or mortgages, that are sliced up into various levels of risk, from AAA, which is deemed relatively safe, to BBB (and lower), which is highly risky. In the late 1990s, a team of quants at J. P. Morgan created “synthetic” CDOs by bundling credit default swaps linked to bonds and slicing them up into various portions of risk.

Many CDS traders, such as Weinstein, weren’t really in the game to protect themselves against a loss on a bond or mortgage. Often these investors never actually held the debt in the first place. Instead, they were gambling on the perception of whether a company would default or not. If all of this weren’t strange enough, things became truly surreal when the world of credit default swaps met the world of securitization. Brown had watched, with some horror, as banks started to bundle securitized loans into a product they called a collateralized debt obligation, or CDO. CDOs were similar to the CMOs (collateralized mortgage obligations) Brown had encountered in the 1980s. But they were more diverse and could be used to package any kind of debt, from mortgages to student loans to credit card debt. Some CDOs were made up of other pieces of CDOs, a Frankenstein-like beast known as CDO-squared.

His testimony provided little insight into the problems behind the meltdown, though it did offer a rare glimpse into Renaissance’s trading methods. “Renaissance is a somewhat atypical investment management firm,” he said. “Our approach is driven by my background as a mathematician. We manage funds whose trading is determined by mathematical formulas. … We operate only in highly liquid publicly traded securities, meaning we don’t trade in credit default swaps or collateralized debt obligations. Our trading models tend to be contrarian, buying stocks recently out of favor and selling those recently in favor.” For his part, Griffin sounded a note of defiance, fixing his unblinking blue eyes on the befuddled array of legislators. Hedge funds weren’t behind the meltdown, he said. Heavily regulated banks were. “We haven’t seen hedge funds as the focal point of the carnage in this financial tsunami,” said Griffin, clad in a dark blue jacket, black tie, and light blue shirt.

Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America by Matt Taibbi

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affirmative action, Affordable Care Act / Obamacare, Bernie Sanders, Bretton Woods, carried interest, clean water, collateralized debt obligation, collective bargaining, computerized trading, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, David Brooks, desegregation, diversification, diversified portfolio, Donald Trump, financial innovation, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, illegal immigration, interest rate swap, laissez-faire capitalism, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, medical malpractice, money market fund, moral hazard, mortgage debt, obamacare, passive investing, Ponzi scheme, prediction markets, quantitative easing, reserve currency, Ronald Reagan, Sergey Aleynikov, short selling, sovereign wealth fund, too big to fail, trickle-down economics, Y2K, Yom Kippur War

One has to do with the sales pitch of Tea Party rhetoric, which cleverly exploits Main Street frustrations over genuinely intrusive state and local governments that are constantly in the pockets of small businesses for fees and fines and permits. The other reason is obvious: the bubble economy is hard as hell to understand. To even have a chance at grasping how it works, you need to commit large chunks of time to learning about things like securitization, credit default swaps, collateralized debt obligations, etc., stuff that’s fiendishly complicated and that if ingested too quickly can feature a truly toxic boredom factor. So long as this stuff is not widely understood by the public, the Grifter class is going to skate on almost anything it does—because the tendency of most voters, in particular conservative voters, is to assume that Wall Street makes its money engaging in normal capitalist business and that any attempt to restrain that sector of the economy is thinly disguised socialism.

Even as she spends every day publicly flubbing political SAT questions, she’s always dead-on when it comes to her basic message, which is that government is always the problem and there are no issues the country has that can’t be worked out with basic common sense (there’s a reason why many Tea Party groups are called “Common Sense Patriots” and rally behind “common sense campaigns”). Common sense sounds great, but if you’re too lazy to penetrate the mysteries of carbon dioxide—if you haven’t mastered the whole concept of breathing by the time you’re old enough to serve in the U.S. Congress—you’re not going to get the credit default swap, the synthetic collateralized debt obligation, the interest rate swap. And understanding these instruments and how they were used (or misused) is the difference between perceiving how Wall Street made its money in the last decades as normal capitalist business and seeing the truth of what it often was instead, which was simple fraud and crime. It’s not an accident that Bachmann emerged in the summer of 2010 (right as she was forming the House Tea Party Caucus) as one of the fiercest opponents of financial regulatory reform; her primary complaint with the deeply flawed reform bill sponsored by Senator Chris Dodd and Congressman Barney Frank was that it would “end free checking accounts.”

Despite these legally questionable efforts of Rubin and Greenspan, Born did eventually release her paper on May 7 of that year, but to no avail; Greenspan et al. eventually succeeded not only in unseating Born from the CFTC the next year, but in passing a monstrosity called the Commodity Futures Modernization Act of 2000, which affirmatively deregulated the derivatives market. The new law, which Greenspan pushed aggressively, not only prevented the federal government from regulating instruments like collateralized debt obligations and credit default swaps, it even prevented the states from regulating them using gaming laws—which otherwise might easily have applied, since so many of these new financial wagers were indistinguishable from racetrack bets. The amazing thing about the CFMA was that it was passed immediately after the Long-Term Capital Management disaster, a potent and obvious example of the destructive potential inherent in an unregulated derivatives market.


pages: 701 words: 199,010

The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini

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affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bernie Madoff, Black-Scholes formula, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, John Meriwether, labour mobility, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, survivorship bias, systematic trading, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

See also Buffett, Warren Bernanke, Ben Black, Fischer Black-Scholes formula Blankfein, Lloyd Blasnik, Steve Bond arbitrage Born, Brooksley Box trade Brady Plan Brazilian C bonds Brendsel, Leland Broker-dealers Buffett, Warren Buoni del Tesoro Poliennali Buoni Ordinari del Tesoro Bush, George Butler, Angus Butterfly yield curve trades Callan, Erin Capital, contingency Capital adequacy ratio (CAR) Capital markets Capital ratio and leverage Capital-to-asset ratio Carhart, Mark Cash business Cassano, Joseph Caxton macro hedge fund Cayne, James E. (Jimmy) CDOs. See Collateralized debt obligations CDSs (credit default swaps) CDX index Central Bank of Russia Chow, Andrew Cioffi, Ralph Citadel hedge fund Citibank CLA (collateralized lending agreement) Clearinghouses Client services Clinton, Bill CMBS securities CMBX index CMOs (collateralized mortgage obligations) Collateral-backed bonds Collateralized debt obligations (CDOs): AIG and Basel Committee and Bear Stearns and overview of ratings agencies and Collateralized lending agreement (CLA) Collateralized mortgage obligations (CMOs) Commercial paper, trust in Commercial real estate Commodity Futures Modernization Act Compensation models Conflicts of interest: CDOs and financial crisis of 2008 and ratings agencies and Conforming loans Consolidated tape Convergence trades Copycat funds Copycat investors: definition of effects of Salomon Brothers Corporate debt securities and loans Correlation: copycats, puppies, and counterparties economics between LTCM strategies before and during crisis overview of pre- and during LTCM crisis short-term and long-term Corzine, Jon Counterparties: bankrupt firms and booking of derivative profits by confidence and due diligence of interaction of Lehman Brothers and LTCM and overview of Cox, Cristopher Cramer, Jim Crash of 1987, cause of Credit default swaps (CDSs) Credit risk Crockett, Andrew Crowds/crowding: crisis of desirability of effects of interconnected in 1998 in quant crisis Currency union.

It eliminated the SEC and CFTC’s oversight of the OTC derivative market. It is difficult to determine the consequences of this decision. It may have been the reason AIG Financial Products became so heavily involved in credit default swap transactions. AIG sold CDS that effectively insured every mortgage pool against defaults. Unlike traditional insurance contracts, the CDS didn’t force AIG to set aside a large amount of capital against potential future losses, nor did the company have to post collateral. AIG’s CDS protection let other banks continue betting on the housing market. AIG’s position in credit default swaps rose to $500 billion. The entire market jumped from $6.4 trillion in 2004 to $58 trillion by 2007. In 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act extended collateral rights in repo transactions to include securities other than GSE debt or Treasuries, if the counterparty went bankrupt.

They need to know how risks and values should change. They need to understand when a report doesn’t make sense. A rule to add a risk officer to report directly to the board per se won’t do this. He will just tick a box and mistakes will go on as usual. —Robert Merton interview, Nobel prizewinner in economics, July 9, 2011 Large insurance companies’ use of credit-default swaps is another example of misusing derivatives. AIG and other insurers sold credit protection on mortgage pools using a derivative known as the credit-default swap (CDS). Traditional insurance is based on pooling many independent risks, but AIG was insuring the interlinked housing market. Given the probability of losses, AIG should have put many reserves aside, but it did not. With equities and other liquid securities, traders essentially vote on an asset’s proper price every time they buy or short it, and the price eventually reflects these votes.


pages: 460 words: 122,556

The End of Wall Street by Roger Lowenstein

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Asian financial crisis, asset-backed security, bank run, banking crisis, Berlin Wall, Bernie Madoff, Black Swan, break the buck, Brownian motion, Carmen Reinhart, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, fear of failure, financial deregulation, fixed income, high net worth, Hyman Minsky, interest rate derivative, invisible hand, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, Martin Wolf, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, Ponzi scheme, profit motive, race to the bottom, risk tolerance, Ronald Reagan, Rubik’s Cube, savings glut, short selling, sovereign wealth fund, statistical model, the payments system, too big to fail, tulip mania, Y2K

See credit/credit market; finance/financial markets; housing market; stock market Maughan, Deryck Mayo, Michael MBIA MDC Holdings Meltzer, Allan Merkel, Angela Merrill Lynch Bank of America’s negotiations with and acquisition of Bear Stearns and Ben Bernanke and board of capital raised by CDOs and change of leadership at come-to-Jesus moment for compensation at concern over Jamie Dimon and efforts to sell failure to pull back from mortgage-backed securities First Franklin acquired by Goldman Sachs and job losses at JPMorgan Chase and leverage of losses Morgan Stanley and mortgage bubble and Hank Paulson and stock price of Stuyvesant Town sale and Wachovia and Miller, Harvey Minsky, Hyman Mitsubishi UFJ money market crisis Ben Bernanke and Timothy Geithner and Lehman’s bankruptcy and Hank Paulson and Money Store Montag, Peter Moody, John Moody’s AIG and Lehman Brothers and moral hazard Morgan Stanley AIG and as bank holding company capital sought by credit default swaps and Timothy Geithner and government efforts to arrange a merger for hedge funds and history of insurance (credit default swap) premiums of job losses at JPMorgan Chase and leverage Merrill Lynch and Mitsubishi and panic and Hank Paulson and rumors about short selling against stock price of John Thain and Wachovia and mortgage-backed securities BBB rated Bear Stearns and checks on capital level for collapse of market for collateralized debt obligations. See collateralized debt obligations (CDOs) cooling of market for credit rating agencies and example of fall in prices of foreign-held Goldman Sachs and growth of insurance claims on Lehman Brothers and Merrill Lynch and mortgage bubble and payment waterfall prime risk taking and subprime mortgages and swimming pool metaphor for total amount floated in mortgage banking, as race to the bottom mortgage bubble banking regulators and banks’ late stage desperation in bursting of Citigroup and credit and developing disaster, evidence of Federal Reserve’s role in Freddie Mac and Fannie Mae and mass hallucination in Merrill Lynch and mortgage securitization and reasons for ripple effect of Wall Street and Washington Mutual and mortgage lenders.

California Callan, Erin capitalism Carroll, David Cassano, Joseph Cayne, James (Jimmy) CDOs. See collateralized debt obligations (CDOs) Cerenzie, Michael Chase Manhattan China China Investment Corporation Chrysler Citigroup acquisitions by n bailouts of capital raised by CDOs and corporate loans of dissent at Timothy Geithner and Glass-Steagall act repeal and history of mortgage bond insurance of international portfolio of job losses at leadership change at leverage of losses mortgage bubble and New York Federal Reserve and nonregulated subsidiaries of Hank Paulson and risk at annual letters to shareholders of stock price of subprime mortgages and Wachovia and Clinton, Bill Clinton, Hillary CNBC Cohen, H. Rodgin Cohn, Gary collateralized debt obligations (CDOs) AIG and amount invested in Bear Stearns and bond ratings for Citigroup and demand for Federal Reserve and insurance for Lehman Brothers and Merrill Lynch and squared synthetic UBS and yields on commercial banks/banking ascendancy of concentration of financial crisis and mortgage bubble and regulation of risk management by commercial paper commercial properties commissions, real estate Commodity Futures Modernization Act Commodity Futures Trading Commission compensation at AIG Congress and for failed executives Federal Reserve and at Goldman Sachs at Merrill Lynch public opinion on confidence Congress, U.S.

Russo was apoplectic, but Lehman’s stock, now down to the midteens, held its own through August. Equally distressing to the banks, Wall Street had constructed an alternative way of speculating against troubled corporations, via derivatives, and this wholly unregulated market doubled back on its Wall Street creators with a vengeance. Credit default swaps had been invented by financial engineers at Bankers Trust as a form of insurance on corporate defaults.af The initial purpose was supposedly as a hedging vehicle. A bank that had lent money to General Motors could hedge its risk by purchasing a credit default swap from another party who believed that the loan would be repaid. Thus, if GM defaulted on the loan, the bank would recoup its investment via the swap. Unfortunately, such hedges dulled the bank’s incentive to perform the one function for which society depended on it: thoughtfully rationing credit to worthy borrowers.


pages: 394 words: 85,734

The Global Minotaur by Yanis Varoufakis, Paul Mason

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active measures, banking crisis, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, business climate, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, correlation coefficient, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, declining real wages, deindustrialization, endogenous growth, eurozone crisis, financial innovation, first-past-the-post, full employment, Hyman Minsky, industrial robot, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, light touch regulation, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, Mexican peso crisis / tequila crisis, money market fund, mortgage debt, Myron Scholes, negative equity, new economy, Northern Rock, paper trading, Paul Samuelson, planetary scale, post-oil, price stability, quantitative easing, reserve currency, rising living standards, Ronald Reagan, special economic zone, Steve Jobs, structural adjustment programs, systematic trading, too big to fail, trickle-down economics, urban renewal, War on Poverty, Yom Kippur War

A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data available ISBN 978 1 78032 646 7 Contents ABBREVIATIONS PREFACE TO THE NEW EDITION ACKNOWLEDGEMENTS 1 Introduction 2 Laboratories of the future 3 The Global Plan 4 The Global Minotaur 5 The beast’s handmaidens 6 Crash 7 The handmaidens strike back 8 The Minotaur’s global legacy: the dimming sun, the wounded tigers, a flighty Europa and an anxious dragon 9 A world without the Minotaur? POSTCRIPT TO THE NEW EDITION NOTES RECOMMENDED READING SELECT BIBLIOGRAPHY INDEX Abbreviations AC alternating current ACE aeronautic–computer–electronics complex AIG American Insurance Group ATM automated telling machine CDO collateralized debt obligation CDS credit default swap CEO chief executive officer DC direct current ECB European Central Bank ECSC European Coal and Steel Community EFSF European Financial Stability Facility EIB European Investment Bank EMH Efficient Market Hypothesis ERAB Economic Recovery Advisory Board EU European Union FDIC Federal Deposit Insurance Corporation GDP gross domestic product GM General Motors GSRM global surplus recycling mechanism IBRD International Bank for Reconstruction and Development ICU International Currency Union IMF International Monetary Fund LTCM Long-Term Capital Management (hedge fund) MIE military–industrial establishment NAFTA North American Free Trade Agreement NATO North Atlantic Treaty Organization OECD Organisation for Economic Co-operation and Development OEEC Organisation for European Economic Co-operation OMT outright monetary operations OPEC Organization of the Petroleum Exporting Countries RBCT Real Business Cycle Theory RBS Royal Bank of Scotland REH Rational Expectations Hypothesis RMB renminbi – Chinese currency SME small and medium-sized enterprise SPV Special Purpose Vehicle TARP Troubled Asset Relief Program For Danae Stratou, my global partner Preface to the new edition This book originally aimed at pressing a useful metaphor into the service of elucidating a troubled world; a world that could no longer be understood properly by means of the paradigms that dominated our thinking before the Crash of 2008.

., 149, 156, 157 Byrnes, James, 68 capital, and the human will, 18–19 capitalism: dynamic system, 139–40; free market, 68; generation of crises, 34; global, 58, 72, 114, 115, 133; Greenspan and, 11–12; Marxism, 17–18; static system, 139; supposed cure for poverty, 41–2; surplus recycling mechanisms, 64–5 capitalists, origin of, 31 car production, 70, 103, 116, 157–8 carry trade, 189–90 Carter, Jimmy, 99, 100 CDOs (collateralized debt obligations), 141–2, 147–8, 149, 150, 153; for crops, 163; eurozone, 205; explanation, 6–9; France, 203; function, 130–2; Greece, 206 see also EFSF; Geithner–Summers Plan CDSs (credit default swaps), 149, 150, 153, 154, 176, 177 CEOs (chief executive officers), 46, 48, 49 Chamber of Commerce, British, 152 cheapness, ideology of, 124 Chiang Kai-shek, 76 Chicago Commodities Exchange, 120 Chicago Futures Exchange, 163 China: aggregate demand, 245; Crash of 2008, 156, 162; currency, 194, 213, 214, 217, 218, 252; economic development, 106–7; effects of the Crash of 2008, 3; financial support for the US, 216; global capital, 116; Global Plan, 76; growth, 92; rise and impact, 212–18, 219–20 Chrysler, 117, 159 CIA (Central Intelligence Agency), 69 Citigroup, 149, 156, 158 City of London: Anglo-Celtic model, 12; Crash of 2008, 148, 152; debt in relation to GDP, 4–5; financialization, 118–19; under Thatcher, 138; wealth of merchants, 28 civilization, 27, 29–30, 128 Clinton, Hillary, 212, 215–16 Cold War, 71, 80, 81, 86 collateralized debt obligations see CDOs commodification: resistance to, 53–4; rise of, 30, 33, 54; of seeds, 175 commodities: global, 27–8; human nature not, 53; labour as, 45, 49, 54; money as, 45, 49; prices, 96, 98, 102, 125; trading, 31, 175 common market, European, 195 communism, collapse of, 22, 107–8 complexity, and economic models, 139–40 Condorcet, Nicholas de Caritat, marquis de, 29, 32 Congress (US): bail-outs, 77, 153–4, 155; import tariff bill, 45 Connally, John, 94–5 council houses, selling off, 137, 138 Crash of 1907, 40 Crash of 1929, 38–43, 44, 181 Crash of 2008, 146–68; aftermath, 158–60; chronicle, 2007, 147–9; chronicle, 2008, 149, 151–8; credit default swaps, 150; effects, 2–3; epilogue, 164–8; explanations, 4–19; in Italy, 237; review, 160–4; in Spain, 237; warnings, 144–5 credit crunch, 149, 151 credit default swaps (CDSs), 149, 150, 153, 154, 176, 177 credit facilities, 127–8 credit rating agencies, 6–7, 8, 9, 20, 130 crises: as laboratories of the future, 28; nature of, 141; pre-1929, 40; pre-2008, 2; proneness to, 30; redemptive, 33–5, 35 currency unions, 60–1, 61–2, 65, 251 Cyprus, Britain’s role in, 69, 79 Daimler-Benz, 117 DaimlerChrysler, 117 Darling, Alistair, 159 Darwinian process, 167 Das Kapital (Marx), 49 de Gaulle, Charles, 76, 93 Debenhams, takeover of, 119 debt: and GDP, 4–5; unsecured, 128; US government, 92; US households, 161–2 see also CDOs; leverage debt–deflation cycle, 63 deficits: in the EU, 196; US budget, 22–3, 25, 112, 136, 182–3, 215–16; US trade, 22–3, 25, 111, 182–3, 196, 227 Deng Xiao Ping, 92, 212 Depressions: US 1873–8, 40; US Great Depression, 55, 58, 59, 80 deregulations, 138, 143, 170 derivatives, 120, 131–2, 174, 178 Deutschmark, 74, 96, 195, 197 Dexia, 154 distribution, and production, 30, 31, 54, 64 dollar: devaluing, 188; flooding markets, 92–3; pegging, 190; reliance on, 57, 60, 102; value of, 96, 204; zone, 62, 78, 89, 164 dotcom bubble, 2, 5 Draghi, Mario, 239 East Asia, 79, 143, 144, 194 see also Asia; specific countries East Germany, 201, 202 see also Germany Eastern Europe, 108, 198, 203 ECB (European Central Bank): aftermath of Crash of 2008, 158; bank bail-outs, 203, 204; Crash of 2008, 148, 149, 155, 156, 157; European banking crisis, 208, 209–10; Greek crisis, 207; LTRO, 238; Maastricht Treaty, 199–200; toxic theory, 15 economic models, 139–42 Economic Recovery Advisory Board (ERAB), 180, 181 Economic Report of the President (1999), 116 ECSC (European Coal and Steel Community), 74, 75–6 Edison, Thomas, 38–9 Efficient Market Hypothesis (EMH), 15 EFSF (European Financial Stability Facility), 174, 175–7, 207, 208–9 EIB (European Investment Bank), 210 Eisenhower, Dwight D., 82 Elizabeth II, Queen, 4, 5 ERAB (Economic Recovery Advisory Board), 180, 181 ERM (European Exchange Rate Mechanism), 197 EU (European Union): economies within, 196; EFSF, 174; European Financial Stability Mechanism, 174; financial support for the US, 216; origins, 73, 74, 75; SPV, 174 euro see eurozone eurobonds, toxic, 175–7 Europa myth, 201 Europe: aftermath of Crash of 2008, 162; bank bail-outs, 203–5; Crash of 2008, 2–3, 12–13, 183; end of Bretton Woods system, 95; eurozone problems, 165; Geithner–Summers Plan, 174–7; oil price rises, 98; unemployment, 164 see also specific countries European Central Bank see ECB European Coal and Steel Community (ECSC), 74, 75–6 European Commission, 157, 203, 204 European Common Market, 195 European Exchange Rate Mechanism (ERM), 197 European Financial Stability Facility (EFSF), 174, 207, 208–9 European Financial Stability Mechanism, 174, 175–7 European Investment Bank (EIB), 210 European Recovery Progam see Marshall Plan European Union see EU eurozone, 61, 62, 156, 164; crisis, 165, 174, 204, 208–9, 209–11; European banks’ exposure to, 203; formation of, 198, 202; France and, 198; Germany and, 198–201; and Greek crisis, 207 exchange rate system, Bretton Woods, 60, 63, 67 falsifiability, empirical test of, 221 Fannie Mae, 152, 166 Fed, the (Federal Reserve): aftermath of Crash of 2008, 159; Crash of 2008, 148, 149, 151, 153, 155, 156, 157; creation, 40; current problems, 164; Geithner–Summers Plan, 171–2, 173, 230; Greenspan and, 3, 10; interest rate policy, 99; sub-prime crisis, 147, 149; and toxic theory, 15 feudalism, 30, 31, 64 Fiat, 159 finance: as a pillar of industry, 31; role of, 35–8 Financial Crisis Inquiry Commission, 166 financialization, 30, 190, 222 First World War, Gold Standard suspension, 44 food: markets, 215; prices, 163 Ford, Henry, 39 formalist economic model, 139–40 Forrestal, James, 68 Fortis, 153 franc, value against dollar, 96 France: aid for banks, 157; colonialism criticized, 79; EU membership, 196; and the euro, 198; gold request, 94; Plaza Accord, 188; reindustrialization of Germany, 74; support for Dexia, 154 Freddie Mac, 152, 166 free market fundamentalism, 181, 182 French Revolution, 29 G7 group, 151 G20 group, 159, 163–4 Galbraith, John Kenneth, 73 GATT (General Agreement on Tariffs and Trade), 78 GDP (Gross Domestic Product): Britain, 4–5, 88, 158; eurozone, 199, 204; France, 88; Germany, 88, 88; Japan, 88, 88; US, 4, 72, 73, 87, 88, 88, 161; world, 88 Geithner–Summers Plan, 159, 169–83; in Europe, 174–7; results, 178–81; in the US, 169–74, 170, 230 Geithner, Timothy, 170, 173, 230 General Motors (GM), 131–2, 157–8, 160 General Theory (Keynes), 37 geopolitical power, 106–8 Germany: aftermath of the Second World War, 68, 73–4; competition with US, 98, 103; current importance, 251; and Europe, 195–8; and the eurozone, 198–201, 211; global capital, 115–16; Global Plan, 69, 70; Greek crisis, 206; house prices, 129; Marshall Plan, 73; reunification, 201–3; support for Hypo Real Estate, 155; trade surplus, 251; trade surpluses, 158 Giscard d’Estaing, Valery, 93 Glass–Steagall Act (1933), 10, 180 global balance, 22 global imbalances, 251–2 Global Plan: appraisal, 85–9; architects, 68; end of, 100–1, 182; geopolitical ideology, 79–82; Germany, 75; Marshall Plan, 74; origins, 67–71; real GDP per capita, 87; unravelling of, 90–4; US domestic policies, 82–5 global surplus recycing mechanism see GSRM global warming, 163 globalization, 12, 28, 125 GM (General Motors), 131–2, 157–8, 160 gold: prices, 96; rushes, 40; US reserves, 92–3 Gold Exchange Standard, collapse, 43–5 Goodwin, Richard, 34 Great Depression, 55, 58, 59, 80 Greece: currency, 205; debt crisis, 206–8 greed, Crash of 2008, 9–12 Greek Civil War, 71, 72, 79 Greenspan, Alan, 3, 10–11 Greenwald, Robert, 125–6 Gross Domestic Product see GDP GSRM (global surplus recycling mechanism), 62, 66, 85, 90, 109–10, 222, 223, 224, 248, 252–6 HBOS, 153, 156 Heath, Edward, 94 hedge funds, 147, 204; LTCM, 2, 13; toxic theory, 15 hedging, 120–1 history: consent as driving force, 29; Marx on, 178; as undemocratic, 28 Ho Chi Minh, 92 Holland, 79, 120, 155, 196, 204 home ownership, 12, 127–8; reposessions, 161 Homeownership Preservation Foundation, 161 Hoover, Herbert, 42–3, 44–5, 230 House Committee on Un-American Activities, 73 house prices, 12, 128–9, 129, 138; falling, 151, 152 human nature, 10, 11–12 humanity, in the workforce, 50–2, 54 Hypo Real Estate, 155 Ibn Khaldun, 33 IBRD (International Bank for Reconstruction and Development) see World Bank Iceland, 154, 155, 156, 203 ICU (International Currency Union) proposal, 60–1, 66, 90, 251 IMF (International Monetary Fund): burst bubbles, 190; cost of the credit crunch, 151; Crash of 2008, 155–6, 156, 159; demise of social services, 163; on economic growth, 159; European banking crisis, 208; G20 support for, 163–4; Greek crisis, 207; origins, 59; South East Asia, 192, 193; Third World debt crisis, 108; as a transnational institution, 253, 254 income: distribution, 64; national, 42; US national, 43 India: Britain’s stance criticized, 79; Crash of 2008, 163; suicides of farmers, 163 Indochina, and colonization, 79 Indonesia, 79, 191 industrialization: Britain, 5; Germany, 74–5; Japan, 89, 185–6; roots of, 27–8; South East Asia, 86 infinite regress, 47 interest rates: CDOs, 7; post-Global Plan, 99; prophecy paradox, 48; rises in, 107 International Bank for Reconstruction and Development (IBRD) see World Bank International Currency Union (ICU) proposal, 60–1, 66, 90, 253 International Labour Organisation, 159 International Monetary Fund see IMF Iran, Shah of, 97 Ireland: bankruptcy, 154, 156; EFSF, 175; nationalization of Anglo Irish Bank, 158 Irwin, John, 97 Japan: aftermath of the Second World War, 68–9; competition with the US, 98, 103; in decline, 186–91; end of Bretton Woods system, 95; financial support for the US, 216; global capital, 115–16; Global Plan, 69, 70, 76–8, 85–6; house prices, 129; labour costs, 105; new Marshall Plan, 77; Plaza Accord, 188; post-war, 185–91; post-war growth, 185–6; relations with the US, 187–8, 189; South East Asia, 91, 191–2; trade surpluses, 158 joblessness see unemployment Johnson, Lyndon B.: Great Society programmes, 83, 84, 92; Vietnam War, 92 JPMorgan Chase, 151, 153 keiretsu system, Japan, 186, 187, 188, 189, 191 Kennan, George, 68, 71 Kennedy, John F., New Frontier social programmes, 83, 84 Keynes, John Maynard: Bretton Woods conference, 59, 60, 62, 109; General Theory, 37; ICU proposal, 60, 66, 90, 109, 254, 255; influence on New Dealers, 81; on investment decisions, 48; on liquidity, 160–1; trade imbalances, 62–6 Keynsianism, 157 Kim Il Sung, 77 Kissinger, Henry, 94, 98, 106 Kohl, Helmut, 201 Korea, 91, 191, 192 Korean War, 77, 86 labour: as a commodity, 28; costs, 104–5, 104, 105, 106, 137; hired, 31, 45, 46, 53, 64; scarcity of, 34–5; value of, 50–2 labour markets, 12, 202 Labour Party (British), 69 labourers, 32 land: as a commodity, 28; enclosure, 64 Landesbanken, 203 Latin America: effect of China on, 215, 218; European banks’ exposure to, 203; financial crisis, 190 see also specific countries lead, prices, 96 Lebensraum, 67 Left-Right divide, 167 Lehman Brothers, 150, 152–3 leverage, 121–2 leveraging, 37 Liberal Democratic Party (Japan), 187 liberation movements, 79, 107 LIBOR (London Interbank Offered Rate), 148 liquidity traps, 157, 190 Lloyds TSB, 153, 156 loans: and CDOs, 7–8, 129–31; defaults on, 37 London School of Economics, 4, 66 Long-Term Capital Management (LTCM) hedge fund collapse, 13 LTCM (Long-Term Capital Management) hedge fund collapse, 2, 13 Luxembourg, support for Dexia, 154 Maastricht Treaty, 199–200, 202 MacArthur, Douglas, 70–1, 76, 77 machines, and humans, 50–2 Malaysia, 91, 191 Mao, Chairman, 76, 86, 91 Maresca, John, 106–7 Marjolin, Robert, 73 Marshall, George, 72 Marshall Plan, 71–4 Marx, Karl: and capitalism, 17–18, 19, 34; Das Kapital, 49; on history, 178 Marxism, 181, 182 Matrix, The (film), 50–2 MBIA, 149, 150 McCarthy, Senator Joseph, 73 mercantilism, in Germany, 251 merchant class, 27–8 Merkel, Angela, 158, 206 Merrill Lynch, 149, 153, 157 Merton, Robert, 13 Mexico: effect of China on, 214; peso crisis, 190 Middle East, oil, 69 MIE (military-industrial establishment), 82–3 migration, Crash of 2008, 3 military-industrial complex mechanism, 65, 81, 182 Ministry for International Trade and Industry (Japan), 78 Ministry of Finance (Japan), 187 Minotaur legend, 24–5, 25 Minsky, Hyman, 37 money markets, 45–6, 53, 153 moneylenders, 31, 32 mortgage backed securities (MBS) 232, 233, 234 NAFTA (North American Free Trade Agreement), 214 National Bureau of Economic Research (US), 157 National Economic Council (US), 3 national income see GDP National Security Council (US), 94 National Security Study Memorandum 200 (US), 106 nationalization: Anglo Irish Bank, 158; Bradford and Bingley, 154; Fortis, 153; Geithner–Summers Plan, 179; General Motors, 160; Icelandic banks, 154, 155; Northern Rock, 151 NATO (North Atlantic Treaty Organization), 76, 253 negative engineering, 110 negative equity 234 neoliberalism, 139, 142; and greed, 10 New Century Financial, 147 New Deal: beginnings, 45; Bretton Woods conference, 57–9; China, 76; Global Plan, 67–71, 68; Japan, 77; President Kennedy, 84; support for the Deutschmark, 74; transfer union, 65 New Dealers: corporate power, 81; criticism of European colonizers, 79 ‘new economy’, 5–6 New York stock exchange, 40, 158 Nietzsche, Friedrich, 19 Nixon, Richard, 94, 95–6 Nobel Prize for Economics, 13 North American Free Trade Agreement (NAFTA), 214 North Atlantic Treaty Organization (NATO), 76 North Korea see Korea Northern Rock, 148, 151 Obama administration, 164, 178 Obama, Barack, 158, 159, 169, 180, 230, 231 OECD (Organisation for Economic Co-operation and Development), 73 OEEC (Organisation for European Economic Co-operation), 73, 74 oil: global consumption, 160; imports, 102–3; prices, 96, 97–9 OPEC (Organization of the Petroleum Exporting Countries), 96, 97 paradox of success, 249 parallax challenge, 20–1 Paulson, Henry, 152, 154, 170 Paulson Plan, 154, 173 Penn Bank, 40 Pentagon, the, 73 Plaza Accord (1985), 188, 192, 213 Pompidou, Georges, 94, 95–6 pound sterling, devaluing, 93 poverty: capitalism as a supposed cure for, 41–2; in China, 162; reduction in the US, 84; reports on global, 125 predatory governance, 181 prey–predator dynamic, 33–5 prices, flexible, 40–1 private money, 147, 177; Geithner–Summers Plan, 178; toxic, 132–3, 136, 179 privatization, of surpluses, 29 probability, estimating, 13–14 production: cars, 70, 103, 116, 157–8; coal, 73, 75; costs, 96, 104; cuts in, 41; in Japan, 185–6; processes, 30, 31, 64; steel, 70, 75 production–distribution cycle, 54 property see real estate prophecy paradox, 46, 47, 53 psychology, mass, 14 public debt crisis, 205 quantitative easing, 164, 231–6 railway bubbles, 40 Rational Expectations Hypothesis (REH), 15–16 RBS (Royal Bank of Scotland), 6, 151, 156; takeover of ABN-Amro, 119–20 Reagan, Ronald, 10, 99, 133–5, 182–3 Real Business Cycle Theory (RBCT), 15, 16–17 real estate, bubbles, 8–9, 188, 190, 192–3 reason, deferring to expectation, 47 recession predictions, 152 recessions, US, 40, 157 recycling mechanisms, 200 regulation, of banking system, 10, 122 relabelling, 14 religion, organized, 27 renminbi (RMB), 213, 214, 217, 218, 253 rentiers, 165, 187, 188 representative agents, 140 Reserve Bank of Australia, 148 reserve currency status, 101–2 risk: capitalists and, 31; riskless, 5, 6–9, 14 Roach, Stephen, 145 Robbins, Lionel, 66 Roosevelt, Franklin D., 165; attitude towards Britain, 69; and bank regulation, 10; New Deal, 45, 58–9 Roosevelt, Theodore (‘Teddy’), 180 Royal Bank of Scotland (RBS), 6, 151, 156; takeover of ABN-Amro, 119–20 Rudd, Kevin, 212 Russia, financial crisis, 190 Saudi Arabia, oil prices, 98 Scandinavia, Gold Standard, 44 Scholes, Myron, 13 Schopenhauer, Arthur, 19 Schuman, Robert, 75 Schumpter, Joseph, 34 Second World War, 45, 55–6; aftermath, 87–8; effect on the US, 57–8 seeds, commodification of, 163 shares, in privatized companies, 137, 138 silver, prices, 96 simulated markets, 170 simulated prices, 170 Singapore, 91 single currencies, ICU, 60–1 slave trade, 28 SMEs (small and medium-sized enterprises), 186 social welfare, 12 solidarity (asabiyyah), 33–4 South East Asia, 91; financial crisis, 190, 191–5, 213; industrialization, 86, 87 South Korea see Korea sovereign debt crisis, 205 Soviet Union: Africa, 79; disintegration, 201; Marshall Plan, 72–3; Marxism, 181, 182; relations with the US, 71 SPV (Special Purpose Vehicle), 174 see also EFSF stagflation, 97 stagnation, 37 Stalin, Joseph, 72–3 steel production, in Germany, 70 Strauss-Kahn, Dominique, 60, 254, 255 Summers, Larry, 230 strikes, 40 sub-prime mortgages, 2, 5, 6, 130–1, 147, 149, 151, 166 success, paradox of, 33–5, 53 Suez Canal trauma, 69 Suharto, President of Indonesia, 97 Summers, Larry, 3, 132, 170, 173, 180 see also Geithner–Summers Plan supply and demand, 11 surpluses: under capitalism, 31–2; currency unions, 61; under feudalism, 30; generation in the EU, 196; manufacturing, 30; origin of, 26–7; privatization of, 29; recycling mechanisms, 64–5, 109–10 Sweden, Crash of 2008, 155 Sweezy, Paul, 73 Switzerland: Crash of 2008, 155; UBS, 148–9, 151 systemic failure, Crash of 2008, 17–19 Taiwan, 191, 192 Tea Party (US), 162, 230, 231, 281 technology, and globalization, 28 Thailand, 91 Thatcher, Margaret, 117–18, 136–7 Third World: Crash of 2008, 162; debt crisis, 108, 219; interest rate rises, 108; mineral wealth, 106; production of goods for Walmart, 125 tiger economies, 87 see also South East Asia Tillman Act (1907), 180 time, and economic models, 139–40 Time Warner, 117 tin, prices, 96 toxic theory, 13–17, 115, 133–9, 139–42 trade: balance of, 61, 62, 64–5; deficits (US), 111, 243; global, 27, 90; surpluses, 158 trades unions, 124, 137, 202 transfer unions, New Deal, 65 Treasury Bills (US), 7 Treaty of Rome, 237 Treaty of Versailles, 237 Treaty of Westphalia, 237 trickle-down, 115, 135 trickle-up, 135 Truman Doctrine, 71, 71–2, 77 Truman, Harry, 73 tsunami, effects of, 194 UBS, 148–9, 151 Ukraine, and the Crash of 2008, 156 UN Security Council, 253 unemployment: Britain, 160; Global Plan, 96–7; rate of, 14; US, 152, 158, 164 United States see US Unocal, 106 US economy, twin deficits, 22–3, 25 US government, and South East Asia, 192 US Mortgage Bankers Association, 161 US Supreme Court, 180 US Treasury, 153–4, 156, 157, 159; aftermath of the Crash of 2008, 160; Geithner–Summers Plan, 171–2, 173; bonds, 227 US Treasury Bills, 109 US (United States): aftermath of the Crash of 2008, 161–2; assets owned by foreign state institutions, 216; attitude towards oil price rises, 97–8; China, 213–14; corporate bond purchases, 228; as a creditor nation, 57; domestic policies during the Global Plan, 82–5; economy at present, 184; economy praised, 113–14; effects of the Crash of 2008, 2, 183; foreign-owned assets, 225; Greek Civil War, 71; labour costs, 105; Plaza Accord, 188; profit rates, 106; proposed invasion of Afghanistan, 106–7; role in the ECSC, 75; South East Asia, 192 value, costing, 50–1 VAT, reduced, 156 Venezuela, oil prices, 97 Vietnamese War, 86, 91–2 vital spaces, 192, 195, 196 Volcker, Paul: 2009 address to Wall Street, 122; demand for dollars, 102; and gold convertibility, 94; interest rate rises, 99; replaced by Greenspan, 10; warning of the Crash of 2008, 144–5; on the world economy, 22, 100–1, 139 Volcker Rule, 180–1 Wachowski, Larry and Andy, 50 wage share, 34–5 wages: British workers, 137; Japanese workers, 185; productivity, 104; prophecy paradox, 48; US workers, 124, 161 Wal-Mart: The High Cost of Low Price (documentary, Greenwald), 125–6 Wall Street: Anglo-Celtic model, 12; Crash of 2008, 11–12, 152; current importance, 251; Geithner–Summers Plan, 178; global profits, 23; misplaced confidence in, 41; private money, 136; profiting from sub-prime mortgages, 131; takeovers and mergers, 115–17, 115, 118–19; toxic theory, 15 Wallace, Harry, 72–3 Walmart, 115, 123–7, 126; current importance, 251 War of the Currents, 39 Washington Mutual, 153 weapons of mass destruction, 27 West Germany: labour costs, 105; Plaza Accord, 188 Westinghouse, George, 39 White, Harry Dexter, 59, 70, 109 Wikileaks, 212 wool, as a global commodity, 28 working class: in Britain, 136; development of, 28 working conditions, at Walmart, 124–5 World Bank, 253; origins, 59; recession prediction, 149; and South East Asia, 192 World Trade Organization, 78, 215 written word, 27 yen, value against dollar, 96, 188, 193–4 Yom Kippur War, 96 zombie banks, 190–1

., 149, 156, 157 Byrnes, James, 68 capital, and the human will, 18–19 capitalism: dynamic system, 139–40; free market, 68; generation of crises, 34; global, 58, 72, 114, 115, 133; Greenspan and, 11–12; Marxism, 17–18; static system, 139; supposed cure for poverty, 41–2; surplus recycling mechanisms, 64–5 capitalists, origin of, 31 car production, 70, 103, 116, 157–8 carry trade, 189–90 Carter, Jimmy, 99, 100 CDOs (collateralized debt obligations), 141–2, 147–8, 149, 150, 153; for crops, 163; eurozone, 205; explanation, 6–9; France, 203; function, 130–2; Greece, 206 see also EFSF; Geithner–Summers Plan CDSs (credit default swaps), 149, 150, 153, 154, 176, 177 CEOs (chief executive officers), 46, 48, 49 Chamber of Commerce, British, 152 cheapness, ideology of, 124 Chiang Kai-shek, 76 Chicago Commodities Exchange, 120 Chicago Futures Exchange, 163 China: aggregate demand, 245; Crash of 2008, 156, 162; currency, 194, 213, 214, 217, 218, 252; economic development, 106–7; effects of the Crash of 2008, 3; financial support for the US, 216; global capital, 116; Global Plan, 76; growth, 92; rise and impact, 212–18, 219–20 Chrysler, 117, 159 CIA (Central Intelligence Agency), 69 Citigroup, 149, 156, 158 City of London: Anglo-Celtic model, 12; Crash of 2008, 148, 152; debt in relation to GDP, 4–5; financialization, 118–19; under Thatcher, 138; wealth of merchants, 28 civilization, 27, 29–30, 128 Clinton, Hillary, 212, 215–16 Cold War, 71, 80, 81, 86 collateralized debt obligations see CDOs commodification: resistance to, 53–4; rise of, 30, 33, 54; of seeds, 175 commodities: global, 27–8; human nature not, 53; labour as, 45, 49, 54; money as, 45, 49; prices, 96, 98, 102, 125; trading, 31, 175 common market, European, 195 communism, collapse of, 22, 107–8 complexity, and economic models, 139–40 Condorcet, Nicholas de Caritat, marquis de, 29, 32 Congress (US): bail-outs, 77, 153–4, 155; import tariff bill, 45 Connally, John, 94–5 council houses, selling off, 137, 138 Crash of 1907, 40 Crash of 1929, 38–43, 44, 181 Crash of 2008, 146–68; aftermath, 158–60; chronicle, 2007, 147–9; chronicle, 2008, 149, 151–8; credit default swaps, 150; effects, 2–3; epilogue, 164–8; explanations, 4–19; in Italy, 237; review, 160–4; in Spain, 237; warnings, 144–5 credit crunch, 149, 151 credit default swaps (CDSs), 149, 150, 153, 154, 176, 177 credit facilities, 127–8 credit rating agencies, 6–7, 8, 9, 20, 130 crises: as laboratories of the future, 28; nature of, 141; pre-1929, 40; pre-2008, 2; proneness to, 30; redemptive, 33–5, 35 currency unions, 60–1, 61–2, 65, 251 Cyprus, Britain’s role in, 69, 79 Daimler-Benz, 117 DaimlerChrysler, 117 Darling, Alistair, 159 Darwinian process, 167 Das Kapital (Marx), 49 de Gaulle, Charles, 76, 93 Debenhams, takeover of, 119 debt: and GDP, 4–5; unsecured, 128; US government, 92; US households, 161–2 see also CDOs; leverage debt–deflation cycle, 63 deficits: in the EU, 196; US budget, 22–3, 25, 112, 136, 182–3, 215–16; US trade, 22–3, 25, 111, 182–3, 196, 227 Deng Xiao Ping, 92, 212 Depressions: US 1873–8, 40; US Great Depression, 55, 58, 59, 80 deregulations, 138, 143, 170 derivatives, 120, 131–2, 174, 178 Deutschmark, 74, 96, 195, 197 Dexia, 154 distribution, and production, 30, 31, 54, 64 dollar: devaluing, 188; flooding markets, 92–3; pegging, 190; reliance on, 57, 60, 102; value of, 96, 204; zone, 62, 78, 89, 164 dotcom bubble, 2, 5 Draghi, Mario, 239 East Asia, 79, 143, 144, 194 see also Asia; specific countries East Germany, 201, 202 see also Germany Eastern Europe, 108, 198, 203 ECB (European Central Bank): aftermath of Crash of 2008, 158; bank bail-outs, 203, 204; Crash of 2008, 148, 149, 155, 156, 157; European banking crisis, 208, 209–10; Greek crisis, 207; LTRO, 238; Maastricht Treaty, 199–200; toxic theory, 15 economic models, 139–42 Economic Recovery Advisory Board (ERAB), 180, 181 Economic Report of the President (1999), 116 ECSC (European Coal and Steel Community), 74, 75–6 Edison, Thomas, 38–9 Efficient Market Hypothesis (EMH), 15 EFSF (European Financial Stability Facility), 174, 175–7, 207, 208–9 EIB (European Investment Bank), 210 Eisenhower, Dwight D., 82 Elizabeth II, Queen, 4, 5 ERAB (Economic Recovery Advisory Board), 180, 181 ERM (European Exchange Rate Mechanism), 197 EU (European Union): economies within, 196; EFSF, 174; European Financial Stability Mechanism, 174; financial support for the US, 216; origins, 73, 74, 75; SPV, 174 euro see eurozone eurobonds, toxic, 175–7 Europa myth, 201 Europe: aftermath of Crash of 2008, 162; bank bail-outs, 203–5; Crash of 2008, 2–3, 12–13, 183; end of Bretton Woods system, 95; eurozone problems, 165; Geithner–Summers Plan, 174–7; oil price rises, 98; unemployment, 164 see also specific countries European Central Bank see ECB European Coal and Steel Community (ECSC), 74, 75–6 European Commission, 157, 203, 204 European Common Market, 195 European Exchange Rate Mechanism (ERM), 197 European Financial Stability Facility (EFSF), 174, 207, 208–9 European Financial Stability Mechanism, 174, 175–7 European Investment Bank (EIB), 210 European Recovery Progam see Marshall Plan European Union see EU eurozone, 61, 62, 156, 164; crisis, 165, 174, 204, 208–9, 209–11; European banks’ exposure to, 203; formation of, 198, 202; France and, 198; Germany and, 198–201; and Greek crisis, 207 exchange rate system, Bretton Woods, 60, 63, 67 falsifiability, empirical test of, 221 Fannie Mae, 152, 166 Fed, the (Federal Reserve): aftermath of Crash of 2008, 159; Crash of 2008, 148, 149, 151, 153, 155, 156, 157; creation, 40; current problems, 164; Geithner–Summers Plan, 171–2, 173, 230; Greenspan and, 3, 10; interest rate policy, 99; sub-prime crisis, 147, 149; and toxic theory, 15 feudalism, 30, 31, 64 Fiat, 159 finance: as a pillar of industry, 31; role of, 35–8 Financial Crisis Inquiry Commission, 166 financialization, 30, 190, 222 First World War, Gold Standard suspension, 44 food: markets, 215; prices, 163 Ford, Henry, 39 formalist economic model, 139–40 Forrestal, James, 68 Fortis, 153 franc, value against dollar, 96 France: aid for banks, 157; colonialism criticized, 79; EU membership, 196; and the euro, 198; gold request, 94; Plaza Accord, 188; reindustrialization of Germany, 74; support for Dexia, 154 Freddie Mac, 152, 166 free market fundamentalism, 181, 182 French Revolution, 29 G7 group, 151 G20 group, 159, 163–4 Galbraith, John Kenneth, 73 GATT (General Agreement on Tariffs and Trade), 78 GDP (Gross Domestic Product): Britain, 4–5, 88, 158; eurozone, 199, 204; France, 88; Germany, 88, 88; Japan, 88, 88; US, 4, 72, 73, 87, 88, 88, 161; world, 88 Geithner–Summers Plan, 159, 169–83; in Europe, 174–7; results, 178–81; in the US, 169–74, 170, 230 Geithner, Timothy, 170, 173, 230 General Motors (GM), 131–2, 157–8, 160 General Theory (Keynes), 37 geopolitical power, 106–8 Germany: aftermath of the Second World War, 68, 73–4; competition with US, 98, 103; current importance, 251; and Europe, 195–8; and the eurozone, 198–201, 211; global capital, 115–16; Global Plan, 69, 70; Greek crisis, 206; house prices, 129; Marshall Plan, 73; reunification, 201–3; support for Hypo Real Estate, 155; trade surplus, 251; trade surpluses, 158 Giscard d’Estaing, Valery, 93 Glass–Steagall Act (1933), 10, 180 global balance, 22 global imbalances, 251–2 Global Plan: appraisal, 85–9; architects, 68; end of, 100–1, 182; geopolitical ideology, 79–82; Germany, 75; Marshall Plan, 74; origins, 67–71; real GDP per capita, 87; unravelling of, 90–4; US domestic policies, 82–5 global surplus recycing mechanism see GSRM global warming, 163 globalization, 12, 28, 125 GM (General Motors), 131–2, 157–8, 160 gold: prices, 96; rushes, 40; US reserves, 92–3 Gold Exchange Standard, collapse, 43–5 Goodwin, Richard, 34 Great Depression, 55, 58, 59, 80 Greece: currency, 205; debt crisis, 206–8 greed, Crash of 2008, 9–12 Greek Civil War, 71, 72, 79 Greenspan, Alan, 3, 10–11 Greenwald, Robert, 125–6 Gross Domestic Product see GDP GSRM (global surplus recycling mechanism), 62, 66, 85, 90, 109–10, 222, 223, 224, 248, 252–6 HBOS, 153, 156 Heath, Edward, 94 hedge funds, 147, 204; LTCM, 2, 13; toxic theory, 15 hedging, 120–1 history: consent as driving force, 29; Marx on, 178; as undemocratic, 28 Ho Chi Minh, 92 Holland, 79, 120, 155, 196, 204 home ownership, 12, 127–8; reposessions, 161 Homeownership Preservation Foundation, 161 Hoover, Herbert, 42–3, 44–5, 230 House Committee on Un-American Activities, 73 house prices, 12, 128–9, 129, 138; falling, 151, 152 human nature, 10, 11–12 humanity, in the workforce, 50–2, 54 Hypo Real Estate, 155 Ibn Khaldun, 33 IBRD (International Bank for Reconstruction and Development) see World Bank Iceland, 154, 155, 156, 203 ICU (International Currency Union) proposal, 60–1, 66, 90, 251 IMF (International Monetary Fund): burst bubbles, 190; cost of the credit crunch, 151; Crash of 2008, 155–6, 156, 159; demise of social services, 163; on economic growth, 159; European banking crisis, 208; G20 support for, 163–4; Greek crisis, 207; origins, 59; South East Asia, 192, 193; Third World debt crisis, 108; as a transnational institution, 253, 254 income: distribution, 64; national, 42; US national, 43 India: Britain’s stance criticized, 79; Crash of 2008, 163; suicides of farmers, 163 Indochina, and colonization, 79 Indonesia, 79, 191 industrialization: Britain, 5; Germany, 74–5; Japan, 89, 185–6; roots of, 27–8; South East Asia, 86 infinite regress, 47 interest rates: CDOs, 7; post-Global Plan, 99; prophecy paradox, 48; rises in, 107 International Bank for Reconstruction and Development (IBRD) see World Bank International Currency Union (ICU) proposal, 60–1, 66, 90, 253 International Labour Organisation, 159 International Monetary Fund see IMF Iran, Shah of, 97 Ireland: bankruptcy, 154, 156; EFSF, 175; nationalization of Anglo Irish Bank, 158 Irwin, John, 97 Japan: aftermath of the Second World War, 68–9; competition with the US, 98, 103; in decline, 186–91; end of Bretton Woods system, 95; financial support for the US, 216; global capital, 115–16; Global Plan, 69, 70, 76–8, 85–6; house prices, 129; labour costs, 105; new Marshall Plan, 77; Plaza Accord, 188; post-war, 185–91; post-war growth, 185–6; relations with the US, 187–8, 189; South East Asia, 91, 191–2; trade surpluses, 158 joblessness see unemployment Johnson, Lyndon B.: Great Society programmes, 83, 84, 92; Vietnam War, 92 JPMorgan Chase, 151, 153 keiretsu system, Japan, 186, 187, 188, 189, 191 Kennan, George, 68, 71 Kennedy, John F., New Frontier social programmes, 83, 84 Keynes, John Maynard: Bretton Woods conference, 59, 60, 62, 109; General Theory, 37; ICU proposal, 60, 66, 90, 109, 254, 255; influence on New Dealers, 81; on investment decisions, 48; on liquidity, 160–1; trade imbalances, 62–6 Keynsianism, 157 Kim Il Sung, 77 Kissinger, Henry, 94, 98, 106 Kohl, Helmut, 201 Korea, 91, 191, 192 Korean War, 77, 86 labour: as a commodity, 28; costs, 104–5, 104, 105, 106, 137; hired, 31, 45, 46, 53, 64; scarcity of, 34–5; value of, 50–2 labour markets, 12, 202 Labour Party (British), 69 labourers, 32 land: as a commodity, 28; enclosure, 64 Landesbanken, 203 Latin America: effect of China on, 215, 218; European banks’ exposure to, 203; financial crisis, 190 see also specific countries lead, prices, 96 Lebensraum, 67 Left-Right divide, 167 Lehman Brothers, 150, 152–3 leverage, 121–2 leveraging, 37 Liberal Democratic Party (Japan), 187 liberation movements, 79, 107 LIBOR (London Interbank Offered Rate), 148 liquidity traps, 157, 190 Lloyds TSB, 153, 156 loans: and CDOs, 7–8, 129–31; defaults on, 37 London School of Economics, 4, 66 Long-Term Capital Management (LTCM) hedge fund collapse, 13 LTCM (Long-Term Capital Management) hedge fund collapse, 2, 13 Luxembourg, support for Dexia, 154 Maastricht Treaty, 199–200, 202 MacArthur, Douglas, 70–1, 76, 77 machines, and humans, 50–2 Malaysia, 91, 191 Mao, Chairman, 76, 86, 91 Maresca, John, 106–7 Marjolin, Robert, 73 Marshall, George, 72 Marshall Plan, 71–4 Marx, Karl: and capitalism, 17–18, 19, 34; Das Kapital, 49; on history, 178 Marxism, 181, 182 Matrix, The (film), 50–2 MBIA, 149, 150 McCarthy, Senator Joseph, 73 mercantilism, in Germany, 251 merchant class, 27–8 Merkel, Angela, 158, 206 Merrill Lynch, 149, 153, 157 Merton, Robert, 13 Mexico: effect of China on, 214; peso crisis, 190 Middle East, oil, 69 MIE (military-industrial establishment), 82–3 migration, Crash of 2008, 3 military-industrial complex mechanism, 65, 81, 182 Ministry for International Trade and Industry (Japan), 78 Ministry of Finance (Japan), 187 Minotaur legend, 24–5, 25 Minsky, Hyman, 37 money markets, 45–6, 53, 153 moneylenders, 31, 32 mortgage backed securities (MBS) 232, 233, 234 NAFTA (North American Free Trade Agreement), 214 National Bureau of Economic Research (US), 157 National Economic Council (US), 3 national income see GDP National Security Council (US), 94 National Security Study Memorandum 200 (US), 106 nationalization: Anglo Irish Bank, 158; Bradford and Bingley, 154; Fortis, 153; Geithner–Summers Plan, 179; General Motors, 160; Icelandic banks, 154, 155; Northern Rock, 151 NATO (North Atlantic Treaty Organization), 76, 253 negative engineering, 110 negative equity 234 neoliberalism, 139, 142; and greed, 10 New Century Financial, 147 New Deal: beginnings, 45; Bretton Woods conference, 57–9; China, 76; Global Plan, 67–71, 68; Japan, 77; President Kennedy, 84; support for the Deutschmark, 74; transfer union, 65 New Dealers: corporate power, 81; criticism of European colonizers, 79 ‘new economy’, 5–6 New York stock exchange, 40, 158 Nietzsche, Friedrich, 19 Nixon, Richard, 94, 95–6 Nobel Prize for Economics, 13 North American Free Trade Agreement (NAFTA), 214 North Atlantic Treaty Organization (NATO), 76 North Korea see Korea Northern Rock, 148, 151 Obama administration, 164, 178 Obama, Barack, 158, 159, 169, 180, 230, 231 OECD (Organisation for Economic Co-operation and Development), 73 OEEC (Organisation for European Economic Co-operation), 73, 74 oil: global consumption, 160; imports, 102–3; prices, 96, 97–9 OPEC (Organization of the Petroleum Exporting Countries), 96, 97 paradox of success, 249 parallax challenge, 20–1 Paulson, Henry, 152, 154, 170 Paulson Plan, 154, 173 Penn Bank, 40 Pentagon, the, 73 Plaza Accord (1985), 188, 192, 213 Pompidou, Georges, 94, 95–6 pound sterling, devaluing, 93 poverty: capitalism as a supposed cure for, 41–2; in China, 162; reduction in the US, 84; reports on global, 125 predatory governance, 181 prey–predator dynamic, 33–5 prices, flexible, 40–1 private money, 147, 177; Geithner–Summers Plan, 178; toxic, 132–3, 136, 179 privatization, of surpluses, 29 probability, estimating, 13–14 production: cars, 70, 103, 116, 157–8; coal, 73, 75; costs, 96, 104; cuts in, 41; in Japan, 185–6; processes, 30, 31, 64; steel, 70, 75 production–distribution cycle, 54 property see real estate prophecy paradox, 46, 47, 53 psychology, mass, 14 public debt crisis, 205 quantitative easing, 164, 231–6 railway bubbles, 40 Rational Expectations Hypothesis (REH), 15–16 RBS (Royal Bank of Scotland), 6, 151, 156; takeover of ABN-Amro, 119–20 Reagan, Ronald, 10, 99, 133–5, 182–3 Real Business Cycle Theory (RBCT), 15, 16–17 real estate, bubbles, 8–9, 188, 190, 192–3 reason, deferring to expectation, 47 recession predictions, 152 recessions, US, 40, 157 recycling mechanisms, 200 regulation, of banking system, 10, 122 relabelling, 14 religion, organized, 27 renminbi (RMB), 213, 214, 217, 218, 253 rentiers, 165, 187, 188 representative agents, 140 Reserve Bank of Australia, 148 reserve currency status, 101–2 risk: capitalists and, 31; riskless, 5, 6–9, 14 Roach, Stephen, 145 Robbins, Lionel, 66 Roosevelt, Franklin D., 165; attitude towards Britain, 69; and bank regulation, 10; New Deal, 45, 58–9 Roosevelt, Theodore (‘Teddy’), 180 Royal Bank of Scotland (RBS), 6, 151, 156; takeover of ABN-Amro, 119–20 Rudd, Kevin, 212 Russia, financial crisis, 190 Saudi Arabia, oil prices, 98 Scandinavia, Gold Standard, 44 Scholes, Myron, 13 Schopenhauer, Arthur, 19 Schuman, Robert, 75 Schumpter, Joseph, 34 Second World War, 45, 55–6; aftermath, 87–8; effect on the US, 57–8 seeds, commodification of, 163 shares, in privatized companies, 137, 138 silver, prices, 96 simulated markets, 170 simulated prices, 170 Singapore, 91 single currencies, ICU, 60–1 slave trade, 28 SMEs (small and medium-sized enterprises), 186 social welfare, 12 solidarity (asabiyyah), 33–4 South East Asia, 91; financial crisis, 190, 191–5, 213; industrialization, 86, 87 South Korea see Korea sovereign debt crisis, 205 Soviet Union: Africa, 79; disintegration, 201; Marshall Plan, 72–3; Marxism, 181, 182; relations with the US, 71 SPV (Special Purpose Vehicle), 174 see also EFSF stagflation, 97 stagnation, 37 Stalin, Joseph, 72–3 steel production, in Germany, 70 Strauss-Kahn, Dominique, 60, 254, 255 Summers, Larry, 230 strikes, 40 sub-prime mortgages, 2, 5, 6, 130–1, 147, 149, 151, 166 success, paradox of, 33–5, 53 Suez Canal trauma, 69 Suharto, President of Indonesia, 97 Summers, Larry, 3, 132, 170, 173, 180 see also Geithner–Summers Plan supply and demand, 11 surpluses: under capitalism, 31–2; currency unions, 61; under feudalism, 30; generation in the EU, 196; manufacturing, 30; origin of, 26–7; privatization of, 29; recycling mechanisms, 64–5, 109–10 Sweden, Crash of 2008, 155 Sweezy, Paul, 73 Switzerland: Crash of 2008, 155; UBS, 148–9, 151 systemic failure, Crash of 2008, 17–19 Taiwan, 191, 192 Tea Party (US), 162, 230, 231, 281 technology, and globalization, 28 Thailand, 91 Thatcher, Margaret, 117–18, 136–7 Third World: Crash of 2008, 162; debt crisis, 108, 219; interest rate rises, 108; mineral wealth, 106; production of goods for Walmart, 125 tiger economies, 87 see also South East Asia Tillman Act (1907), 180 time, and economic models, 139–40 Time Warner, 117 tin, prices, 96 toxic theory, 13–17, 115, 133–9, 139–42 trade: balance of, 61, 62, 64–5; deficits (US), 111, 243; global, 27, 90; surpluses, 158 trades unions, 124, 137, 202 transfer unions, New Deal, 65 Treasury Bills (US), 7 Treaty of Rome, 237 Treaty of Versailles, 237 Treaty of Westphalia, 237 trickle-down, 115, 135 trickle-up, 135 Truman Doctrine, 71, 71–2, 77 Truman, Harry, 73 tsunami, effects of, 194 UBS, 148–9, 151 Ukraine, and the Crash of 2008, 156 UN Security Council, 253 unemployment: Britain, 160; Global Plan, 96–7; rate of, 14; US, 152, 158, 164 United States see US Unocal, 106 US economy, twin deficits, 22–3, 25 US government, and South East Asia, 192 US Mortgage Bankers Association, 161 US Supreme Court, 180 US Treasury, 153–4, 156, 157, 159; aftermath of the Crash of 2008, 160; Geithner–Summers Plan, 171–2, 173; bonds, 227 US Treasury Bills, 109 US (United States): aftermath of the Crash of 2008, 161–2; assets owned by foreign state institutions, 216; attitude towards oil price rises, 97–8; China, 213–14; corporate bond purchases, 228; as a creditor nation, 57; domestic policies during the Global Plan, 82–5; economy at present, 184; economy praised, 113–14; effects of the Crash of 2008, 2, 183; foreign-owned assets, 225; Greek Civil War, 71; labour costs, 105; Plaza Accord, 188; profit rates, 106; proposed invasion of Afghanistan, 106–7; role in the ECSC, 75; South East Asia, 192 value, costing, 50–1 VAT, reduced, 156 Venezuela, oil prices, 97 Vietnamese War, 86, 91–2 vital spaces, 192, 195, 196 Volcker, Paul: 2009 address to Wall Street, 122; demand for dollars, 102; and gold convertibility, 94; interest rate rises, 99; replaced by Greenspan, 10; warning of the Crash of 2008, 144–5; on the world economy, 22, 100–1, 139 Volcker Rule, 180–1 Wachowski, Larry and Andy, 50 wage share, 34–5 wages: British workers, 137; Japanese workers, 185; productivity, 104; prophecy paradox, 48; US workers, 124, 161 Wal-Mart: The High Cost of Low Price (documentary, Greenwald), 125–6 Wall Street: Anglo-Celtic model, 12; Crash of 2008, 11–12, 152; current importance, 251; Geithner–Summers Plan, 178; global profits, 23; misplaced confidence in, 41; private money, 136; profiting from sub-prime mortgages, 131; takeovers and mergers, 115–17, 115, 118–19; toxic theory, 15 Wallace, Harry, 72–3 Walmart, 115, 123–7, 126; current importance, 251 War of the Currents, 39 Washington Mutual, 153 weapons of mass destruction, 27 West Germany: labour costs, 105; Plaza Accord, 188 Westinghouse, George, 39 White, Harry Dexter, 59, 70, 109 Wikileaks, 212 wool, as a global commodity, 28 working class: in Britain, 136; development of, 28 working conditions, at Walmart, 124–5 World Bank, 253; origins, 59; recession prediction, 149; and South East Asia, 192 World Trade Organization, 78, 215 written word, 27 yen, value against dollar, 96, 188, 193–4 Yom Kippur War, 96 zombie banks, 190–1


pages: 468 words: 145,998

On the Brink: Inside the Race to Stop the Collapse of the Global Financial System by Henry M. Paulson

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asset-backed security, bank run, banking crisis, break the buck, Bretton Woods, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Doha Development Round, fear of failure, financial innovation, fixed income, housing crisis, income inequality, London Interbank Offered Rate, Long Term Capital Management, margin call, money market fund, moral hazard, Northern Rock, price discovery process, price mechanism, regulatory arbitrage, Ronald Reagan, Saturday Night Live, short selling, sovereign wealth fund, technology bubble, too big to fail, trade liberalization, young professional

Efficient, well-regulated capital markets can continue to provide economic progress around the world. That inevitably leads to more political freedom and greater individual liberty. ACRONYMS USED IN THE TEXT ABCP: asset-backed commercial paper AIG: American International Group AMLF: Asset-Backed Commercial Paper Money Market Fund Liquidity Facility ARM: adjustable-rate mortgage ASF: American Securitization Forum BofA: Bank of America CDO: collateralized debt obligation CDS: credit default swap(s) CIC: China Investment Corporation CPP: capital purchase program ECB: European Central Bank ESF: Exchange Stabilization Fund FDIC: Federal Deposit Insurance Corporation FHA: Federal Housing Administration FHFA: Federal Housing Finance Agency FSA: Financial Services Authority FSB: Financial Stability Board GAO: Government Accountability Office GDP: gross domestic product GSE: government-sponsored enterprise (Fannie Mae, Freddie Mac) HERA: Housing and Economic Recovery Act HUD: U.S.

He seemed much more comfortable after the meeting. The market stayed strong through the day, with the Dow closing up 290 points, or 2.6 percent, at 11,511. But Lehman’s shares dropped $2.05, to $14.15, while its credit default swaps edged up to a worrisome 328 basis points. And the markets still did not know that Lehman’s talks with KDB were collapsing. I had hoped that the GSE takeovers would give Lehman a bit of breathing room, but I was wrong. Tuesday, September 9, 2008 I arrived at the office shortly after 6:00 a.m. and headed straight to the Markets Room. Lehman’s shares were headed toward single digits, and its credit default swaps were under pressure. I went to Ken Wilson’s office to get the latest on Dick Fuld. The KDB deal, Ken told me, was dead. “Does he know how serious the problem is?” I asked. “He’s still clinging to the view that somehow or other the Fed has the power to inject capital,” Ken answered.

AIG’s problems had been exacerbated by the crumbling financial markets; since the deal had been made, the global insurance business had slumped. Now the company’s credit default swaps had neared 2,400 basis points. That meant that it cost almost $24 to insure $100 of AIG credit—an extraordinarily high amount. The market could see that AIG’s capital structure was unsustainable. The Federal Reserve’s loan had saved it, but the company still had too much debt. The loan’s high cost strained interest coverage, and its short, two-year duration created pressure to sell assets quickly in a soft market. Meantime, the company was still weighed down by substantial market and credit risks from its holdings of residential mortgage-backed securities and the credit default swaps it had written on residential MBS. It had even used its securities lending program to purchase residential MBS.


pages: 620 words: 214,639

House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan

asset-backed security, call centre, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Deng Xiaoping, diversification, Financial Instability Hypothesis, fixed income, Hyman Minsky, Irwin Jacobs, John Meriwether, Long Term Capital Management, margin call, merger arbitrage, money market fund, moral hazard, mortgage debt, mutually assured destruction, Myron Scholes, New Journalism, Northern Rock, Renaissance Technologies, Rod Stewart played at Stephen Schwarzman birthday party, savings glut, shareholder value, sovereign wealth fund, too big to fail, traveling salesman, Y2K, yield curve

The article ended by saying: “The real test, of course, will be when a crisis hits, whatever the crisis may be.” On February 12, Gyan Sinha, a senior managing director at Bear Stearns in charge of the firm's market research regarding asset-backed securities and collateralized debt obligations, held a conference call for some nine hundred investors where he spelled out his belief that the market had overreacted to the news about New Century and HSBC. “It's time to buy the [ABX] index,” he said, adding that based on his modeling, “the market has overreacted” and predictions of rising problems in the mortgage market should be taken “with a large grain of salt.” (The ABX index is a series of credit default swaps related to subprime mortgages, allowing bets to be made on the value of those mortgages.) Had Sinha been less well respected—he testified in front of Congress on April 17, 2007, about the subprime market—less attention might have been paid.

., the nation's fifth-largest investment bank, was in trouble, big trouble. “Yep,” Sedacca wrote on the Minyanville Web site, which is dedicated to helping investors comprehend the financial world. “The great credit unwind is upon us. Credit default swaps on all brokers, particularly Lehman and Bear Stearns, are blowing out, big time.” Sedacca, the forty-eight-year-old president of Atlantic Advisors, a $3.5 billion investment management company and hedge fund, had been watching his Bloomberg screens on a daily basis as the cost of insuring the short-term obligations—known in Wall Street argot as “credit default swaps”—of both Lehman and Bear Stearns had increased steadily since the summer of 2007 and then more rapidly in February 2008. Now he was calling the end of the credit party that had been raging on Wall Street for six years.

Now they're being questioned from the standpoint of fundamental liquidity. He said that he believed that these short sellers had been speculating in the credit default swap market and telling counterparties at other firms that they had concerns about Bear Stearns's liquidity and solvency, and that was driving the cost of spreads wider. What that was doing was making their overnight funding more expensive. That was cutting into their profit margin, and in turn was also starting a sort of a cottage industry of rumors about Bear Stearns.” Although the two men spoke for about fifteen minutes, the import of the call was clear immediately. “‘There's no need to explain anything between us,' he said. I said, ‘Are you sure you're seeing this?' He said, ‘Look at [the credit default] swaps.' So I looked them up and then I see the hockey sticks”—a sharp spike up in their cost, as Sedacca wrote.


pages: 206 words: 70,924

The Rise of the Quants: Marschak, Sharpe, Black, Scholes and Merton by Colin Read

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Albert Einstein, Bayesian statistics, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, Myron Scholes, naked short selling, Paul Samuelson, price stability, principal–agent problem, quantitative trading / quantitative finance, RAND corporation, random walk, risk tolerance, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve

Finance has not, and cannot, create Conclusions 181 a crystal ball to foresee the future. The world is uncertain because we never know how markets, economies, resources, or institutions will be abused or used in ways that could not have been broadly anticipated. The failure of Long Term Capital Management in 1999 and the credit crisis of 2008 brought about by a freezing-up of the derivatives market in credit default swaps and collateralized debt obligations demonstrates that, while risk can be hedged, it can never be reduced to zero. Notes 1 Introduction 1. John Maynard Keynes, “The General Theory of Employment,” Quarterly Journal of Economics, 51 (1937), 209–23, at p. 214. 3 The Early Years 1. www.newschool.edu/nssr/het/profiles/neisser.htm, date accessed January 23, 2012. 2. A. Cowles, “Can Stock Market Forecasters Forecast?”

Index Alpha, 67, 73, 110, 121 American options, 100, 101, 116, 123 Arrow, Kenneth, 23 Arrow-Pratt measure of risk aversion, 29 Beta, 66, 67, 69, 72, 73, 110, 111, 112, 121, 152 Binomial model, 122 Black-Scholes equation, 96, 97, 113, 117, 121, 122, 124, 125, 128, 150, 153, 158, 159, 160, 161, 163, 179, 180 Bond, 5, 33, 59, 96, 106, 121, 126, 140, 142, 154, 159, 160, 168, 169, 170, 185 Brownian motion, 32, 105, 113, 120, 155 Calculus of variations, 143 Call, 98, 99, 100, 101, 104, 106, 107, 108, 112, 114, 115, 116, 122, 123, 136, 151, 153, 160, 165, 166, 167, 185, 186 Capital allocation line, 63, 64, 67 Capital Asset Pricing Model (CAPM), 4, 41, 48, 49, 51–3, 57, 60, 61, 65–81, 87, 88, 89, 93, 94, 96, 106, 109–12, 118, 121, 124, 141, 150, 152, 158, 177, 179, 180 Chicago Board Options Exchange (CBOE), 100, 101, 102, 117, 118, 119, 120, 122, 125, 129, 158, 159 Chicago Board of Trade (CBOT), 100, 101, 109, 119, 156 Chicago School, 86, 120, 152, 153 Classical model, 17 Collateralized debt obligation, 181 Consumption, 23 Consumption CAPM, 72 Corporate finance, 32, 76, 81, 106, 127, 143, 144 Correlation, 23, 34, 36, 59, 62, 67, 73, 155 Coupon rate c, 168 Covariance, 23, 32, 34, 58, 59, 60, 62, 65, 66, 74, 93 Cowles Commission, 13, 14, 15, 18, 19, 23, 24, 25, 36, 55, 61, 69, 105, 141 Credit default swaps, 5, 129, 130, 160, 161, 181, 185 Debreu, Gerard, 23 Delta, 123, 124 Derivative, 5, 25, 26, 27, 29, 30, 81, 101, 106, 109, 121, 125, 128, 129, 130, 131, 142, 155, 159, 160, 162, 169, 173, 174, 175, 179, 181, 184 Differential equation, 111, 112, 113, 115, 121, 125, 127, 139, 142, 143, 148, 149, 152, 153, 154, 155, 157, 158, 179 Discount rate, 53, 58, 93, 106, 108, 111, 113 Diversification, 23, 32, 59, 66, 67, 76 Dynamic, 5, 14, 67, 68, 71, 114, 124, 143, 144, 145, 146, 147, 148, 149, 150, 151, 152, 153, 179 Econometric, 14, 19, 36, 39, 61, 78, 79, 141, 144, 150, 173 Efficient market hypothesis, 13, 32, 70, 72, 73, 94, 95, 111, 124 Elliptical distribution of return, 69 Equilibrium, 2, 13, 14, 17, 18, 23, 24, 36, 38, 56, 57, 61, 74, 77, 89, 119, 147, 150, 175, 183, 184 European option, 100, 101, 115, 116, 122 Face value F, 96 First moment, 23, 26, 70, 112, 177 Irving, 1 Friedman, Milton, 1 Full information, 14, 71 Fundamentals analysis, 33, 58, 158 193 194 Index Gamma, 124 Hicks, John, 21, 22 Homogenity, 65 Infinite time horizon, 25 Interest rate, 1, 58, 59, 96, 106, 110, 114, 115, 116, 126, 152, 153, 154, 168, 185 Intertemporal CAPM, 71 Intertemporal choice, 1, 69, 71, 75, 124, 125, 143, 150, 184, 186 Keynes, John Maynard, 1 Kurtosis, 121 Life cycle, 1, 76, 125, 143, 144, 149, 150 Life Cycle Model, 1, 125, 144, 150 Markov process, 116, 120, 126 Markowitz, Harry, 23, 63 Markowitz bullet, 63 Marschak, Jacob, 22, 23, 24 Martingale, 105, 120, 121, 185 Mean, 4, 20, 22, 23, 25, 26, 27, 28, 29, 31, 32, 33, 34, 35, 36, 41, 43, 48, 58, 59, 60, 63, 66, 69, 70, 72, 104, 118, 121, 126, 154, 155, 177, 179, 184 MIT School, 141, 142 Modern Portfolio Theory, 2, 3, 4, 19, 23, 24, 34, 41, 43, 44, 46, 48, 56, 57, 61, 64, 68, 69, 72, 73, 74, 76, 89, 95, 125, 177 Modigliani, Franco, 1 Monte Carlo simulation, 122 Mortgage-backed securities, 5 Naked short, 129 Normal distribution of return, 116, 161 Options pricing theory, 5, 32, 68, 71, 72, 77, 109, 111, 113, 115, 116, 120, 124, 180 Ordinal theory, 22 Ordinary least squares, 70 Perfect market, 71, 154 Personal finance, 76, 146, 175, 179 Price/earnings ratio, 58 Put, 100, 122, 123 Quadratic utility function, 26, 70 Ramsey, Frank Plumpton, 1, 24 Random walk, 13, 32, 103, 104, 105, 113, 161 Rational, 21, 23, 37, 38, 58, 66, 70, 151, 156 Regression, 67, 70, 75 Representative agent, 65, 73, 74, 111, 142, 143 Return, 2, 4, 22, 23, 25, 26, 27, 28, 53, 58, 59, 60, 61, 62, 63, 64, 65, 66–7, 68, 70, 79, 88, 92, 93, 104, 111, 112, 113, 114, 115, 118, 121, 122 Rho, 124 Risk aversion, 29, 31, 61, 107, 117 Risk-free asset, 2, 59, 62, 63, 65, 70, 73 Risk-free rate of return, 66, 67, 111, 112, 113, 114, 124, 153 Risk–reward trade-off, 46, 87 Savage, Leonard Jimmie, 23 Second moment, 4, 23, 26, 27, 28, 34, 43, 59, 69, 70, 105, 112, 177 Securities market line, 2, 140, 156 Security, 32–33, 35, 43–4, 57–8, 66–7, 96 St Petersburg Paradox, 20, 102 Static, 1, 5, 13, 68, 71, 143, 149, 152, 153, 179 Steinhaus, Hugo, 102 Stochastic calculus, 105, 120, 143, 157 Stochastic process, 126 Subjective probability, 24 Systematic risk, 2, 67, 70 Taylor’s series, 25, 27, 28 Theta, 124 Transactions cost, 66, 71, 75, 100, 101, 110 Uncertainties, 2, 20, 36, 53, 101 Uncertainty, 1, 2, 4, 15, 16, 19, 20, 21, 22, 23, 24, 25, 27, 29, 35, 36, Index 195 37, 38, 43, 47, 61, 68, 69, 79, 98, 137, 151, 157 Unsystematic risk, 2, 67 Variance, 4, 22, 23, 24, 25, 26, 27, 28, 29, 31, 32, 33, 34, 35, 36, 41, 43, 48, 57, 58, 59, 60, 61, 62, 63, 64, 65, 66, 67, 69, 70, 72, 93, 104, 111, 112, 121, 154, 177, 179, 184 Vega, 99, 124, 184 Volatility, 30, 32, 33, 59, 96, 113, 122, 123, 124, 126, 158, 160 Von Neumann, John, 22, 23 Warrant, 96, 97, 98, 99, 100, 107, 109, 111, 112, 118, 140, 142, 143, 149, 151, 156, 162, 185, 186 Weiner process, 104, 105, 154

A commonly traded type of derivatives contract insures against default of promises to pay. For instance, we may wish to insure against the default of a portfolio of subprime mortgages with an insured value of $50,000,000. The seller of a credit default swap written for $40,000,000 on this $50,000,000 receives the equivalent of a put price as a premium and is obliged to pay the purchaser of the swap the difference, or $10,000,000, if the portfolio value falls to less than $40,000,000. The insurance role for such credit default swaps is obvious. The investor can purchase a policy that limits the downside risk. However, these credit default swaps can also be purchased by an investor who does not own the underlying portfolios. Such a purchase is a speculation on another’s misfortune, but also provides an opportunity for liquidity and more efficient valuations through a very broad insurance market, with low transaction costs and relatively simple contracting.


pages: 309 words: 95,495

Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe by Greg Ip

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Affordable Care Act / Obamacare, Air France Flight 447, air freight, airport security, Asian financial crisis, asset-backed security, bank run, banking crisis, break the buck, Bretton Woods, capital controls, central bank independence, cloud computing, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, Daniel Kahneman / Amos Tversky, diversified portfolio, double helix, endowment effect, Exxon Valdez, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, global supply chain, hindsight bias, Hyman Minsky, Joseph Schumpeter, Kenneth Rogoff, London Whale, Long Term Capital Management, market bubble, money market fund, moral hazard, Myron Scholes, Network effects, new economy, offshore financial centre, paradox of thrift, pets.com, Ponzi scheme, quantitative easing, Ralph Nader, Richard Thaler, risk tolerance, Ronald Reagan, savings glut, technology bubble, The Great Moderation, too big to fail, transaction costs, union organizing, Unsafe at Any Speed, value at risk, William Langewiesche, zero-sum game

The Fed was hardly alone in taking these preparatory measures. Numerous other central banks, and the International Monetary Fund, had been regularly publishing “financial stability reports” to highlight potential crisis threats. All suffered from the same problem: ignorance of the risks then propagating in the shadows of the financial system. The Fed knew that subprime mortgages and more exotic instruments such as collateralized debt obligations and credit default swaps existed, but as one study later found, rarely did any of these seem important enough to be mentioned in monetary policy makers’ regular meetings. So, by 2007, there was widespread awareness that homes were probably overvalued but little concern that this would produce a systemic crisis. Twenty-five years of experience and reform had moved most of the risks out of the banking system, provided new tools such as secured repo loans to contain risks, and slain inflation, the single biggest threat to financial stability anyone alive had ever known.

It was a major player in the subprime frenzy, originating $100 billion in mortgage-backed securities and related collateralized debt obligations in 2006 and 2007. But at the end of 2006 it became nervous and decided to cut its exposure, and in early 2007 it switched to a short position, in other words a position that would go up in value if mortgage-backed securities fell. A few years earlier, Goldman and several other banks spotted a problem in the mortgage market. If you held a big position in stocks, you could protect yourself against a drop with an option or a futures contract. No such instruments existed in subprime mortgages; the only way to protect yourself was to sell them. So in early 2006, Goldman and these other banks teamed up with a company called Markit to create the ABX, a series of indexes that tracked credit default swaps on groups of mortgages. The ABX helped Goldman to shift its position in mortgages.

Nonetheless, the crash taught an important lesson about insurance against financial catastrophes. It works when only a few people buy it; when everyone does, it not only makes the catastrophe more likely, it threatens the survival of the system. This became apparent when, twenty years later, an almost identical problem erupted over the use of another financial innovation: credit default swaps, or CDSs. J.P. Morgan hit upon the idea of the credit default swap in 1994. As Gillian Tett recounts in her book Fool’s Gold, Exxon (now Exxon Mobil) had asked for a $4.8 billion credit line to handle an expected fine for the Exxon Valdez oil spill. This was more than J.P. Morgan was comfortable committing to a single client, but it didn’t want to say no, so it asked the European Bank for Reconstruction and Development to take on the credit risk of the loan in exchange for a fee.


pages: 358 words: 106,729

Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan

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accounting loophole / creative accounting, Andrei Shleifer, Asian financial crisis, asset-backed security, assortative mating, bank run, barriers to entry, Bernie Madoff, Bretton Woods, business climate, Clayton Christensen, clean water, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, diversification, Edward Glaeser, financial innovation, fixed income, floating exchange rates, full employment, global supply chain, Goldman Sachs: Vampire Squid, illegal immigration, implied volatility, income inequality, index fund, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, knowledge worker, labor-force participation, Long Term Capital Management, market bubble, Martin Wolf, medical malpractice, microcredit, money market fund, moral hazard, new economy, Northern Rock, offshore financial centre, open economy, price stability, profit motive, Real Time Gross Settlement, Richard Florida, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, school vouchers, short selling, sovereign wealth fund, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, upwardly mobile, Vanguard fund, women in the workforce, World Values Survey

But even while the dullards ascended to the top positions at the banks, Wall Street became a more exciting and challenging place, paying people beyond their wildest dreams. It started attracting and recruiting the smartest students in class, people who thought they could price CDO squared and CDO cubed (particularly egregious forms of securitization involving collateralized debt obligations) and manage their risks. As Trillin writes: “When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.”11 The suggestion that bosses, recruited in a staid and regulated era, were of lower caliber than the employees they had recruited from the top of the class in a deregulated and high-paying era is not completely without foundation.

The right approach would be to reduce the various distortions to the pricing of risk that stem from actual and potential government intervention, as well as from herd behavior. We should not worry so much about rugged individualism as about undifferentiated groupthink, for that is the primary source of systemic problems. A competitive system is also likely to produce the financial innovation necessary to broaden access and spread risk. Financial innovation nowadays seems to be synonymous with credit-default swaps and collateralized debt obligations, derivative securities that few outside Wall Street now think should have been invented. But innovation also gave us the money-market account, the credit card, interest-rate swaps, indexed funds, and exchange-traded funds, all of which have proved very useful. So, as with many things, financial innovations span the range from the good to the positively dangerous. Some have proposed a total ban on offering a financial product unless it has been vetted, much as the Food and Drug Administration vets new drugs.

See collateralized debt obligations central banks: Chinese of developing countries objectives of purchases of dollar assets regulatory responsibilities of resources for managing crises See also Federal Reserve; interest rates; monetary policy chaebols Chanos, James charitable giving charter schools children: Chinese one-child policy development of health and nutrition of, See also education Chile, economic growth of China: consumption in economic growth of energy consumption in exchange-rate intervention by export-led growth strategy of exports of foreign reserves of interest rates in investment in middle class in one-child policy of reforms in savings in state-owned enterprises in Chrysler Citigroup: board members of CEO of off–balance sheet assets of risk managers of risks taken by salaries in stock price of climate change Clinton, Bill Clinton administration CLOs. See collateralized loan obligations cognitive capture Cole, Shawn collateralized debt obligations (CDOs) collateralized loan obligations (CLOs) colleges. See higher education Community Reinvestment Act (CRA) conglomerates consumption: in China in developing countries discouragement of of energy excess in Japan of middle class political pressure for economic stimulus to in United States contingent capital corruption CRA. See Community Reinvestment Act credit: benefits and costs of easy definition of democratization of credit card debt credit default swaps credit markets: access to in developing countries expansion of government intervention in informal microcredit political pressure for easy credit See also subprime mortgage market credit ratings, of mortgage-backed securities crises.


pages: 297 words: 91,141

Market Sense and Nonsense by Jack D. Schwager

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3Com Palm IPO, asset allocation, Bernie Madoff, Brownian motion, collateralized debt obligation, commodity trading advisor, computerized trading, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index arbitrage, index fund, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, negative equity, pattern recognition, performance metric, pets.com, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, Sharpe ratio, short selling, statistical arbitrage, statistical model, survivorship bias, transaction costs, two-sided market, value at risk, yield curve

Fixed income arbitrage normally requires the use of substantial leverage because the relative price aberrations it seeks to exploit tend to be small. Therefore, although the magnitude of potential adverse price moves in fixed income arbitrage trades is normally small, the fact that these trades tend to be heavily leveraged can lead to occasional large losses. Credit arbitrage. This strategy can involve long and short positions in all types of credit instruments (e.g., corporate bonds, bank loans, credit default swaps, collateralized debt obligations). In its most basic form, the strategy is the credit counterpart of an equity hedge strategy: The manager will buy corporate bonds whose prices are expected to rise (rates expected to fall) and sell corporate bonds whose prices are considered vulnerable, with a net long bias being typical. As is the case of equity hedge funds, the net exposure held by credit arbitrage managers can vary widely.

Index Adjustable-rate mortgages (ARMs) Allocation bias Allocation decisions, future AMEX Internet Index Arbitrage Arbitrary investment rules ARM subprime mortgages Asness, Clifford Automatic selling Automatic trading Average maximum retracement (AMR) Average pair correlation Average return Back-adjusted return measures gain-to-pain ratio (GPR) MAR and Calmar ratios return retracement ratio (RRR) risk-adjusted return performance measures Sharpe ratio Sortino ratio strategy comparison symmetric downside-risk (SDR) Sharpe ratio tail ratio Backfilling bias Backwardation Bankrupt stocks Bear market of 2008 Bear market returns Bear markets vulnerability Behavioral biases Bernanke, Ben Best strategy risk for standard deviation Beta and correlation quantitative measures Black Monday (October 19, 1987) Black Tuesday (October 29, 1920) Bottoms-up allocation Brady commission Bubbles and crashes emotion-driven housing (mid-2000s) Internet market price tech timing and level Bubbles and crashes Bull market Bull market of 2009 Burn rate Calls Calmar ratio and MAR ratio Capital gains Capital losses Capital structure arbitrage Carve-out portfolio Catastrophe insurance Cause-and-effect relationship Church, George J. Clarity Portfolio Viewer Closet benchmarker Closet index fund CNBC Coincident negative return (CNR) matrix Collateralized debt obligations (CDOs) vs. commercial paper Commercial paper, vs. collateralized debt obligations (CDOs) Commodity Futures Trading Commission (CFTC) Commodity prices Commodity trading advisors (CTAs) Comparison pitfalls markets strategy style time period Conservative investment Contango Contrarian indicator Convergence strategies Convertible arbitrage Convertible bond prices Correlation among managers and beta beyond coefficient of determination definition down months focus linear relationships to managers misconceptions about plus beta within portfolios spurious Correlation assumptions Correlation coefficient Correlation matrix Correlations going to one event Costs Countertrend strategies Countrywide Cramer, Jim Credit arbitrage Credit default swaps Credit hedge funds Credit quality Credit rating agencies Credit risk Credit spreads Critical financial applications CTA approaches The Daily Show Data relevance Default risk Deficient market hypothesis.

Given the extremely poor quality of the subprime mortgages that were the building blocks of these bonds (adjustable rates, no verification, etc.), these securities were extraordinarily vulnerable to any downturn in the housing market. So surely at the first sign of trouble in the housing market subprime bond prices should have fallen sharply below par. Figure 2.9 shows the prices of the ABX-HE-AAA index, an index of credit default swaps tied to 20 subprime-loan bonds rated AAA. (Credit default swaps are derivatives that mirror the risk premiums of the reference bonds.) Note that prices remained near par until early July 2007 when they went over a cliff. Figure 2.9 ABX-HE-AAA 07-1 Index, January to August 2007 Source: Markit.com. Did the real estate market suddenly worsen in early summer 2007, as one might infer from this price chart? Figure 2.10 shows that subprime delinquencies actually reached multiyear highs a year earlier and continued to climb steadily higher.


pages: 261 words: 64,977

Pity the Billionaire: The Unexpected Resurgence of the American Right by Thomas Frank

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Affordable Care Act / Obamacare, bank run, big-box store, bonus culture, collateralized debt obligation, collective bargaining, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Deng Xiaoping, financial innovation, housing crisis, invisible hand, money market fund, Naomi Klein, obamacare, payday loans, profit maximization, profit motive, road to serfdom, Robert Bork, Ronald Reagan, shareholder value, strikebreaker, The Chicago School, The Myth of the Rational Market, Thorstein Veblen, too big to fail, union organizing, Washington Consensus, white flight, Works Progress Administration

One testament to the zesty innovativeness of markets was the industry that had sprung up to supply credit to “subprime” borrowers, selling off the loans thus made to the investment banking industry on Wall Street. Then there were the geniuses at the next few steps of the process, who bundled those subprime mortgages into bonds and those bonds into collateralized debt obligations—and then sold credit default swaps to insure against the possibility of their failure.2 The gospel of deregulation, meanwhile, had become such an irresistible ideological juggernaut that no amount of real-world failure could call it into question. Under the guidance of this doctrine, our leaders removed certain derivatives from regulatory oversight; they watered down requirements that banks balance their risk with safe assets; they exempted credit default swaps from regulation as insurance products; they dialed back the Federal Reserve’s regulatory powers; and they struck down a rule that required hedge-fund advisers to register with the Securities and Exchange Commission.

See also free market Atlas Shrugged and crisis of 2008–9 and Depression and Right’s defense of utopian Capitalism (Beck) Capra, Frank Carender, Keli Carnegie, Dale Cato Institute Cheney, Dick Chicago, University of Chicago Board of Trade children’s literature Chile Chomsky, Noam Chrysler Churchill, Winston CIA Citibank Cleaver, Emanuel Clinton, Bill Clinton, Hillary Cloward, Richard CNBC coal miners Code Red rally Codevilla, Angelo collateralized debt obligations colleges and universities Commodity Futures Modernization Act communism Community Reinvestment Act (1977) compromise Conservative Action Project ConservativeHQ (website) Conservative Political Action Conference conservatives. See Right-wing revival construction industry consumer advocates Consumer Product Safety Commission Consumer Product Safety Improvement Act (2008) Continetti, Matthew Contract from America (2009–10) Contract with America (1994) Coolidge, Calvin Coughlin, Father Charles Council of Economic Advisers Cowley, Malcolm CPAC credit-card rules credit default swaps Crimes Against Liberty (Limbaugh) Crist, Don cronyism Culture of Corruption (Malkin) culture wars Daily Worker Daley, Bill Daschle, Tom “death panels” debt-ceiling debate debt securitization Declaration of Independence Dedication and Leadership (Hyde) deficit spending DeLay, Tom DeMint, Jim democracy Democratic Party bailouts and banks and Beck vs.

And although nearly everything in high finance is related to everything else, Fannie and Freddie are not the same as AIG, which is an insurance company that acted like a hedge fund, investing in mortgage-related securities and issuing credit default swaps. These were the businesses that got AIG into trouble. It is true that AIG owned a subsidiary that originated subprime mortgages—all the Wall Street playaz did—but to my knowledge no one has ever thought to blame AIG’s travails on that subsidiary. Government regulations, for their part, never required anyone to make risky mortgage loans and they certainly never forced anyone to invest in securities based on risky mortgage loans. The credit-default-swaps business was almost completely unregulated. * One of the photos of himself that Beck includes in his first book, The Real America, shows the right-wing showman directing a radio drama while striking virtually the same pose as Welles in one of the photos taken of the latter during his Mars-invasion broadcast

Global Financial Crisis by Noah Berlatsky

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accounting loophole / creative accounting, asset-backed security, banking crisis, Bretton Woods, capital controls, Celtic Tiger, centre right, circulation of elites, collapse of Lehman Brothers, collateralized debt obligation, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, deindustrialization, Doha Development Round, energy security, eurozone crisis, financial innovation, Food sovereignty, George Akerlof, God and Mammon, Gordon Gekko, housing crisis, illegal immigration, income inequality, market bubble, market fundamentalism, mass immigration, moral hazard, new economy, Northern Rock, purchasing power parity, quantitative easing, race to the bottom, regulatory arbitrage, reserve currency, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, South China Sea, structural adjustment programs, too big to fail, trade liberalization, transfer pricing, working poor

., 18, 24, 144, 147 migrant workers, 110, 116, 130 must join with U.S. to control crisis, 65–71 stimulus packages, 19, 135, 140, 141–142, 144–145 trade with Africa, 195 trade with U.S., 65, 66, 70–71, 144, 147 unrest, 19, 25, 108–120, 139– 140 Clearinghouse regulations, 49–50 Climate change policy, 26, 163 Collateralized debt obligations (CDOs), 50, 88 Colombia, 161–162, 180, 182, 183, 184 Common Cause, 205–206 Communist Party, China, 110, 114–116, 139–140 Comparative advantage, 192–193 Competitiveness, financial, 48–49 Congress business subsidies, 202, 203, 204, 205–206 hearings, 175 predatory lending, 206 protectionism and trade agreements, 181, 182, 184 Construction industry, 34, 130, 131, 133 Consumer confidence, 63, 91, 100, 208, 213, 216 Corporate welfare, 201, 202–206 See also Bailouts Cox, Pamela, 158–159 Credit default swaps (CDSs), 17, 28, 29, 50, 175–176, 215 Credit derivatives. See Derivatives Credit markets bubble/freezes, 34–35, 208, 211, 212 securitization’s effects, 56, 82, 89–90 Credit ratings, national, 94, 95, 100 Credit risks, 17, 28 See also Derivatives Currency instability, 59–64, 103, 106, 118 Czech Republic, 99 D Daremblum, Jaime, 180–185 Darling, Alistair, 113, 222 David Rockefeller Center for Latin American Studies, 158 Davos, Switzerland World Economic Forum, 2009, 22–26, 113 Debt relief, 193, 198–199 Defaults, mortgages, 34 Deflation Europe, 97–98, 99 Federal Reserve avoidance measures, 41 Japan, 209, 215 Dembele, Demba Moussa, 186– 200 Denmark, 95 Dennis, Felix, 60 251 The Global Financial Crisis Deposit insurance, 150, 154, 208– 209, 213, 214, 229 Deposit Insurance Corporation of Japan, 208–209, 210, 218 Deposits.

Based on this theory, banks repackaged and sold these mortgages as investments, or mortgagebased securities. Thus, an investor could buy a bunch of mortgages (or a small piece of a bunch of mortgages) which were guaranteed to pay back a certain return. The banks were so sure that these mortgage-based securities would always pay that they even sold insurance on the investments. These insurance contracts were called credit default swaps. A credit default swap (CDS) means an investor in mortgage-based securities would pay a certain amount of money to the bank on a regular basis as long as the securities made money. If the securities ever stopped making money, though, the bank would have to pay the investor a large sum. CDSs were very popular because they made investors feel safer, and banks were certain they would never have to pay on them; investments would never default because housing prices would go up forever, or so they believed.

Nevertheless, many commentators argue that significant risks remain for property prices in Australia. The US Banking Crisis Hurt Australia When it came to the second phase of the crisis, Australia was not so lucky. Many investors held securities with direct exposure to the ailing US subprime mortgage-backed market. Two prominent casualties were high-yield funds managed by Basis Capital and Absolute Capital. Mortgage-backed securities that had been repackaged in the form of collateralized debt obligations (CDOs) had also been widely distributed to so-called middle market investors: local councils, universities, schools and hospitals. Non-bank mortgage lender RAMS also found itself in trouble. RAMS was heavily reliant on short-term funding, much of which it sourced from US investors who 88 Effects of the Global Financial Crisis on Wealthier Nations Australia’s Foreign Debt, 1998–2007 net foreign debt (% GDP) 70% 60% 50% 40% 30% 20% 10% -0 7 Ju n -0 6 Ju n -0 5 Ju n -0 4 Ju n -0 3 Ju n -0 2 Ju n -0 1 Ju n -0 0 Ju n -9 9 Ju n Ju n -9 8 0% TAKEN FROM: Sean Carmody, “Australia and the Global Financial Crisis,” A Stubborn Mule’s Perspective, October 25, 2008. www.stubbornmule.net.


pages: 397 words: 112,034

What's Next?: Unconventional Wisdom on the Future of the World Economy by David Hale, Lyric Hughes Hale

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affirmative action, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Berlin Wall, Black Swan, Bretton Woods, capital controls, Cass Sunstein, central bank independence, cognitive bias, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate social responsibility, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, debt deflation, declining real wages, deindustrialization, diversification, energy security, Erik Brynjolfsson, Fall of the Berlin Wall, financial innovation, floating exchange rates, full employment, Gini coefficient, global reserve currency, global village, high net worth, Home mortgage interest deduction, housing crisis, index fund, inflation targeting, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Just-in-time delivery, Kenneth Rogoff, labour market flexibility, labour mobility, Long Term Capital Management, Mahatma Gandhi, Martin Wolf, Mexican peso crisis / tequila crisis, Mikhail Gorbachev, money market fund, money: store of value / unit of account / medium of exchange, mortgage tax deduction, Network effects, new economy, Nicholas Carr, oil shale / tar sands, oil shock, open economy, passive investing, payday loans, peak oil, Ponzi scheme, post-oil, price stability, private sector deleveraging, purchasing power parity, quantitative easing, race to the bottom, regulatory arbitrage, rent-seeking, reserve currency, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, sovereign wealth fund, special drawing rights, technology bubble, The Great Moderation, Thomas Kuhn: the structure of scientific revolutions, Tobin tax, too big to fail, total factor productivity, trade liberalization, Washington Consensus, Westphalian system, women in the workforce, yield curve

These include: • Developing Country Debt Crisis (1983) • US Savings and Loan Crisis (1980s) • Resolution Trust Company, which created REITS (Real Estate Investment Trusts) (late 1980s) • The 1988 Basel Capital Accord (1988) • The beginning of derivatives (early 1990s) • Proliferation of derivatives and Special Purpose Entities (SPEs) (1990s) • Asian Financial Crisis (1997–1998) • Collapse of Long-Term Capital Management (LTCM) (1998) • The repeal of Glass-Steagall (1999) and the adoption of Gramm-Leach-Bliley Financial Modernization Act (GLBA) (1998) • The failure of dot-coms (2000) Causes of the Global Financial Crisis after SOX and Prior to September 18, 2008 It is also important to understand the events and economic climate after the July 31, 2002, passage of SOX and prior to September 18, 2008. These events include: • The increasing complexity of derivative products, including CDSs (Credit Default Swaps) and CDOs (Collateralized Debt Obligations)4 • The ascendancy of rating agencies • Alt-A subprime lending • Basel II (2005–2006) • The subprime housing crisis in the United States, including the rise of “NINJA” (no income, no jobs, no assets) financing • The rise of hedge funds • The oil crisis (2008) • The collapse of Bear Stearns, Fannie Mae, Freddie Mac, and Lehman Brothers (2008) Understanding the causes of the global financial crisis will go hand in hand with regulatory reform and increasing targeted global compliance and ethics programs.5 Why SOX Failed SOX was supposed to remedy the financial improprieties and excesses that existed prior to July 31, 2002.

These events include: • The increasing complexity of derivative products, including CDSs (Credit Default Swaps) and CDOs (Collateralized Debt Obligations)4 • The ascendancy of rating agencies • Alt-A subprime lending • Basel II (2005–2006) • The subprime housing crisis in the United States, including the rise of “NINJA” (no income, no jobs, no assets) financing • The rise of hedge funds • The oil crisis (2008) • The collapse of Bear Stearns, Fannie Mae, Freddie Mac, and Lehman Brothers (2008) Understanding the causes of the global financial crisis will go hand in hand with regulatory reform and increasing targeted global compliance and ethics programs.5 Why SOX Failed SOX was supposed to remedy the financial improprieties and excesses that existed prior to July 31, 2002. The debacles of WorldCom, Enron, Adelphia, and Tyco were only the last in a long series of financial abuses. Further, after SOX, despite the subprime mortgage crisis in the United States, rating services failed to calculate the risk of credit default swaps (CDSs), collateralized debt obligations (CDOs), and other financial abuses. Until September 18, 2008, there was no general sense that SOX had not alleviated the possibility of a global financial meltdown, or at least a US financial meltdown. No one seemed to question SOX’s ability to create greater transparency and integrity in the US financial market. However, SOX ultimately failed to deliver the kind of protection its framers anticipated.

., 36 buy America provisions, 24–25 Calderón, Felipe, 37–39 Canada, aging population of, 25–26; banking system in, 15–16; consumer debt in, 18–19; corporate sector in, 20; economic recovery in, xvii–xviii, 14–15; economy of, 12–28; employment in, 17–18; environmental policies, 27–28; fiscal deficit of, 257; fiscal situation in, 21–22; foreign investment in, 26–27; household sector in, 17–20; long-term issues and challenges for, 25–28; monetary policy, 22–23; productivity in, 26; real estate market in, 16–17, 19–20; risks facing, 23–25; tax policy, 20, 26; US and, 13–14, 24 Canada Mortgage and Housing Corporation (CMHC), 17 Canadian dollar, 23 cap-and-trade system, xxvi, 5 capital flows, 7–8 capital requirements, 233–235, 237–238, 241–244, 246–248 capital spending, 259 carbon emissions, xxvi–xxvii, 5, 219, 227. See also climate change career risk, 289 Carr, Nicholas, xxix, 292–293 CDOs. See collateralized debt obligations (CDOs) CDSs. See credit default swaps (CDSs) Central Africa, 126 central banks, Asia, 82–83; asset buying by, 81; demand for gold by, 169–170, 174–175; money supply and, 246–248; selling public debt to, 259 Chile, 8, 33, 48, 49, 51 China, xv, xx; Australian exports to, 145–146; climate change and, xxvi, 225; consumption in, 89–90; currency intervention by, 10; economic growth in, 10, 52; economy of, xxiii, 24; equity markets, 83–84, 85; excess of thrift in, 88–89; as financial capital, 245–246; financial sector in, xxvii; fiscal deficit, 257; gold market in, 170–171; gold reserves, xxv, 168–169, 170, 174; household incomes in, 89; influence of, in Africa, 122–123; labor costs in, 86–87, 89–90; monetary policy, 10; savings rate in, 245–246; structural shift in, 84–85 Citigroup, 272 Clean Development Mechanism (CDM), 225 climate change, adaptation to, 227–229; Canada and, xviii, 27–28; future outcomes for, 224–225; international agreements on, 220–223; oil industry and, xxv, 189–191; public policy and, xxvi–xxvii, 219–230; South Africa and, xxii coal, 125 Coates, John, 290 cognitive abilities, 293–294 cognitive biases, 287, 288–289 collateralized debt obligations (CDOs), 275 Colombia, 33, 48, 49 commodity prices, xv, xxii, 50, 52–54, 117, 195 Common Market for Eastern and Southern Africa (COMESA), 122 compensation plans, 277 composite currencies, 161–163 Conference of the Parties to the Convention (COP), 222 confirmatory evidence, 288 conflicts, in Sub-Saharan Africa, 123–124 Congdon, Tim, xxvii Constitutionalist Revolution (1906), 206 consumer debt, 18–19 Consumer Protection Financial Bureau, 267, 269 consumer spending, 8, 18 consumption-based taxes, 261–263 Copenhagen Accord, 222, 225 Cordero, Ernesto, 45 corporate compliance, xxviii–xxix, 271–282 corporate governance, 267, 268 corporate profits, 8 corporate sector: Canada, 20; US, xvi, 4, 8 corporate taxes, 260 cortisol, 290 Costa Rica, 48 Côte D’Ivoire, 127 credit default swaps (CDSs), 275 creditor status, 156 Creel, Santiago, 37, 45 crime, in Mexico, 43 culture of ethics, 276–280 currencies: African, 122; composite, 161–163; domestic, 155; international, 155–156; synthetic, 161–163.


pages: 726 words: 172,988

The Bankers' New Clothes: What's Wrong With Banking and What to Do About It by Anat Admati, Martin Hellwig

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Andrei Shleifer, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bonus culture, break the buck, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, diversified portfolio, en.wikipedia.org, Exxon Valdez, financial deregulation, financial innovation, financial intermediation, fixed income, George Akerlof, Growth in a Time of Debt, income inequality, invisible hand, Jean Tirole, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, Larry Wall, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, margin call, Martin Wolf, money market fund, moral hazard, mortgage debt, mortgage tax deduction, negative equity, Nick Leeson, Northern Rock, open economy, peer-to-peer lending, regulatory arbitrage, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Satyajit Das, shareholder value, sovereign wealth fund, technology bubble, The Market for Lemons, the payments system, too big to fail, Upton Sinclair, Yogi Berra

The chapter epigraph, from Lewis (2010, 72), refers to the enormous risk that insurance company AIG had taken by selling so-called credit default swaps (CDSs), insurance contracts that pay in the event of default, for a total value of close to $500 billion. AIG greatly underestimated the possibility that many defaults might occur at the same time. We discuss this issue later in this chapter and in Chapter 11. 2. For the distinction between subprime and other mortgages, see note 43 in Chapter 4. We use the term mortgage-related securities for a broad class of securities containing not only mortgage-backed securities (MBS) but also securities resulting from the securitization of MBS. MBS themselves might serve as collateral for collateralized debt obligations (CDOs) (see, for example, Das 2010, Chapter 9). The idea and the procedure are the same as those for the creation of a mortgage-backed security out of a package of mortgages except that the collateral consists of MBS or more general asset-backed securities (ABS) rather than mortgages.

See payouts cash reserve (reserve requirements): in balance sheets, 48; capital confused with, 6–7, 97–98, 234n23, 274n61, 275n2; versus capital requirements, costs and benefits of, 98; central banks funded by issuing, 272n41; costs of, to banks, 92; definition of, 6, 92, 97; interest on, 92, 271n41; international differences in, 272n41; liquidity coverage ratio and, 92; minimum requirements for, 272n41 CBO. See Congressional Budget Office CDOs. See collateralized debt obligations CDSs. See credit default swaps Cecchetti, Stephen G., 257n17 Center for Responsive Politics, 229n4, 326n60 central banks: banknotes issued by, 150, 151, 294n15; collateral accepted by, 157, 297n36, 297n39; as funding source for governments, 157–58, 200; implicit subsidies provided by, through bank borrowing, 137–38; and inflation, 157–58; interest rates paid by, 200, 297n37; as “lenders of last resort,” 63, 93, 297n35, 318n2; limitations on activities of, 157–58, 297n39, 318n2; liquidity injections by, 39–40, 63, 179, 256n13; in monetary policy, 298n39; money of, 151, 295n16; and public budget, 157; reserve requirements in funding of, 272n41; response to financial crisis of 2007-2009, 63, 137, 256n13; and sovereign debt, ban on funding, 298n39; and sovereign debt, European, 170, 302n4.

At each stage, a package of junior (“mezzanine”) claims, with low credit ratings of BBB or worse, would be formed, and new claims, with different priorities, would be issued against the returns from this package. Under the assumption that credit risks on the different securities in a package of mezzanine mortgage-backed securities (MBS) were independent, the senior MBS collateralized debt obligations (CDOs) would be treated as almost riskless and given ratings of AAA. However, the assumption of independence of credit risks was unwarranted because all of the underlying mortgages depended on the factors driving U.S. real estate markets, such as the overall economy, the interest rate policy of the Federal Reserve, and the real estate bubble itself. McLean and Nocera (2010, 362) sarcastically ask: “Collateralized debt obligation? Synthetic securities? What had been the point of that?” The point was that banks responded to flawed regulations in their own interest; their actions had little to do with efficiency. 72.


Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

Albert Einstein, Alfred Russel Wallace, algorithmic trading, Andrei Shleifer, Arthur Eddington, Asian financial crisis, asset allocation, asset-backed security, backtesting, bank run, barriers to entry, Berlin Wall, Bernie Madoff, bitcoin, Bonfire of the Vanities, bonus culture, break the buck, Brownian motion, business process, butterfly effect, capital asset pricing model, Captain Sullenberger Hudson, Carmen Reinhart, Chance favours the prepared mind, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Daniel Kahneman / Amos Tversky, delayed gratification, Diane Coyle, diversification, diversified portfolio, double helix, easy for humans, difficult for computers, Ernest Rutherford, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, Fractional reserve banking, framing effect, Gordon Gekko, greed is good, Hans Rosling, Henri Poincaré, high net worth, housing crisis, incomplete markets, index fund, interest rate derivative, invention of the telegraph, Isaac Newton, James Watt: steam engine, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, Joseph Schumpeter, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Pasteur, mandelbrot fractal, margin call, Mark Zuckerberg, market fundamentalism, martingale, merger arbitrage, meta analysis, meta-analysis, Milgram experiment, money market fund, moral hazard, Myron Scholes, Nick Leeson, old-boy network, out of africa, p-value, paper trading, passive investing, Paul Lévy, Paul Samuelson, Ponzi scheme, predatory finance, prediction markets, price discovery process, profit maximization, profit motive, quantitative hedge fund, quantitative trading / quantitative finance, RAND corporation, random walk, randomized controlled trial, Renaissance Technologies, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, Robert Shiller, Robert Shiller, short selling, sovereign wealth fund, statistical arbitrage, Steven Pinker, stochastic process, survivorship bias, The Great Moderation, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, theory of mind, Thomas Malthus, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, Triangle Shirtwaist Factory, ultimatum game, Upton Sinclair, US Airways Flight 1549, Walter Mischel, Watson beat the top human players on Jeopardy!, WikiLeaks, Yogi Berra, zero-sum game

Let’s follow the dominos as they fell. First, the risk-taking mortgage lenders went bankrupt. Their mortgages had already been incorporated into mortgage-backed securities and collateralized debt obligations, now held in large portfolios across the world. These securities were down-rated. Not only did they lose their value, they became very difficult to sell, and their illiquidity made it hard to value them. Securities that were once considered darlings of the fixed-income industry were now called “toxic assets.” 300 • Chapter 9 The companies that insured these securities through credit default swaps now found themselves obliged to pay out. But because credit default swaps weren’t regulated like insurance contracts, insurers like Ambac, MBIA, and AIG weren’t required to maintain sufficient capital to cover potential claims.

At current interest rates, more than $27 billion can be financed by issuing long-term A-rated bonds.14 And if we use all the other tools of financial engineering—securitization, collateralized debt obligations, credit default swaps, and other types of derivative securities—we can do even better. At this point, you’re probably wondering whether this is really a good idea. After all, didn’t we encounter these very same financial innovations in chapter 10, when we were reviewing the recent financial crisis? I have to admit that it was studying the financial crisis that motivated my thinking along these lines. The financial crisis didn’t happen because these techniques didn’t work; it happened because they worked all too well. There is an element of truth to Warren Buffett’s characterization of these techniques as “financial weapons of mass destruction.” Securitization, credit default swaps, and other derivative securities are the financial equivalent of Einstein’s E = mc2.

During this time, there was an enormous amount of financial evolution at the speed of thought. There was an adaptive radiation of new mortgage types: adjustable-rate mortgages, “pick-a-payment” mortgages, and even the infamous NINJA loan (“No Income, No Job, no Assets”), evaluated and approved by automated loan-review programs. At the same time, investment banks issued collateralized debt obligations, which enabled large pools of mortgages to be packaged and chopped up into a variety of new securities, and sold with the blessings of the rating agencies. Ultimately, the credit default swap market emerged, in order to provide insurance on some of those new debt issues, which encouraged even more investors to participate in the markets. This process expanded the mortgage ecosystem’s size and reach. In 1996, $480 billion in mortgage-related securities were issued in the United States, including mortgage‐backed securities and collateralized mortgage obligations.


pages: 305 words: 69,216

A Failure of Capitalism: The Crisis of '08 and the Descent Into Depression by Richard A. Posner

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Andrei Shleifer, banking crisis, Bernie Madoff, collateralized debt obligation, collective bargaining, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, diversified portfolio, equity premium, financial deregulation, financial intermediation, Home mortgage interest deduction, illegal immigration, laissez-faire capitalism, Long Term Capital Management, market bubble, money market fund, moral hazard, mortgage debt, Myron Scholes, oil shock, Ponzi scheme, price stability, profit maximization, race to the bottom, reserve currency, risk tolerance, risk/return, Robert Shiller, Robert Shiller, savings glut, shareholder value, short selling, statistical model, too big to fail, transaction costs, very high income

But I have acknowledged that there are political problems with pricking asset-price bubbles, and the Federal Reserve cannot maintain its political independence if it ruffles too many political feathers. Not enough economists noticed (or at least remarked) the relation between executive compensation practices and risky lending, or appreciated the riskiness of mortgage-backed securities, other collateralized-debt obligations, and credit-default swaps, or connected the decline in personal savings to the danger that such lending posed to the economy. Not enough seem to have realized that the crisis of the banking industry, when it hit, was a crisis not of (or at least not mainly of) illiquidiry but of insolvency. Not only were warning signs ignored until too late, but when the economics profession finally woke up we learned that neither government economists like Bernanke nor private economists had prepared any contingency plans for dealing with a depression.

But they also could, and many did, buy a form of insurance, issued in great quantity by, among many other firms, the American International Group, against declines in the value of mortgage-backed securities, as well as of other investments. This form of insurance, called "credit-default swaps," had originally been intended as insurance against bond defaults, of which there was a long history on the basis of which premiums could be computed with reasonable confidence. But AIG and other financial firms (not limited to insurance companies and commercial banks, the traditional issuers of credit insurance, such as conventional mortgage insurance, as distinct from insurance of securitized debt) began issuing credit-default swaps to insure against losses in the value of mortgage-backed securities, which lacked such a history. One beauty of swaps was that they reduced the amount of collateral that a lender needed in order to protect itself from the consequence of the borrower's default.

Because the banking industry was highly leveraged, and because much of its capital consisted of securities that were very difficult to value, the bursting of the housing bubble shrank the banks' capital —but by an unknown amount because of the valuation problem. The banks didn't know how meager their equity cushion had become and therefore how much they could lend without incurring a high risk of bankruptcy, since as we know lending is increasingly risky the more leverage the lender has in its capital structure. A further complication was that banks that had bought the insurance side of credit-default swaps did not know their exposure. When Lehman Brothers collapsed, issuers of credit-default swaps all over the world were on the hook because Lehman had purchased many swaps. It had issued many swaps as well, and its equity, devoured by the collapse of the mortgagebacked securities, which it had held in great quantity, was insufficient to enable it to pay the debts that it had insured. Suppose bank A had insured Lehman against a loss of $X, and bank B was insured by Lehman against a loss of $X.


pages: 471 words: 124,585

The Ascent of Money: A Financial History of the World by Niall Ferguson

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Admiral Zheng, Andrei Shleifer, Asian financial crisis, asset allocation, asset-backed security, Atahualpa, bank run, banking crisis, banks create money, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, BRICs, British Empire, capital asset pricing model, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, collateralized debt obligation, colonial exploitation, commoditize, Corn Laws, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, deglobalization, diversification, diversified portfolio, double entry bookkeeping, Edmond Halley, Edward Glaeser, Edward Lloyd's coffeehouse, financial innovation, financial intermediation, fixed income, floating exchange rates, Fractional reserve banking, Francisco Pizarro, full employment, German hyperinflation, Hernando de Soto, high net worth, hindsight bias, Home mortgage interest deduction, Hyman Minsky, income inequality, information asymmetry, interest rate swap, Intergovernmental Panel on Climate Change (IPCC), Isaac Newton, iterative process, John Meriwether, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, knowledge economy, labour mobility, Landlord’s Game, liberal capitalism, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, means of production, Mikhail Gorbachev, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, Naomi Klein, negative equity, Nick Leeson, Northern Rock, Parag Khanna, pension reform, price anchoring, price stability, principal–agent problem, probability theory / Blaise Pascal / Pierre de Fermat, profit motive, quantitative hedge fund, RAND corporation, random walk, rent control, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, seigniorage, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spice trade, structural adjustment programs, technology bubble, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Bayes, Thomas Malthus, Thorstein Veblen, too big to fail, transaction costs, value at risk, Washington Consensus, Yom Kippur War

In 2006, for example, the volume of leveraged buyouts (takeovers of firms financed by borrowing) surged to $753 billion. An explosion of ‘securitization’, whereby individual debts like mortgages are ‘tranched’ then bundled together and repackaged for sale, pushed the total annual issuance of mortgage backed securities, asset-backed securities and collateralized debt obligations above $3 trillion. The volume of derivatives - contracts derived from securities, such as interest rate swaps or credit default swaps (CDS) - has grown even faster, so that by the end of 2007 the notional value of all ‘over-the-counter’ derivatives (excluding those traded on public exchanges) was just under $600 trillion. Before the 1980s, such things were virtually unknown. New institutions, too, have proliferated. The first hedge fund was set up in the 1940s and, as recently as 1990, there were just 610 of them, with $38 billion under management.

The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a spasm in the credit markets caused by mounting defaults on a species of debt known euphemistically as subprime mortgages. So intricate has our global financial system become, that relatively poor families in states from Alabama to Wisconsin had been able to buy or remortgage their homes with often complex loans that (unbeknown to them) were then bundled together with other, similar loans, repackaged as collateralized debt obligations (CDOs) and sold by banks in New York and London to (among others) German regional banks and Norwegian municipal authorities, who thereby became the effective mortgage lenders. These CDOs had been so sliced and diced that it was possible to claim that a tier of the interest payments from the original borrowers was as dependable a stream of income as the interest on a ten-year US Treasury bond, and therefore worthy of a coveted triple-A rating.

Instead of putting their own money at risk, they pocketed fat commissions on signature of the original loan contracts and then resold their loans in bulk to Wall Street banks. The banks, in turn, bundled the loans into high-yielding residential mortgage-backed securities (RMBS) and sold them on to investors around the world, all eager for a few hundredths of a percentage point more return on their capital. Repackaged as collateralized debt obligations (CDOs), these subprime securities could be transformed from risky loans to flaky borrowers into triple-A rated investment-grade securities. All that was required was certification from one of the two dominant rating agencies, Moody’s or Standard & Poor’s, that at least the top tier of these securities was unlikely to go into default. The lower ‘mezzanine’ and ‘equity’ tiers were admittedly more risky; then again, they paid higher interest rates.


pages: 348 words: 99,383

The Financial Crisis and the Free Market Cure: Why Pure Capitalism Is the World Economy's Only Hope by John A. Allison

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Affordable Care Act / Obamacare, bank run, banking crisis, Bernie Madoff, clean water, collateralized debt obligation, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, fiat currency, financial innovation, Fractional reserve banking, full employment, high net worth, housing crisis, invisible hand, life extension, low skilled workers, market bubble, market clearing, minimum wage unemployment, money market fund, moral hazard, negative equity, obamacare, Paul Samuelson, price mechanism, price stability, profit maximization, quantitative easing, race to the bottom, reserve currency, risk/return, Robert Shiller, Robert Shiller, The Bell Curve by Richard Herrnstein and Charles Murray, too big to fail, transaction costs, yield curve, zero-sum game

., and administration: action in financial panic, 161, 167 banking regulations, 133–136 economic proposals, 15 Patriot Act, 45, 46 regulation of Fannie Mae and Freddie Mac, 63 California, 21, 74, 90 CalPERS (California Public Employees’ Retirement System), 93, 116, 121, 131 Canada, 192 Capital: against GSE loans, 137 and leverage, 70–71 and loan loss reserves, 153 misinvestment of, 9–11, 14 wasting of, 159–160 Capital markets, 85–87, 101 Capital standards: for banks, 190 for loans, 51–52 and TARP, 170–171 Capitalism: crony, 6, 102, 129, 179 and freedom, 253–254 at universities, 231–233 Capitalism (Alan Greenspan), 32 Carter, Jimmy, 161, 179 Cash basis accounting, 110 Cash flows, 106–107, 115 Cato Institute, 201 CDOs (collateralized debt obligations), 124–126 CDSs (credit default swaps), 126–128 CEOs (Chief Executive Officers): behavior of, 2–3 decisions of Federal Reserve vs., 34 and rules-based accounting, 109 wage rates of, 210 China: currency standard, 77 demographics, 205 education, 230 GDP of U.S. vs., 183 government debt in, 200 manufacturing in, 10, 25–26, 161 market-based pricing in, 34 military spending in, 198 stimulus fund use, 181–182 trade with, 204–205 U.S. investment by, 29, 159 Chrysler, 130, 179–180 Citigroup: bailout of, 50, 104, 130, 177 CDOs of, 125–126 credit decisions, 238 crony capitalism, 6 funding of shadow banking system, 120 long-term debt of, 71 and panic during financial crisis, 163 pragmatism at, 217–218 reason at, 245 “too-big-to-fail” firms, 173 Clearing, 104 Clinton, Bill: lending reforms, 42–44, 56 subprime lending requirements, 58–60 Collateralized debt obligations (CDOs), 124–126 Colonial Bank, 47–48 Commercial real estate, 11, 97 Common good, 215–216 Community Reinvestment Act (CRA), 42, 55–57, 59 Compensation, 50, 83–84, 197–198 Confidence, 84–87, 184–185 Conservatives, 108 Consumer compliance, 193 Consumer Price Index (CPI), 26–27 Consumption: borrowing for, 57–58 housing as, 9–12, 54–55, 73–74 Contagion risk, 123 Corporate debt, 107 Counterparty risk, 123, 124 Countrywide: crony capitalism at, 6 and fair-value accounting change, 114, 118 and FDIC insurance, 39, 41, 46 necessary failure of, 159 pick-a-payment mortgages of, 91–93 subprime business at, 99 thrift history of, 98 CPI (see Consumer Price Index) CRA (see Community Reinvestment Act) Creativity, 7, 247 Credit default swaps (CDSs), 126–128 Credit rating agencies (see Rating agencies) Crony capitalism, 6, 102, 129, 179 Cross-guarantor insurance fund, 48–52 Cuba, 34, 247, 252 Cuomo, Andrew, 58 Currency, debasing, 22 Debt, 21–22, 107 Declaration of Independence, 220, 252 Defaults, 90–91, 126–128 Defense spending, 198–199, 227 Deflation, 22 Demand, supply and, 104, 185, 209, 210 Department of Housing and Urban Development (HUD), 15, 58 Deposits, disintermediation of, 120–121 Derivatives, 3, 120, 122–124 Disclosure requirements, 150–152 Dodd, Christopher, 7, 46, 61, 63, 64 Dodd-Frank Wall Street Reform and Consumer Protection Act: deficiencies of, 193 introduction of, 63–64, 183 as misregulation, 147 results of, 130 and TARP, 173, 174 Dollar, U.S., 77, 188, 229 Durbin amendment, 193 Earnings, operating, 103–106 East Germany, 34, 247 Eastern Europe, 34, 252 Economic cycles, 108, 189–193 Economic health, 159–161 Economic recovery, 1, 207–208 Economy, banking industry in, 67–69 Edison, Thomas, 19, 158–159 Education, 230–235, 247 Egypt, ancient, 230 Elitism, 7 Ely, Bert, 48 Employee Retirement Income Security Act (ERISA), 82, 149 Enron, 60, 109, 133, 149 Entitlement programs, reforms for, 199–204 Equal Credit Opportunity Act, 42, 55 ERISA (Employee Retirement Income Security Act), 82, 149 Ethical incentives, lending, 57–58 Euro, 189 European banking crisis, 51–52, 137 Expensing (stock options), 114–117 Experiential learners, 244–245 Fair Housing Act, 55 Fair-value accounting, 103–118 asset valuation in, 106–108 and expensing of stock options, 114–117 and losses on CDSs, 126–127 private accounting systems vs., 177–178 SEC involvement in, 151–152 for selling vs. servicing mortgages, 113–114 Fannie Mae: accounting scandal, 112–113, 149 in current environment, 251 and disintermediation of deposits, 121 failure of, 61–65, 164 and fair-value accounting, 118 in housing policy, 58–61 misallocation of resources by, 14 misleading of rating agencies by, 83 mortgage lending by, 97–101 reforms for, 190–192 selling mortgages to, 113–114 subprime lending by, 58, 99–101 FASB (see Financial Accounting Standards Board) FDIC (see Federal Deposit Insurance Corporation) FDIC insurance, 37–52 and bank liquidity, 171 and failing banks, 140 and fractional reserve banking, 68–69 and pick-a-payment mortgages, 91 reform of, 190 and S&L failures, 97 Federal Deposit Insurance Corporation (FDIC), 37–38 as external auditors, 134 and failing banks, 47–48 misallocation of resources by, 14 and pick-a-payment mortgages, 91 as regulator, 41–48, 143 take over of Washington Mutual, 75–77 Federal Housing Administration (FHA), 15, 190–192, 252 Federal Reserve, 22–23, 102, 189 antitrust policy, 174 bailouts by, 120–121, 190, 192 and banking industry reforms, 187–188 as external auditors, 134 and federal debt, 21–22 and leverage, 72 mathematical modeling by, 136 misallocation of resources by, 14, 208 misleading information from, 46, 83, 101, 125 monetary policy of, 17–20, 31–35, 96 overreaction by, 154 stimulus from, 152, 153, 208 and TARP, 165, 167–168, 171 and unemployment, 213 and Washington Mutual, 75 Federal Reserve Board, 18 Federal Reserve Open Market Committee, 31 Federal Savings and Loan Insurance Corporation (FSLIC), 37–38, 50, 96 FHA (see Federal Housing Administration) Financial Accounting Standards Board (FASB), 105, 106, 114–117 Financial crisis (2007-2009), 1–3, 251–254 banking industry in, 70–72 derivatives in, 122–124 Freddie Mac and Fannie Mae in, 65 free-market response to, 177–186 and Great Depression, 25 lessons from, 251–252 SEC role in, 154–155 Financial reporting requirements, SEC, 150–152 Financial Services Roundtable (FSR), 32, 61–62 First Horizon, 237 Fitch, John Knowles, 150 Fitch Ratings: investor confidence in, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Flat tax, 197 Forbes, Steve, 197 Ford, 179 Foreclosure laws, 77–80 Fractional reserve banking, 69–70 Frank, Barney, 7, 61, 63, 64 Fraud, 109–113 Freddie Mac: accounting scandal, 112–113, 149 current environment, 251 and disintermediation of deposits, 121 failure of, 61–65, 164 in housing policy, 58–61 misallocation of resources by, 14 misleading information from, 83 mortgage lending by, 97–101 reforms for, 190–192 selling mortgages to, 113–114 subprime lending by, 58, 99–101 Free markets: experimentation in, 19 justice in, 92, 177 market corrections in, 157–159 and monetary policy, 31–35 risk taking by banks in, 40–41 wage rates in, 210–211 Free trade, 204–205 Friedman, Milton, 20, 189 FSLIC (see Federal Savings and Loan Insurance Corporation) FSR (Financial Services Roundtable), 32, 61–62 GAAP accounting, 116, 117 Gates, Bill, 216 GDP, 183, 197–199 General Electric, 168, 169 General Motors (GM), 169, 178–180 General Theory of Employment, Interest and Money, The (Keynes), 181 Germany, 52 GM (General Motors), 169, 178–180 GMAC, 168, 169, 178–180 Gold standard: and deflation, 25–26 and economic future of U.S., 188–189 Greenspan’s view of, 32 Golden West, 39, 91, 92, 98, 159 Goldman Sachs, 71, 173 as AIG counterparty, 128–129 bailout of, 104, 164, 179 CDSs of, 126 counterparty risk at, 124 crony capitalism at, 6 financial “innovations” of, 101 Government policy: as cause of financial crisis, 1, 5–6, 251 and residential real estate bubble, 6 (See also Housing policy; Policy reforms) Government regulation, 5–8, 41–48, 204 Government spending, 180–183, 197–199 Government-sponsored enterprises (GSEs), 59, 64–65, 98, 137 (See also Fannie Mae; Freddie Mac) Great Depression: and avoidance of stock market, 74 banking industry in, 70–72 economic policies after, 161 and Federal Reserve, 19–20, 24, 188 and gold standard, 188 and government interference, 170 and Smoot-Hawley Tariff Act, 205 Great Recession, 1, 251–254 and Federal Reserve, 188 Freddie Mac and Fannie Mae in, 65 and interest-rate variation, 33 market corrections and depth of, 160 and monetary policy, 17 and residential real estate, 9–15 Great Society, 6, 55, 96 Greece, 51, 52, 137, 228 Greenspan, Alan, 23–30, 32, 33, 160 Gross domestic product, 183, 197–199 Hamilton, Alexander, 19 Harvard University, 43, 131 Hayek, Friedrich, 31 Health insurance, 201–202 High-net-worth shareholders, 93 Home Builders Association, 60 Home foreclosure laws, 77–80 Homeownership, 53–55 Hoover, Herbert, 24, 161, 205 Housing: as consumption, 9–12, 54–55, 73–74 government support of, 12 Housing policy, 53–65 HUD (Department of Housing and Urban Development), 15, 58 Human Action (von Mises), 238 Immigration, 19, 205–206 India, 10, 25, 205 IndyMac, 39, 75, 98 Inflation: CPI as indicator of, 26–27 and fair-value accounting, 103 and Federal Reserve, 21–22 and prices, 24–25 (See also Monetary policy) Initial public offerings, 150 Insurance: bond, 86–87 cross-guarantor, 48–52 FDIC (see FDIC insurance) health, 201–202 private deposit, 48–52 self-insurance at banks, 48–52 unemployment, 212–213 Interest rates, 26–27, 31–35 Inverted yield curves, 27–29 Investment banks: disclosure requirements for, 151 government bailout of, 162 “innovations” of, 101–102 leverage ratios of, 71–72 IPOs, 150 Iran, 198, 199, 227 Iraq, 198 Ireland, 77 Isaac, Bill, 107–108, 161–162 Italy, 51, 52 Japan, 159, 200, 205 Jefferson, Thomas, 19, 220 Johnson, Lyndon Baines, 6, 55, 96, 161, 188 JPMorgan Chase, 75 and Bear Stearns, 162 and shadow banking system, 120 as “too-big-to-fail” firm, 173 and Washington Mutual, 163 Keynes, John Maynard, 181 Labor: allocation of, 10–11, 14 minimum-wage laws, 209–212 Lehman Brothers, 71, 76, 101, 104, 129, 164 and Bear Stearns bailout, 162–163 corporate debt at, 107 counterparty risk at, 124 derivatives from, 123 Limited government, 182–183, 195, 231, 253 Liquidity: of banks, 68–69 and FDIC insurance, 171 and financial crises, 70–72 and housing prices, 74–75 and TARP, 171–172 Loan loss reserves accounting, 152–154 Loans: capital standards for, 51–52 qualified, 98 substandard, 140–141 Madoff, Bernie, 149, 225 March of Dimes, 241 Market corrections, 157–165 Federal Reserve’s prevention of, 23, 32 prevention of, 13 residential real estate, 78 and response to financial crisis, 177–180 Market discipline, 21, 38 Market-based monetary policy, 31–35 Market-clearing price, 209 Mathematical modeling: for loan loss reserves, 152–153 by ratings agencies, 82–83 for risk management, 136–138 MBIA, 86 Medicaid, 6, 55, 201 Medicare, 6, 8, 55, 201, 203 Meltdown (Michaels), 35 Merrill Lynch, 101, 124–125 Michaels, Patrick J., 35 Microsoft, 217 Military spending, 198–199, 227 Minimum-wage laws, 209–212 Mises, Ludwig von, 34, 238 Monetary policy, 17–35 of Bernanke, 27–31, 33, 35, 40, 125, 213 and federal debt, 21–22 and Federal Reserve, 17–23 of Greenspan, 23–27 market-based, 31–35 and unemployment, 208–209 Money market mutual funds, bailout of, 120–121, 192 Money supply, 21–22, 24, 189 Moody, John, 83, 150 Moody’s, 81–87 investor confidence in, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Morgan Stanley, 71, 101, 124, 173 Mortgage lending, 95–102 by Fannie Mae and Freddie Mac, 97–101 and investment bank innovations, 101–102 prime, 59, 97–99 by private banks, 97–99 savings and loan industry in, 95–97 subprime, 43, 56–57, 99–101 Mortgages: by BB&T Corporation, 97–98 jumbo, 62 pick-a-payment (see Pick-a-payment mortgages) selling vs. servicing, 113–114 Mozilo, Angelo, 46 Multiplier effect, 181 Naked shorting, 127–128, 151 Nationally recognized statistical rating organizations, 82 Negative real interest rates, 26–27 Neo-Keynesian response to financial crisis, 185–186 Neutral taxes, 197 New Deal, 53, 170, 232 Nixon, Richard, 96, 161, 188 North Korea, 34, 198, 227, 247, 252 NRSROs, 82 Obama administration, 142–144: and Dodd-Frank Act, 64 economic policies of, 15, 161 healthcare bill, 183, 201 and Patriot Act, 45 stimulus plan, 181–182 Office of the Comptroller of the Currency (OCC), 40, 154 Office of Thrift Supervision, 40, 41, 45–46 Operating earnings, 103–106 OTS, 40, 41, 45–46 Panics, 137–138, 161–165 Patriot Act, 45, 46, 48, 133–136, 147 Paulson, Henry: in 2008 panic, 164, 167 and AIG bailout, 128, 129 credibility of, 164 development of TARP, 76, 168–170, 172 Pick-a-payment mortgages, 89–93 borrowers using, 90–91 and FDIC, 91 and rise of Fannie Mae/Freddie Mac, 98 Policy reforms, 195–206 for entitlement programs, 199–204 and free trade, 204–205 and government regulations, 204 for government spending, 197–199 for immigration, 205–206 for political system, 206–207 and tax rate, 196–197 Politics: in banking regulation, 42–46 and crony capitalism, 129 and failure of Fannie Mae/Freddie Mac, 59–62 and Federal Reserve appointments, 18 policy reforms for, 206–207 Poor, Henry Varnum, 150 Portugal, 51 Price fixing, 31, 193 Price setting, 31–32 Prime lending, 59, 97–99 Prince, Charlie, 217 Principles-based accounting, 109 Privacy Act, 133, 135 Private accounting systems, 177–178 Private banks, 97–99, 187–188 Private deposit insurance, 48–52 Public schools, 228, 233–235 Racial discrimination (in lending), 42–45 Raines, Frank, 59 Rand, Ayn, 225, 231 Rating agencies, 81–87 investor confidence in, 84–87 mathematical modeling by, 136 and subprime mortgage bonds, 82–84 and “too-big-to-fail” firms, 173 and SEC, 81–82, 149–150 Real estate: commercial, 11, 97 residential (see Residential real estate market) Recessions, 28, 29, 160 Recovery (see Economic recovery) Reforms: banking industry (see Banking industry reforms) government policy (see Policy reforms) Regions Bank, 237 Regulation: of banking industry (see Banking regulation) by government (see Government regulation) Reporting, financial, 150–152 Reserve currency, U.S. dollar as, 77, 188, 229 Residential real estate market: economics of, 73–74 misinvestment in, 9–15 Residential real estate market bubble, 73–80 and government policy, 6 international impact of, 77 and job creation, 80 and state home foreclosure laws, 77–80 Risk: contagion, 123 counterparty, 123, 124 with derivatives, 122–124 diversification of, 67–69 and economic cycles, 189–193 and FDIC insurance, 38–41 and government regulation, 50–51 liquidity, 68–70 mathematical modeling for, 136–138 and “originate and sell” model, 100 systemic, 50–51 RMBS (residential mortgage-backed securities), 81 Roman empire, fall of, 230 Roosevelt, Franklin D., 24, 37, 103, 161 Rules-based accounting, 109 Russia, 198 Samuelson, Paul, 238 Sarbanes-Oxley Act, 133–134 and fair-value accounting, 106 and Fannie Mae/Freddie Mac, 99 misregulation by, 48, 147 and SEC, 150 violations of, 136 SARs (Suspicious Activity Reports), 136 Satchwell, Jack, 57 Savings and loan (S&L) industry, 95–97, 110, 191 Securities and Exchange Commission (SEC), 149–155 capital ratio guidelines, 71–72 and complexity of accounting rules, 116–117 and expensing of stock options, 114, 115 loan loss reserves accounting for, 152–154 misallocation of resources by, 14 and rating agencies, 81–82, 149–150 requirements for shorting stock, 127–128, 151 and rules-based accounting, 109, 110 and Sarbanes-Oxley Act, 150 Self-insurance, 48–52 Selgin, George, 189 Senate Banking Committee, 46 Shadow banking system, 119–131 and AIG bailout, 128–130 credit default swaps in, 126–128 and derivatives, 122–124 Federal Reserve’s role in, 30 losses from, 131 S&L industry, 95–97, 110, 191 Small businesses, 144–147, 183–184 Smoot-Hawley Tariff Act, 205 Social Security, 8, 199–204 South Financial, 237 South Korea, 247 Soviet Union, 34, 195–196, 252, 254 S&P (see Standard & Poor’s) Spain, 51, 52, 77 Spitzer, Eliot, 71, 134–135, 151 Stagflation, 181, 208 Standard & Poor’s (S&P), 81–87 investor confidence, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Standard of living, 6–7, 10, 161, 177 Start-up banks, 38–39 State home foreclosure laws, 77–80 Stimulus plan, 181–182 Stock options, expensing of, 114–117 Stocks, shorting, 127–128, 151 Stress tests, banks, 171 Subprime lending: and CRA, 56–57 by Fannie Mae and Freddie Mac, 99–101 and racial discrimination in lending study, 43 Subprime mortgage bonds, 82–87 Substandard loans, 140–141 SunTrust, 152, 237 Suspicious Activity Reports (SARs), 136 Tails (mathematical models), 137 TARP (see Troubled Asset Relief Program) Tax rate, 196–197 Tea Party Movement, 218, 231 Technology industry, 5 “Too-big-to-fail” firms, 130, 173, 193 Trader principle, 92, 223–224 Troubled Asset Relief Program (TARP), 167–175 and 2008 panic, 165 and FDIC, 37 Underwriters Laboratories, 117, 150 Unemployment, 207–213 in economic recovery, 207–208 and minimum-wage laws, 209–212 and misinvestment in residential real estate, 10–11 and monetary policy, 208–209 Unemployment insurance, 212–213 Unions, 179, 180, 212 United Auto Workers, 179, 180 United States: demographic problem in, 228 economic future of, 8, 227–230, 252–253 educational system of, 230–235 founding concepts of, 219–220 as free trade zone, 204–205 GDP of China vs., 183 mixed economy of, 5–6 public schools of, 233–235 university system of, 230–233 United Way, 224, 241 University system, 230–233 U.S.

., 183 government debt in, 200 manufacturing in, 10, 25–26, 161 market-based pricing in, 34 military spending in, 198 stimulus fund use, 181–182 trade with, 204–205 U.S. investment by, 29, 159 Chrysler, 130, 179–180 Citigroup: bailout of, 50, 104, 130, 177 CDOs of, 125–126 credit decisions, 238 crony capitalism, 6 funding of shadow banking system, 120 long-term debt of, 71 and panic during financial crisis, 163 pragmatism at, 217–218 reason at, 245 “too-big-to-fail” firms, 173 Clearing, 104 Clinton, Bill: lending reforms, 42–44, 56 subprime lending requirements, 58–60 Collateralized debt obligations (CDOs), 124–126 Colonial Bank, 47–48 Commercial real estate, 11, 97 Common good, 215–216 Community Reinvestment Act (CRA), 42, 55–57, 59 Compensation, 50, 83–84, 197–198 Confidence, 84–87, 184–185 Conservatives, 108 Consumer compliance, 193 Consumer Price Index (CPI), 26–27 Consumption: borrowing for, 57–58 housing as, 9–12, 54–55, 73–74 Contagion risk, 123 Corporate debt, 107 Counterparty risk, 123, 124 Countrywide: crony capitalism at, 6 and fair-value accounting change, 114, 118 and FDIC insurance, 39, 41, 46 necessary failure of, 159 pick-a-payment mortgages of, 91–93 subprime business at, 99 thrift history of, 98 CPI (see Consumer Price Index) CRA (see Community Reinvestment Act) Creativity, 7, 247 Credit default swaps (CDSs), 126–128 Credit rating agencies (see Rating agencies) Crony capitalism, 6, 102, 129, 179 Cross-guarantor insurance fund, 48–52 Cuba, 34, 247, 252 Cuomo, Andrew, 58 Currency, debasing, 22 Debt, 21–22, 107 Declaration of Independence, 220, 252 Defaults, 90–91, 126–128 Defense spending, 198–199, 227 Deflation, 22 Demand, supply and, 104, 185, 209, 210 Department of Housing and Urban Development (HUD), 15, 58 Deposits, disintermediation of, 120–121 Derivatives, 3, 120, 122–124 Disclosure requirements, 150–152 Dodd, Christopher, 7, 46, 61, 63, 64 Dodd-Frank Wall Street Reform and Consumer Protection Act: deficiencies of, 193 introduction of, 63–64, 183 as misregulation, 147 results of, 130 and TARP, 173, 174 Dollar, U.S., 77, 188, 229 Durbin amendment, 193 Earnings, operating, 103–106 East Germany, 34, 247 Eastern Europe, 34, 252 Economic cycles, 108, 189–193 Economic health, 159–161 Economic recovery, 1, 207–208 Economy, banking industry in, 67–69 Edison, Thomas, 19, 158–159 Education, 230–235, 247 Egypt, ancient, 230 Elitism, 7 Ely, Bert, 48 Employee Retirement Income Security Act (ERISA), 82, 149 Enron, 60, 109, 133, 149 Entitlement programs, reforms for, 199–204 Equal Credit Opportunity Act, 42, 55 ERISA (Employee Retirement Income Security Act), 82, 149 Ethical incentives, lending, 57–58 Euro, 189 European banking crisis, 51–52, 137 Expensing (stock options), 114–117 Experiential learners, 244–245 Fair Housing Act, 55 Fair-value accounting, 103–118 asset valuation in, 106–108 and expensing of stock options, 114–117 and losses on CDSs, 126–127 private accounting systems vs., 177–178 SEC involvement in, 151–152 for selling vs. servicing mortgages, 113–114 Fannie Mae: accounting scandal, 112–113, 149 in current environment, 251 and disintermediation of deposits, 121 failure of, 61–65, 164 and fair-value accounting, 118 in housing policy, 58–61 misallocation of resources by, 14 misleading of rating agencies by, 83 mortgage lending by, 97–101 reforms for, 190–192 selling mortgages to, 113–114 subprime lending by, 58, 99–101 FASB (see Financial Accounting Standards Board) FDIC (see Federal Deposit Insurance Corporation) FDIC insurance, 37–52 and bank liquidity, 171 and failing banks, 140 and fractional reserve banking, 68–69 and pick-a-payment mortgages, 91 reform of, 190 and S&L failures, 97 Federal Deposit Insurance Corporation (FDIC), 37–38 as external auditors, 134 and failing banks, 47–48 misallocation of resources by, 14 and pick-a-payment mortgages, 91 as regulator, 41–48, 143 take over of Washington Mutual, 75–77 Federal Housing Administration (FHA), 15, 190–192, 252 Federal Reserve, 22–23, 102, 189 antitrust policy, 174 bailouts by, 120–121, 190, 192 and banking industry reforms, 187–188 as external auditors, 134 and federal debt, 21–22 and leverage, 72 mathematical modeling by, 136 misallocation of resources by, 14, 208 misleading information from, 46, 83, 101, 125 monetary policy of, 17–20, 31–35, 96 overreaction by, 154 stimulus from, 152, 153, 208 and TARP, 165, 167–168, 171 and unemployment, 213 and Washington Mutual, 75 Federal Reserve Board, 18 Federal Reserve Open Market Committee, 31 Federal Savings and Loan Insurance Corporation (FSLIC), 37–38, 50, 96 FHA (see Federal Housing Administration) Financial Accounting Standards Board (FASB), 105, 106, 114–117 Financial crisis (2007-2009), 1–3, 251–254 banking industry in, 70–72 derivatives in, 122–124 Freddie Mac and Fannie Mae in, 65 free-market response to, 177–186 and Great Depression, 25 lessons from, 251–252 SEC role in, 154–155 Financial reporting requirements, SEC, 150–152 Financial Services Roundtable (FSR), 32, 61–62 First Horizon, 237 Fitch, John Knowles, 150 Fitch Ratings: investor confidence in, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Flat tax, 197 Forbes, Steve, 197 Ford, 179 Foreclosure laws, 77–80 Fractional reserve banking, 69–70 Frank, Barney, 7, 61, 63, 64 Fraud, 109–113 Freddie Mac: accounting scandal, 112–113, 149 current environment, 251 and disintermediation of deposits, 121 failure of, 61–65, 164 in housing policy, 58–61 misallocation of resources by, 14 misleading information from, 83 mortgage lending by, 97–101 reforms for, 190–192 selling mortgages to, 113–114 subprime lending by, 58, 99–101 Free markets: experimentation in, 19 justice in, 92, 177 market corrections in, 157–159 and monetary policy, 31–35 risk taking by banks in, 40–41 wage rates in, 210–211 Free trade, 204–205 Friedman, Milton, 20, 189 FSLIC (see Federal Savings and Loan Insurance Corporation) FSR (Financial Services Roundtable), 32, 61–62 GAAP accounting, 116, 117 Gates, Bill, 216 GDP, 183, 197–199 General Electric, 168, 169 General Motors (GM), 169, 178–180 General Theory of Employment, Interest and Money, The (Keynes), 181 Germany, 52 GM (General Motors), 169, 178–180 GMAC, 168, 169, 178–180 Gold standard: and deflation, 25–26 and economic future of U.S., 188–189 Greenspan’s view of, 32 Golden West, 39, 91, 92, 98, 159 Goldman Sachs, 71, 173 as AIG counterparty, 128–129 bailout of, 104, 164, 179 CDSs of, 126 counterparty risk at, 124 crony capitalism at, 6 financial “innovations” of, 101 Government policy: as cause of financial crisis, 1, 5–6, 251 and residential real estate bubble, 6 (See also Housing policy; Policy reforms) Government regulation, 5–8, 41–48, 204 Government spending, 180–183, 197–199 Government-sponsored enterprises (GSEs), 59, 64–65, 98, 137 (See also Fannie Mae; Freddie Mac) Great Depression: and avoidance of stock market, 74 banking industry in, 70–72 economic policies after, 161 and Federal Reserve, 19–20, 24, 188 and gold standard, 188 and government interference, 170 and Smoot-Hawley Tariff Act, 205 Great Recession, 1, 251–254 and Federal Reserve, 188 Freddie Mac and Fannie Mae in, 65 and interest-rate variation, 33 market corrections and depth of, 160 and monetary policy, 17 and residential real estate, 9–15 Great Society, 6, 55, 96 Greece, 51, 52, 137, 228 Greenspan, Alan, 23–30, 32, 33, 160 Gross domestic product, 183, 197–199 Hamilton, Alexander, 19 Harvard University, 43, 131 Hayek, Friedrich, 31 Health insurance, 201–202 High-net-worth shareholders, 93 Home Builders Association, 60 Home foreclosure laws, 77–80 Homeownership, 53–55 Hoover, Herbert, 24, 161, 205 Housing: as consumption, 9–12, 54–55, 73–74 government support of, 12 Housing policy, 53–65 HUD (Department of Housing and Urban Development), 15, 58 Human Action (von Mises), 238 Immigration, 19, 205–206 India, 10, 25, 205 IndyMac, 39, 75, 98 Inflation: CPI as indicator of, 26–27 and fair-value accounting, 103 and Federal Reserve, 21–22 and prices, 24–25 (See also Monetary policy) Initial public offerings, 150 Insurance: bond, 86–87 cross-guarantor, 48–52 FDIC (see FDIC insurance) health, 201–202 private deposit, 48–52 self-insurance at banks, 48–52 unemployment, 212–213 Interest rates, 26–27, 31–35 Inverted yield curves, 27–29 Investment banks: disclosure requirements for, 151 government bailout of, 162 “innovations” of, 101–102 leverage ratios of, 71–72 IPOs, 150 Iran, 198, 199, 227 Iraq, 198 Ireland, 77 Isaac, Bill, 107–108, 161–162 Italy, 51, 52 Japan, 159, 200, 205 Jefferson, Thomas, 19, 220 Johnson, Lyndon Baines, 6, 55, 96, 161, 188 JPMorgan Chase, 75 and Bear Stearns, 162 and shadow banking system, 120 as “too-big-to-fail” firm, 173 and Washington Mutual, 163 Keynes, John Maynard, 181 Labor: allocation of, 10–11, 14 minimum-wage laws, 209–212 Lehman Brothers, 71, 76, 101, 104, 129, 164 and Bear Stearns bailout, 162–163 corporate debt at, 107 counterparty risk at, 124 derivatives from, 123 Limited government, 182–183, 195, 231, 253 Liquidity: of banks, 68–69 and FDIC insurance, 171 and financial crises, 70–72 and housing prices, 74–75 and TARP, 171–172 Loan loss reserves accounting, 152–154 Loans: capital standards for, 51–52 qualified, 98 substandard, 140–141 Madoff, Bernie, 149, 225 March of Dimes, 241 Market corrections, 157–165 Federal Reserve’s prevention of, 23, 32 prevention of, 13 residential real estate, 78 and response to financial crisis, 177–180 Market discipline, 21, 38 Market-based monetary policy, 31–35 Market-clearing price, 209 Mathematical modeling: for loan loss reserves, 152–153 by ratings agencies, 82–83 for risk management, 136–138 MBIA, 86 Medicaid, 6, 55, 201 Medicare, 6, 8, 55, 201, 203 Meltdown (Michaels), 35 Merrill Lynch, 101, 124–125 Michaels, Patrick J., 35 Microsoft, 217 Military spending, 198–199, 227 Minimum-wage laws, 209–212 Mises, Ludwig von, 34, 238 Monetary policy, 17–35 of Bernanke, 27–31, 33, 35, 40, 125, 213 and federal debt, 21–22 and Federal Reserve, 17–23 of Greenspan, 23–27 market-based, 31–35 and unemployment, 208–209 Money market mutual funds, bailout of, 120–121, 192 Money supply, 21–22, 24, 189 Moody, John, 83, 150 Moody’s, 81–87 investor confidence in, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Morgan Stanley, 71, 101, 124, 173 Mortgage lending, 95–102 by Fannie Mae and Freddie Mac, 97–101 and investment bank innovations, 101–102 prime, 59, 97–99 by private banks, 97–99 savings and loan industry in, 95–97 subprime, 43, 56–57, 99–101 Mortgages: by BB&T Corporation, 97–98 jumbo, 62 pick-a-payment (see Pick-a-payment mortgages) selling vs. servicing, 113–114 Mozilo, Angelo, 46 Multiplier effect, 181 Naked shorting, 127–128, 151 Nationally recognized statistical rating organizations, 82 Negative real interest rates, 26–27 Neo-Keynesian response to financial crisis, 185–186 Neutral taxes, 197 New Deal, 53, 170, 232 Nixon, Richard, 96, 161, 188 North Korea, 34, 198, 227, 247, 252 NRSROs, 82 Obama administration, 142–144: and Dodd-Frank Act, 64 economic policies of, 15, 161 healthcare bill, 183, 201 and Patriot Act, 45 stimulus plan, 181–182 Office of the Comptroller of the Currency (OCC), 40, 154 Office of Thrift Supervision, 40, 41, 45–46 Operating earnings, 103–106 OTS, 40, 41, 45–46 Panics, 137–138, 161–165 Patriot Act, 45, 46, 48, 133–136, 147 Paulson, Henry: in 2008 panic, 164, 167 and AIG bailout, 128, 129 credibility of, 164 development of TARP, 76, 168–170, 172 Pick-a-payment mortgages, 89–93 borrowers using, 90–91 and FDIC, 91 and rise of Fannie Mae/Freddie Mac, 98 Policy reforms, 195–206 for entitlement programs, 199–204 and free trade, 204–205 and government regulations, 204 for government spending, 197–199 for immigration, 205–206 for political system, 206–207 and tax rate, 196–197 Politics: in banking regulation, 42–46 and crony capitalism, 129 and failure of Fannie Mae/Freddie Mac, 59–62 and Federal Reserve appointments, 18 policy reforms for, 206–207 Poor, Henry Varnum, 150 Portugal, 51 Price fixing, 31, 193 Price setting, 31–32 Prime lending, 59, 97–99 Prince, Charlie, 217 Principles-based accounting, 109 Privacy Act, 133, 135 Private accounting systems, 177–178 Private banks, 97–99, 187–188 Private deposit insurance, 48–52 Public schools, 228, 233–235 Racial discrimination (in lending), 42–45 Raines, Frank, 59 Rand, Ayn, 225, 231 Rating agencies, 81–87 investor confidence in, 84–87 mathematical modeling by, 136 and subprime mortgage bonds, 82–84 and “too-big-to-fail” firms, 173 and SEC, 81–82, 149–150 Real estate: commercial, 11, 97 residential (see Residential real estate market) Recessions, 28, 29, 160 Recovery (see Economic recovery) Reforms: banking industry (see Banking industry reforms) government policy (see Policy reforms) Regions Bank, 237 Regulation: of banking industry (see Banking regulation) by government (see Government regulation) Reporting, financial, 150–152 Reserve currency, U.S. dollar as, 77, 188, 229 Residential real estate market: economics of, 73–74 misinvestment in, 9–15 Residential real estate market bubble, 73–80 and government policy, 6 international impact of, 77 and job creation, 80 and state home foreclosure laws, 77–80 Risk: contagion, 123 counterparty, 123, 124 with derivatives, 122–124 diversification of, 67–69 and economic cycles, 189–193 and FDIC insurance, 38–41 and government regulation, 50–51 liquidity, 68–70 mathematical modeling for, 136–138 and “originate and sell” model, 100 systemic, 50–51 RMBS (residential mortgage-backed securities), 81 Roman empire, fall of, 230 Roosevelt, Franklin D., 24, 37, 103, 161 Rules-based accounting, 109 Russia, 198 Samuelson, Paul, 238 Sarbanes-Oxley Act, 133–134 and fair-value accounting, 106 and Fannie Mae/Freddie Mac, 99 misregulation by, 48, 147 and SEC, 150 violations of, 136 SARs (Suspicious Activity Reports), 136 Satchwell, Jack, 57 Savings and loan (S&L) industry, 95–97, 110, 191 Securities and Exchange Commission (SEC), 149–155 capital ratio guidelines, 71–72 and complexity of accounting rules, 116–117 and expensing of stock options, 114, 115 loan loss reserves accounting for, 152–154 misallocation of resources by, 14 and rating agencies, 81–82, 149–150 requirements for shorting stock, 127–128, 151 and rules-based accounting, 109, 110 and Sarbanes-Oxley Act, 150 Self-insurance, 48–52 Selgin, George, 189 Senate Banking Committee, 46 Shadow banking system, 119–131 and AIG bailout, 128–130 credit default swaps in, 126–128 and derivatives, 122–124 Federal Reserve’s role in, 30 losses from, 131 S&L industry, 95–97, 110, 191 Small businesses, 144–147, 183–184 Smoot-Hawley Tariff Act, 205 Social Security, 8, 199–204 South Financial, 237 South Korea, 247 Soviet Union, 34, 195–196, 252, 254 S&P (see Standard & Poor’s) Spain, 51, 52, 77 Spitzer, Eliot, 71, 134–135, 151 Stagflation, 181, 208 Standard & Poor’s (S&P), 81–87 investor confidence, 84–87 misratings by, 82–84, 101, 125, 126 and SEC, 81–82, 149–150 Standard of living, 6–7, 10, 161, 177 Start-up banks, 38–39 State home foreclosure laws, 77–80 Stimulus plan, 181–182 Stock options, expensing of, 114–117 Stocks, shorting, 127–128, 151 Stress tests, banks, 171 Subprime lending: and CRA, 56–57 by Fannie Mae and Freddie Mac, 99–101 and racial discrimination in lending study, 43 Subprime mortgage bonds, 82–87 Substandard loans, 140–141 SunTrust, 152, 237 Suspicious Activity Reports (SARs), 136 Tails (mathematical models), 137 TARP (see Troubled Asset Relief Program) Tax rate, 196–197 Tea Party Movement, 218, 231 Technology industry, 5 “Too-big-to-fail” firms, 130, 173, 193 Trader principle, 92, 223–224 Troubled Asset Relief Program (TARP), 167–175 and 2008 panic, 165 and FDIC, 37 Underwriters Laboratories, 117, 150 Unemployment, 207–213 in economic recovery, 207–208 and minimum-wage laws, 209–212 and misinvestment in residential real estate, 10–11 and monetary policy, 208–209 Unemployment insurance, 212–213 Unions, 179, 180, 212 United Auto Workers, 179, 180 United States: demographic problem in, 228 economic future of, 8, 227–230, 252–253 educational system of, 230–235 founding concepts of, 219–220 as free trade zone, 204–205 GDP of China vs., 183 mixed economy of, 5–6 public schools of, 233–235 university system of, 230–233 United Way, 224, 241 University system, 230–233 U.S.

They were also misled by the artificial economic environment created by the Federal Reserve. In addition, as discussed earlier, they had a significant economic incentive to rate the bonds as highly as possible to increase their revenues. This is where the investment banks (Goldman Sachs, Morgan Stanley, Bear Stearns, Merrill Lynch, and Lehman Brothers) magnified the misallocation of credit to the housing market. They created a series of financial “innovations” (collateralized debt obligations [CDOs], derivatives, swaps, and others, which I discuss later) that leveraged an already overleveraged product. The explanation typically given for these ultimately very bad decisions by investment bankers is greed. However, there was plenty of greed on Wall Street before the bubble. In fact, in my almost 40-year career in banking, there has always been greed on Wall Street. There was no more or less greed on Wall Street during the bubble.


pages: 350 words: 103,270

The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again by Nicholas Dunbar

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asset-backed security, bank run, banking crisis, Basel III, Black Swan, Black-Scholes formula, bonus culture, break the buck, capital asset pricing model, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, delayed gratification, diversification, Edmond Halley, facts on the ground, financial innovation, fixed income, George Akerlof, implied volatility, index fund, interest rate derivative, interest rate swap, Isaac Newton, John Meriwether, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, money market fund, Myron Scholes, Nick Leeson, Northern Rock, offshore financial centre, Paul Samuelson, price mechanism, regulatory arbitrage, rent-seeking, Richard Thaler, risk tolerance, risk/return, Ronald Reagan, shareholder value, short selling, statistical model, The Chicago School, Thomas Bayes, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, yield curve, zero-sum game

They told me about a derivative that had been invented two years earlier. It was called a credit default swap. Rather than being linked to currency markets, interest rates, stocks, or commodities, these derivatives were linked to unmitigated financial disaster: the default of loans or bonds. I found it hard that night to imagine who might be interested in buying such a derivative from a bank. The nonfinancial companies whose activities in the globalized economy exposed them to financial uncertainty didn’t seem interested. The derivatives that were useful to them—futures, options, and swaps linked to commodities, currencies, and interest rates—had already been invented. It seemed to me as if the credit default swap was an invention searching for a real purpose. As it happened, the kind of companies that found credit default swaps most relevant were those that had lots of default risk on their books: the banks.

But Chase’s global entertainment group in Los Angeles wanted a piece of it, so in the late 1990s, the bank’s loan officers loaned some $600 million to producers of films, including The Truman Show, by persuading an executive working for French insurance giant AXA to write policies against poor box office results. Now suppose you preferred to work with people who swore by the market approach to credit, as Peter Hancock did. The credit default swap was the trading world’s modern solution. This industry had already created a thriving business enabling clients to protect themselves from—or speculate on—fluctuating interest rates, currencies, and commodity risk using derivatives. Why not expand the innovation to handle credit? For instance, if Hancock had been able to buy a derivative that hedged J.P. Morgan against clients’ defaulting, the bank would have been spared the embarrassment of its Korean swap fiasco. Like foreign exchange options, credit default swaps could be easily detached from any underlying exposure that might “justify” their existence as a hedge. Like those currency speculators in the 1997 Asian crisis, you could use them to place bets on disasters: in this case, the death of a company.

In fixed income, a company might have hundreds of different bonds in the market, repayable in different currencies, and with myriad maturity dates and interest payment profiles. Which one should you buy or sell? You had to be a geek to figure it out. With credit default swaps, all that detail could be stripped away. As with equities, there was a single “reference entity” or “name,” Walmart Inc., whose potential for default drove the price of the swap contract. Better still, the default swap distilled this crucial credit information out of the hundreds of Walmart bonds. And for Sherwood, information was power. He realized that by combining trading in credit default swaps and corporate bonds on the same desk, Goldman would have its finger on the pulse of the world’s biggest corporate borrowers: not only could Goldman control its own exposure, but it would control its clients’ access to the market for credit.


pages: 447 words: 104,258

Mathematics of the Financial Markets: Financial Instruments and Derivatives Modelling, Valuation and Risk Issues by Alain Ruttiens

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algorithmic trading, asset allocation, asset-backed security, backtesting, banking crisis, Black Swan, Black-Scholes formula, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, discrete time, diversification, fixed income, implied volatility, interest rate derivative, interest rate swap, margin call, market microstructure, martingale, p-value, passive investing, quantitative trading / quantitative finance, random walk, risk/return, Satyajit Das, Sharpe ratio, short selling, statistical model, stochastic process, stochastic volatility, time value of money, transaction costs, value at risk, volatility smile, Wiener process, yield curve, zero-coupon bond

Index 4-moments CAPM actual (ACT) number of days AI see Alternative Investments “algorithmic” trading Alternative Investments (AI) American options bond options CRR pricing model option pricing rho amortizing swaps analytic method, VaR annual interest compounding annualized volatility autocorrelation corrective factor historical volatility risk measures APT see Arbitrage Pricing Theory AR see autoregressive process Arbitrage Pricing Theory (APT) ARCH see autoregressive conditional heteroskedastic process ARIMA see autoregressive integrated moving average process ARMA see autoregression moving average process ask price asset allocation attribution asset swaps ATM see at the money ATMF see at the money forward options at the money (ATM) convertible bonds options at the money forward (ATMF) options attribution asset allocation performance autoregression moving average (ARMA) process autoregressive (AR) process autoregressive conditional heteroskedastic (ARCH) process autoregressive integrated moving average (ARIMA) process backtesting backwardation basket CDSs basket credit derivatives basket options BDT see Black, Derman, Toy process benchmarks Bermudan options Bernardo Ledoit gain-loss ratio BGM model see LIBOR market model BHB model (Brinson’s) bid price binomial distribution binomial models binomial processes, credit derivatives binomial trees Black, Derman, Toy (BDT) process Black and Karasinski model Black–Scholes formula basket options beyond Black–Scholes call-put parity cap pricing currency options “exact” pricing exchange options exotic options floor pricing forward prices futures/forwards options gamma processes hypotheses underlying jump processes moneyness sensitivities example valuation troubles variations “The Black Swan” (Taleb) bond convexity bond duration between two coupon dates calculation assumptions calculation example callable bonds in continuous time duration D effective duration forwards FRNs futures mathematical approach modified duration options physical approach portfolio duration practical approach swaps uses of duration bond futures CFs CTD hedging theoretical price bond options callable bonds convertible bonds putable bonds bond pricing clean vs dirty price duration aspects floating rate bonds inflation-linked bonds risky bonds bonds binomial model CDSs convexity credit derivatives credit risk exotic options forwards futures government bonds options performance attribution portfolios pricing risky/risk-free spot instruments zero-coupon bonds see also bond duration book value method bootstrap method Brinson’s BHB model Brownian motion see also standard Wiener process bullet bonds Bund (German T-bond) 10-year benchmark futures callable bonds call options call-put parity jump processes see also options Calmar ratio Capital Asset Pricing Model (CAPM) 4-moments CAPM AI APT vs CAPM Sharpe capitalization-weighted indexes capital market line (CML) capital markets caplets CAPM see Capital Asset Pricing Model caps carry cash and carry operations cash flows cash settlement, CDSs CBs see convertible bonds CDOs see collateralized debt obligations CDSs see credit default swaps CFDs see contracts for difference CFs see conversion factors charm sensitivity cheapest to deliver (CTD) clean prices clearing houses “close” prices CML see capital market line CMSs see constant maturity swaps Coleman, T. collars collateralized debt obligations (CDOs) color sensitivity commodities commodity futures backwardation contango market price non-financial producers/users trading calculations conditional swaps Conditional VaR (C-VaR) confidence levels constant maturity swaps (CMSs) contango continuous interest compounding continuous interest rates continuous time continuous variables contracts contracts for difference (CFD) contribution, performance convenience yield conversion factors (CFs) convertible bonds (CBs) bond floor CB premium conversion ratio Hard Call protection outcome of operation pricing graph risk premium stock price parity convexity adjustments see also bond convexity copper prices copulas correlation basket options credit derivatives implied Portfolio Theory Spearman’s coefficient VaR calculations volatility counterparty risk futures see also credit risk counter-value currency (c/v) Courtadon model covered period, FRAs Cox, Ingersoll and Ross model Cox–Ross–Rubenstein (CRR) model credit default swaps (CDSs) on basket cash settlement with defined recovery rate market operations variants credit derivatives CDSs credit risk main features valuation application example basket derivatives binomial model CDO pricing correlation measures credit risk models useful measures Merton model “credit events” credit exposure credit risk behind the underlying components data use dangers default rates Merton model models in practice quantification recovery rates credit VaR crossing CRR see Cox–Ross–Rubenstein model CRSs see currency rate swaps crude oil market CTD see cheapest to deliver cubic splines method currencies futures options performance attribution spot instruments currency rate swaps (CRSs) c/v see counter-value currency C-VaR see Conditional VaR D see discount factors DCF see discounted cash flows method decision-making deep ITM (DITM) deep OTM (DOTM) default rates default risk see credit risk delta delta-gamma neutral management delta-normal method, VaR derivatives credit valuation problems volatility Derman see Black, Derman, Toy process deterministic phenomena diff swaps diffusion processes Dirac functions dirty prices discounted cash flows (DCF) method discount factors (D) duration D forward rates IRSs risk-free yield curve spot rates yield curve interpolations discrete interest compounding discrete time discrete variables DITM see deep ITM DOTM see deep OTM drift duration of bonds see bond duration duration D dVega/dTime dynamic replication see delta-Gamma neutral management dZ Black–Scholes formula fractional Brownian motion geometric Wiener process martingales properties of dZ(t) standard Wiener process economic capital ED see exposure at default effective duration, bonds efficient frontier efficient markets EGARCH see exponential GARCH process EONIA see Euro Over-Night Index Average swaps equities forwards futures Portfolio Theory stock indexes stocks valuation EUR see Euros EURIBOR rates CMSs EONIA/OIS swaps FRAs futures in-arrear swaps IRSs quanto/diff swaps short-term rates Euro Over-Night Index Average (EONIA) swaps European options basket options bond options caplets CRR pricing model exchange options exotic options floorlets Monte Carlo simulations option pricing rho Euros (EUR) CRSs forward foreign exchange futures spot market swap rate markets volatility Euro Stoxx EWMA see exponentially weighted moving average process Excel functions MA process Monte Carlo simulations excess return exchange options exotic options basket options Bermudan options binomial pricing model Black–Scholes formula currency options exchange options interest rates Monte Carlo simulations options on bonds options on non-financial underlyings PFCs pricing methods see also second generation options exotic swaps see also second generation swaps expected credit loss expected return exponential GARCH (EGARCH) process exponentially weighted moving average (EWMA) process exposure at default (ED) fair price/value “fat tails” problem financial models ARCH process ARIMA process ARMA process AR process GARCH process MA process MIDAS process finite difference pricing methods fixed leg of swap fixed rate, swaps floating rate notes/bonds (FRNs) floating rates floorlets floors forecasting ARIMA ARMA process AR process MA process foreign exchange (FX) see currencies; forex swaps; forward foreign exchange forex (FX) swaps forward foreign exchange 1 year calculations forex swaps forward forex swaps forward-forward transactions forward spreads NDF market operations forward rate agreements (FRAs) forwards Black–Scholes formula bonds CFDs CRSs equities foreign exchange FRAs futures vs forwards prices options PFCs rates swaps volatility forward zero-coupon rate 4-moments CAPM fractional Brownian motion FRAs see forward rate agreements FRNs see floating rate notes/bonds futures bonds commodities currencies equities forwards vs futures prices IRR margining system market price option pricing pricing settlement at maturity short-term interest rates stock indexes theoretical price future value (FV) bond duration short-term rates spot rates zero-coupon swaps FX see foreign exchange; forex swaps gain-loss ratio (Bernardo Ledoit) gamma gamma processes GARCH see generalized ARCH process Garman–Klass volatility Gaussian copulas Gaussian distribution Gaussian hypothesis generalized ARCH (GARCH) process EWMA process I/E/MGARCH processes non-linear models regime-switching models variants volatility general Wiener process application fractional Brownian motion gamma processes geometric Wiener process Itô Lemma Itô process jump processes volatility modeling see also standard Wiener process geometric average geometric Wiener process German Bund see Bund (German T-Bond) global VaR Gordon–Shapiro method government bonds Greece Greeks see sensitivities Hard Call protection Heath, Jarrow and Morton (HJM) model Heaviside function hedging bond futures delta-gamma neutral management futures 129–30 immunization vs hedging money market rate futures stock index futures heteroskedasticity hidden layers, NNs high frequency trading “high” prices historical method, VaR historical volatility HJM see Heath, Jarrow and Morton model Ho and Lee model Hull and White model Hurst coefficient IGARCH see integrated GARCH process immunization implied correlation implied repo rate (IRR) implied volatility definition historical volatility surface volatility curves volatility smiles in-arrear swaps indexes basket options capitalization-weighted price/value-weighted see also stock indexes inflation-linked bonds inflation swaps Information Ratio (IR) initial margin in the money (ITM) caps convertible bonds deep ITM options innovation term, AR instantaneous returns integrated GARCH (IGARCH) process interbank rates see EURIBOR rates; LIBOR rates interest rate options BDT process Black and Karasinski model caps collars floors forward rates HJM model LMM model single rate processes swaptions yield curve modeling interest rates day counting discount factors futures FV/PV interest compounding IRSs options short-term spot rates term structure see also yield interest rate swaps (IRSs) bond duration and CRSs fixed/floating rates pricing methods prior to swap pricing method revaluation vanilla swaps yield curve see also constant maturity swaps intermediate period, FRAs International Swaps and Derivatives Association (ISDA) intraday margining settlements intraday volatility investor decision-making IR see Information Ratio IRR see implied repo rate IRSs see interest rate swaps ISDA see International Swaps and Derivatives Association ITM see in the money Itô process Itô’s Lemma Japanese yen (JPY) Jarrow, Robert A.

This collateral secures that, in case of default, the protection seller can assume his role vis-à-vis the protection buyer (see product example). 13.1.5 Example of a credit derivative Before looking at credit derivative valuation properly said, let us present the most traded product, the credit default swap (CDS). The CDS is an OTC contract between two parties (at least one is a bank, active in credit derivatives), with a contractual maturity and notional amount, on a specific underlying risky bond (reference obligation): The “protection buyer” can be viewed as a hedger: he holds the bond and pays for being compensated in case of default on this bond; said payment is called “premium”; The “protection seller” receives a premium in exchange of supporting the default risk. If this occurs, under the “vanilla” form of the CDS, he pays 100% of the bond value, but receives the bond from the protection buyer. If no default occurs until the CDS maturity, nothing is paid by the seller, as illustrated in Figure 13.2. Figure 13.2 Diagram of a credit default swap The rationale for “indemnifying” 100% of the bond and its transfer to the indemnifying party is that at the time of a defaulted bond, its price is rather imprecise in the market, and subject to further erratic moves, given a strong lack of market liquidity during such a perturbation.

Coming back to modeling credit risk, if the credit derivative is about a basket of several underlyings, the degree of co-dependence, that is, a broader measure than the traditional correlation coefficient based on a linear regression, will significantly affect the credit risk premium. Indeed, the aim is to price a multivariate product (the default probability of each of the basket constituents) in a consistent way with the prices (over time) of several univariate products. Application to the Pricing of a CDO7 Basket CDSs (cf. Section 12.1.5) are also embedded into “synthetic securitizations”, often called collaterized debt obligations (CDO), for example the C*Star 1, 1999–2001 of Citibank (data 1999), shown in Figure 13.6. Figure 13.6 Example of a CDO In this example, the CDO involves the lower CDS in the figure, in bold (the upper one is a regular CDS with a bank). This second CDS transfers the credit risk to an entity (C*Star) called a special purpose vehicle (SPV), whose function is to pool the debts into several notes, called tranches, offered to investors.


pages: 351 words: 102,379

Too big to fail: the inside story of how Wall Street and Washington fought to save the financial system from crisis--and themselves by Andrew Ross Sorkin

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affirmative action, Asian financial crisis, Berlin Wall, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Fall of the Berlin Wall, fear of failure, fixed income, Goldman Sachs: Vampire Squid, housing crisis, indoor plumbing, invisible hand, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, Mikhail Gorbachev, money market fund, moral hazard, NetJets, Northern Rock, oil shock, paper trading, risk tolerance, rolodex, Ronald Reagan, savings glut, shareholder value, short selling, sovereign wealth fund, supply-chain management, too big to fail, value at risk, éminence grise

Ultimately, Cassano passed on buying BISTROs from JP Morgan, but he was intrigued enough that he ordered his own quants to dissect it. Building computer models based on years of historical data on corporate bonds, they concluded that this new device—a credit default swap—seemed foolproof. The odds of a wave of defaults occurring simultaneously were remote, short of another Great Depression. So, absent a catastrophe of that magnitude, the holders of the swap could expect to receive millions of dollars in premiums a year. It was like free money. Cassano, who became head of the unit in 2001, pushed AIG into the business of writing credit default swaps. By early 2005, it was such a big player in the area that even Cassano had begun to wonder how it had happened so quickly. “How could we possibly be doing so many deals?” he asked his top marketing executive, Alan Frost, during a conference call with the unit’s office in Wilton, Connecticut.

Under European banking regulations, financial institutions had been allowed to meet capital requirements by entering into credit default swap agreements with AIG’s financial products unit. Using the swaps, the banks had essentially wrapped AIG’s triple-A credit rating around riskier assets, such as corporate loans and residential mortgages, allowing the banks to take on more leverage. If AIG were to fail, however, those protective wrappers would vanish, forcing the banks to mark down assets and raise billions of dollars—a frightening prospect in the current markets. And the numbers were staggering: Halfway though 2008, AIG had reported more than $300 billion in credit default swaps involved in this wrapping procedure, which it politely called “regulatory capital relief.” Then, of course, there was the matter of AIG’s vast insurance empire, which included about 81 million life insurance policies around the world with a face value of $1.9 trillion.

The stock would end the day up $14.74, or 46.4 percent to $46.49, for the biggest one-day gain in the stock since it went public in 1994. William Tanona, an analyst with Goldman Sachs, raised his rating on Lehman to “buy” from “neutral.” When the session ended, the excitement at Lehman was palpable. Gregory rushed over to give Callan a big hug. Later, as she went down to the bond-trading floor, she passed by the desk of Peter Hornick, the firm’s head of collateralized debt obligation sales and trading. He held out his palm, and she slapped him a high-five. For a brief, shining moment, all seemed well at Lehman Brothers. 019 Outside Lehman, however, skeptics were already voicing their concerns. “I still don’t believe any of these numbers because I still don’t think there is proper accounting for the liabilities they have on their books,” Peter Schiff, president and chief global strategist of Euro Pacific Capital, told the Washington Post.


pages: 270 words: 73,485

Hubris: Why Economists Failed to Predict the Crisis and How to Avoid the Next One by Meghnad Desai

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3D printing, bank run, banking crisis, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, BRICs, British Empire, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, correlation coefficient, correlation does not imply causation, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deindustrialization, demographic dividend, Eugene Fama: efficient market hypothesis, eurozone crisis, experimental economics, Fall of the Berlin Wall, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, German hyperinflation, Gunnar Myrdal, Home mortgage interest deduction, imperial preference, income inequality, inflation targeting, invisible hand, Isaac Newton, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, laissez-faire capitalism, liquidity trap, Long Term Capital Management, market bubble, market clearing, means of production, Mexican peso crisis / tequila crisis, mortgage debt, Myron Scholes, negative equity, Northern Rock, oil shale / tar sands, oil shock, open economy, Paul Samuelson, price stability, purchasing power parity, pushing on a string, quantitative easing, reserve currency, rising living standards, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, secular stagnation, seigniorage, Silicon Valley, Simon Kuznets, The Chicago School, The Great Moderation, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, women in the workforce

There were more forex, bonds and equity markets now for the investors to put their money into. The market economy was globalized in other ways as well. The WTO was established, capital flows to developing economies accelerated and many governments began to borrow on global financial markets. Activities on the financial front exploded as many new stock markets opened up and many new instruments were innovated: credit default swaps (CDS) and collateralized debt obligations (CDO) being lately the most notorious. Much of this was the consequence of the pioneering work of Black and Scholes on options. Hedge funds and many other institutions of what became known as the shadow banking structure also proliferated. Transactions on the forex markets reached a level of trillions of dollars. (The collapse of Long-Term Capital Management, which invested in foreign bonds, was one example of the collateral damage caused by the implosion in global financial markets.)

Alan Greenspan, as Chairman of the Federal Reserve from 1987 to 2006, had presided over the financial revolution, globalization and the long boom. He believed in free markets and had accepted the theories emanating from the Chicago School of economics. Once the boom collapsed, he recanted. In his testimony to a committee of the US House of Representatives, he explained what happened. The exposition is illuminating: It was the failure to properly price such risky assets [mortgage backed securities and collateral debt obligations] that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts, supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivative markets. This modern risk management paradigm held sway for decades.

(i) Butskellism (i) buying on margin (i) Cambridge University, Marshall’s influence (i) capital attracting (i) free movement (i) valuation (i) capital flows, growth of (i) capital markets, liberalization (i) capital migration (i), (ii) capital movement (i) benefits of (i) lifting of restrictions (i) and profit (i) restricted (i) capital–output ratio (i) capitalism as dynamic disequilibrium (i), (ii) Marx/Engels (i) Marxian view (i) Schumpeter’s model (i) capitalists (i), (ii) Carlyle, Thomas (i) cartels (i) Cassel, Gustav (i) Central Bank of Thailand (i) central banks (i), (ii), (iii) century of inflation (i) Chamberlain, Neville (i), (ii) chance events (i) checks, use of (i) Chicago School, research program (i) China (i), (ii), (iii), (iv) citizens, as rational agents (i) Civil War (i) Clark, J. M. (i) Clayton Act (i) Clinton Administration (i) closed economy (i), (ii), (iii), (iv), (v), (vi) Cobb, Charles (i) Cobb-Douglas Production Function (i), (ii) coincidence, vs.causation (i) Cold War (i) collateralized debt obligations (CDO) (i) colonization (i) Combinations (trade unions), as harmful (i) Committee on the Bank of England Charter (i) commodity markets price rises (i) regulation (i) Common Market (i) communications, advances in (i), (ii) companies, collapse of (i) comparative advantage (i) compatibility microeconomics/macroeconomics (i), (ii), (iii) unique static equilibrium/moving data (i) competition and efficiency (i) imperfect (i) theory of (Marshall) (i) computer technology development of (i), (ii); see also technological innovations stock markets (i) confidence, rise and fall (i) conflicting interests (i), (ii) Connally, John (i) consols (i) consumer credit (i) consumption function (i), (ii) contagion (i), (ii) control of money supply (i) convertibility (i) cooperation (i) correlation/coincidence, vs. causation (i) corruption (i) Countrywide Financial (i) Cournot, Antoine Augustin (i) Cowles, Alfred (i) Cowles Foundation (i) creative destruction (i) credit business dependence (i) cheap (i) as driver of investment (i) credit cards (i) credit default swaps (CDS) (i) crises beginnings of (i) developing countries (i) Juglar’s theory (i) Mexican (i) proliferation (i) as recurrent (i), (ii) as regular occurrences (i) ten year pattern (i) unpredictability (i) crisis of 1825 (i) crisis of profitability (i) Crosland, Anthony (i) The Future of Socialism (i) currency, convertibility (i) depreciation (i) pegging (i), (ii) cycles (i) banking system as root (i) combinations of (i) Goodwin (i), (ii) Juglar’s study (i) Keynes on (i) long (i) loss of interest in (i) Marx’s theories (i), (ii) measuring (i) origins (i) random events (i) reproduction by Keynesian models (i) rocking horse analogy (i) short (i) Wicksell’s theory (i) see also Frisch; Kondratieff cycles debit cards (i) Debreu, Gerard (i), (ii) debt crises (i) easy availability (i) levels (i) see also government debt debt-fueled boom (i) debts brokers (i) farmers’ (i) post-World War II (i) purchase of (i) decisions, patterns (i) deficits, endemic (i) deflation (i) deindustrialization (i), (ii) Deism (i) demand, factors in (i) demographics (i) demutualization (i) depreciation (i) advocacy of (i) Ricardo’s theory (i) value of goods (i) deregulation, banking (i) derivatives (i), (ii) Deserted Village, The (Oliver Goldsmith) (i) deutschmark (i) developing countries, Wicksellian boom (i) disequilibrium dynamic (i), (ii), (iii), (iv) stock (i) system, capitalism as (i) tradition (i) displacement effect, technological innovations (i) division of knowledge (i) division of labor (i), (ii) dollar purchasing power (i) as reserve currency (i), (ii) dollar exchange standard (i), (ii) dot.com boom (i) double deficits (i) Douglas, Paul (i), (ii) Dow Jones (i) Duménil, Gerard (i) durable goods (i) Dutch Disease (i) dynamic stochastic general equilibrium (DSGE) models (i), (ii) econometric modeling (i), (ii) Econometric Society (i), (ii) econometrics (i), (ii) economic activity, shift (i) economic analysis, applicability (i) economic cycles (i) Marx/Engels (i) see also Kondratieff cycles economic data, proliferation (i) economic growth, problems of (i) economic policy, activism (i) economic sectors, conflicting interests (i), (ii) economic slump, post-World War I (i) economic stagnation (i) economic theory (i) and individual lives (i) economic trajectories (i) economic vocabulary (i), (ii), (iii) economics background to (i) celebrated (i) changing scope of (i) as dismal science (i) professionalization (i) teaching of (i) “Economics and Knowledge” (Hayek) (i) economies, interconnections (i) economies of scale (i) economists, research methods (i) economy changing nature of (i) equilibrium/disequilibrium (i) visions of (i) efficiency, use of term (i) efficient market hypothesis (EMH) (i), (ii), (iii) Eisenhower, Dwight D.


pages: 372 words: 107,587

The End of Growth: Adapting to Our New Economic Reality by Richard Heinberg

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3D printing, agricultural Revolution, back-to-the-land, banking crisis, banks create money, Bretton Woods, carbon footprint, Carmen Reinhart, clean water, cloud computing, collateralized debt obligation, computerized trading, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, David Graeber, David Ricardo: comparative advantage, dematerialisation, demographic dividend, Deng Xiaoping, Elliott wave, en.wikipedia.org, energy transition, falling living standards, financial deregulation, financial innovation, Fractional reserve banking, full employment, Gini coefficient, global village, happiness index / gross national happiness, I think there is a world market for maybe five computers, income inequality, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Isaac Newton, Kenneth Rogoff, late fees, liberal capitalism, mega-rich, money market fund, money: store of value / unit of account / medium of exchange, mortgage debt, naked short selling, Naomi Klein, Negawatt, new economy, Nixon shock, offshore financial centre, oil shale / tar sands, oil shock, peak oil, Ponzi scheme, post-oil, price stability, private military company, quantitative easing, reserve currency, ride hailing / ride sharing, Ronald Reagan, short selling, special drawing rights, The Wealth of Nations by Adam Smith, Thomas Malthus, Thorstein Veblen, too big to fail, trade liberalization, tulip mania, working poor, zero-sum game

It’s true that many derivatives largely cancel each other out, and that their ostensible purpose is to reduce financial risk. Nevertheless, if a contract is settled, somebody has to pay — unless they can’t. Credit default swaps (CDSs, discussed in the last chapter) are usually traded “over the counter” — meaning without the knowledge of anyone other than the two counterparties; they are a sort of default insurance: a contract holder acts as “insurer” against default, bankruptcy, or other “credit event,” and collects regular “insurance” payments as premiums; this comes as “free money” to the “insurer.” But if default occurs, then a huge payment becomes due. Perversely, it is perfectly acceptable to take out a credit default swap on someone else’s debt. Here’s one example: In 2005, auto parts maker Delphi defaulted on $5.2 billion in outstanding bonds and loans — but over $20 billion in credit default derivative contracts had been written on those bonds and loans.

In the manic days of 2002 to 2006, millions of Americans came to rely on soaring real estate values as a source of income, turning their houses into ATMs (to use once more the phrase heard so often then). As long as prices kept going up, homeowners felt justified in borrowing to remodel a kitchen or bathroom, and banks felt fine making those loans. Meanwhile, the wizards of Wall Street were finding ways of slicing and dicing sub-prime mortgages into tasty collateralized debt obligations that could be sold at a premium to investors — with little or no risk! After all, real estate values were destined to just keep going up. God’s not making any more land, went the truism. Credit and debt expanded in the euphoria of easy money. All this giddy optimism led to a growth of jobs in construction and real estate industries, masking underlying ongoing job losses in manufacturing.

Nearly everyone agrees that it unfolded in essentially the following steps: • In an attempt to limit the consequences of the “dot-com” crash of 2000, the Federal Reserve drastically lowered interest rates, enabling lenders across the country to provide easy credit to households and businesses who hadn’t been able to access it before. • This led to a housing bubble, which was made much worse by sub-prime lending. • Partly because of the prior deregulation of the financial industry, the housing bubble was also magnified by over-leveraging within the financial services industry, which was in turn exacerbated by financial innovation and complexity (including the use of derivatives, collateralized debt obligations, and a dizzying variety of related investment instruments) — all feeding the boom of a shadow banking system, whose potential problems were hidden by incorrect pricing of risk by ratings agencies. • A commodities boom (which drove up gasoline and food prices) and temporarily rising interest rates (especially on adjustable-rate mortgages) ultimately undermined consumer spending and confidence, helping to burst the housing bubble — which, once it started to deflate, set in motion a chain reaction of defaults and bankruptcies.


pages: 293 words: 88,490

The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction by Richard Bookstaber

asset allocation, bank run, bitcoin, butterfly effect, capital asset pricing model, cellular automata, collateralized debt obligation, conceptual framework, constrained optimization, Craig Reynolds: boids flock, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, dark matter, disintermediation, Edward Lorenz: Chaos theory, epigenetics, feminist movement, financial innovation, fixed income, Flash crash, Henri Poincaré, information asymmetry, invisible hand, Isaac Newton, John Conway, John Meriwether, John von Neumann, Joseph Schumpeter, Long Term Capital Management, margin call, market clearing, market microstructure, money market fund, Paul Samuelson, Pierre-Simon Laplace, Piper Alpha, Ponzi scheme, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, Richard Feynman, Richard Feynman, risk/return, Saturday Night Live, self-driving car, sovereign wealth fund, the map is not the territory, The Predators' Ball, the scientific method, Thomas Kuhn: the structure of scientific revolutions, too big to fail, transaction costs, tulip mania, Turing machine, Turing test, yield curve

Treasury secretary Henry Paulson, assuring a House Appropriations subcommittee that “from the standpoint of the overall economy, my bottom line is we’re watching it closely but it appears to be contained.” Less than three months later, this containment ruptured when two Bear Stearns hedge funds that had held a portfolio of more than twenty billion dollars, most of it in securities backed by subprime mortgages, failed, marking a course that blew through one financial market after another over the following six months—the broader mortgage markets, including collateralized debt obligations and credit default swaps; money markets, including the short-term financing of the repo (repurchase agreement) and interbank markets; and markets that seemed to be clever little wrinkles but turned out to have serious vulnerabilities, such as asset-backed commercial paper and auction-rate securities. In early 2008, as the market turmoil raged, Bernanke gave his semiannual testimony before the Senate Banking Committee.

In the 2008 meltdown, that complexity could arrive in the form of things like synthetic collateralized debt obligations—derivatives based on derivatives. If we are going to use the analogy of war in economics and finance, the battlefield where Boyd’s dictum most applies is the realm of information. One tactic in this battlefield is to create informational asymmetries. If the market is becoming efficient, if information is immediately accessible to everyone at the same time, then either create new private information or else speed up your access to the public information. Derivatives play a role in the first approach, with investment banks such as Goldman Sachs creating information asymmetries by constructing financial instruments such as credit default swaps that they understand better than the buyers. For the second approach, consider the news feeds that are pushed to high-frequency traders with millisecond response times.

To see this, look at the structured financial products coming out of a trading desk in the way petroleum products come out of the distillation tower in a refinery. There, crude oil comes in, and is separated or “cracked” into various grades of products, from heavy heating oil to light naphtha. The raw material for the structured products at the heart of the 2008 crisis was mortgage-backed securities (MBSs), and the distilled products are various grades or tranches of collateralized debt obligations (CDOs), where the grade is determined by the risk of default. Just as any product coming out of the distillation process depends on the crude oil that feeds the process, any CDO coming out of the securitization process will have the markings of the MBS that comprises the feedstock. If the feedstock is tainted or diluted, the structured products will be as well. If the feedstock includes subprime mortgages that rise in defaults, any security that comes out of the process, or that uses those products as its own raw material, will be affected.


pages: 1,088 words: 228,743

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

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Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, Bretton Woods, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commoditize, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, information asymmetry, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, Myron Scholes, negative equity, New Journalism, oil shock, p-value, passive investing, Paul Samuelson, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, selection bias, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, survivorship bias, systematic trading, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond, zero-sum game

Index AAA/AA/A-rated bonds absolute valuation academic investors active investing active risk puzzle (Litterman) active strategies adaptive markets hypothesis (Lo) advisors, CTAs agriculture alpha—beta barbell alpha—beta separation alphas CAPM currency carry hedge funds long horizon investors portable alpha alternative assets assets list commodities hedge funds liquidity momentum strategies PE funds premia real estate risk factors alternative betas AM see arithmetic mean ambiguity aversion Amihud, Yakov announcement days arbitrage behavioral finance CRP front-end trading equity value strategies term structure models Argentina arithmetic mean (AM) art investing asset classes 1990—2009 alternative assets “bad times” performance currency carry derivatives foreign exchange forward-looking indicators growth sensitivities historical returns inflation long history momentum strategies performance 1990—2009 profitable strategies risk factors style diversification traditional trend following understanding returns value strategies volatility selling world wealth assets 1968—2007 asset richening AUM Berk—Green management model cyclical variation empirical “horse races” ERPC feedback loops forward-looking measures growth illiquidity liquidity long-horizon investors market relations multiple asset classes prices/pricing privately held real assets risky assets seasonal regularities survey-based returns tactical forecasting tail risks time-varying illiquidity premia volatility see also asset classes assets under management (AUM) asymmetric information asymmetric returns asymmetric risk at-the-money (ATM) options seasonal regularities tail risks volatility selling attention bias AUM see assets under management BAB see betting against beta backfill bias backwardation “bad times” carry strategies catastrophes crashes crises inflation rare disasters bank credibility Bank of England Barcap Index BBB-rated bonds behavioral finance applications arbitrage biases cross-sectional trading heuristics historical aspects macro-inefficiencies micro-inefficiencies momentum over/underreaction preferences prospect theory psychology rational learning reversal effects speculative bubbles value stocks BEI see break-even inflation benchmarks, view-based expected returns Berk—Green asset management model Bernstein, Peter betas alpha—beta barbell BAB currency carry equity hedge funds long-horizon investors risk time-varying betting against beta (BAB) biases attention behavioral finance confirmation conservatism currency carry downgrading extrapolation forward rate hedge funds heuristic simplifications high equity premium hindsight historical returns learning limits memory momentum overconfidence overfitting overoptimism reporting representativeness reversal tendencies self-attribution self-deception survey data terminology volatility selling binary timing model Black—Litterman optimizers Black—Scholes (BS) option-pricing formula Black—Scholes—Merton (BSM) world blind men and elephant poem (Saxe) bond risk premium (BRP) approximate identities bond yield business cycles covariance risk cyclical factors decomposed-year Treasury yield drivers ex ante measures historical returns inflation interpreting BRP IRP macro-finance models nominal bonds realized/excess return safe haven premium supply—demand survey-based returns tactical forecasting targets terminology theories YC bonds AAA/AA/A-rated balanced portfolios BBB-rated credit spreads ERPB government historical records HY bonds IG bonds inflation-linked long-term nominal non-government relative valuation stock—bond correlation top-rated yields see also bond risk premium; corporate bonds booms break-even inflation (BEI) Bretton Woods system BRIC countries BRP see bond risk premium BSM see Black—Scholes—Merton bubbles absolute valuation memory bias money illusion real estate Shiller’s four elements speculative Buffet, Warren building block approach business cycles asset returns economic regime analysis ex ante indicators realized returns buybacks B-S see Black—Scholes option-pricing formula C-P BRP see Cochrane—Piazzesi BRP forward rate curve calls seasonal regularities tail risks volatility selling Campbell, John Campbell—Cochrane habit formation model Capital Asset Pricing Model (CAPM) alphas carry strategies Consumption CAPM covariance with “bad times” disagreement models ERP Intertemporal CAPM liquidity-adjusted market frictions market price equation multiple risk factors risk factors risk-adjusted returns risk-based models skewness stock—bond correlation supply—demand volatility Capital Ideas (Bernstein) capitalism capitalization (cap) rate CAPM see Capital Asset Pricing Model carry strategies 1990—2009 active investing asset classes business cycles credit carry currency ERP financing rates foreign exchange forward-looking indicators forward-looking measures generic proxy role historical returns long-horizon investors non-zero yield spreads real asset investing roll Sharpe ratios 2008 slide tactical forecasting cash, ERPC cash flow catastrophes see also “bad times” CAY see consumption/wealth ratio CCW see covered call writing CDOs see collateralized debt obligations CDSs see credit default swaps central banks Chen three-factor stock returns model China Citi (Il—)Liquidity indices Cochrane—Piazzesi BRP (C-P BRP) forward rate curve see also Campbell—Cochrane collateral return collateralized debt obligations (CDOs) comfortable approaches commodities characteristics equity value strategies excess returns expected returns expected risk premia futures historical returns inflation momentum return decomposition returns 1984—2009 supply—demand seasonals term structure trading advisors value indicators commodity momentum performance rational stories simple strategies trend following tweaks when it works well why it works see also momentum strategies commodity trading advisors (CTAs) composite ranking cross-asset selection models compound returns conditioners confirmation bias conservatism constant expected returns constant relative risk aversion (CRRA) Consumption CAPM consumption/wealth ratio (CAY) contemporaneous correlation contrarian strategies blunders feedback loops forward indication approach see also reversal convenience yield corporate bonds credit spreads CRP forward-looking indicators front-end trading IG bonds liquidity sample-specific valuation tactical forecasting correlation asset returns correlation premium correlation risk default correlations equities implied risk factors tail risks costs control currency carry enhancing returns taxes trading costs country-specific vulnerability indices covariance with “bad times” covariance risk risk factors covered call writing (CCW) crashes markets see also “bad times” credit default swaps (CDSs) credit-pricing models credit risk credit risk premium (CRP) analytical models attractive opportunities business cycles credit default swaps credit spreads decomposing credit spread default correlations emerging markets debt front-end trading historical excess returns IG bonds low ex post premia mortgage-backed securities non-government debt portfolio risk reduced-form credit-pricing models reward—risk single-name risk swap—Treasury spreads tactical forecasting terminology theory credit spreads AAA/AA/A-rated bonds BBB-rated bonds business cycles CRP cyclical effects decomposition empirical “horse races” forward-looking indicators high-yield bonds rolling yield top-rated bonds volatility yield-level dependence credit and tactical forecasting creditworthiness crises 2007—2008 crisis currency carry liquidity money markets see also “bad times” cross-asset selection forecasting models cross-sectional market relations cross-sectional trading CRP see credit risk premium CRRA see constant relative risk aversion CTAs see commodity trading advisors currency base of returns carry empirical “horse races” equity value strategies inflation see also foreign exchange currency carry baseline variants combining carry conditioners costs diversification emerging markets ex ante opportunity financial crashes foreign exchange historical returns hyperinflation indicators interpreting evidence maturities pairwise carry trading portfolio construction ranking models regime indicators seasonals selection biases strategy improvements “timing” the strategy trading horizons unwind episodes why strategies work cyclical effects credit spreads growth seasonal regularities see also business cycles D/P see dividend yield data mining see also overfitting; selection bias data sources of time series data series construction day-of-the-week effect DDM see dividend discount model debt supercycle default correlations, CDOs default rates, HY bonds deflation delta hedging demand see supply—demand demographics derivatives Dimson, Elroy direct hedge funds disagreement models discount rates discounted cash flows discretionary managers disinflation disposition effect distress diversification currency carry drawdown control long-horizon investors return risk factors style diversification return (DR) dividend discount model (DDM) equities ERP forward-looking indicators growth rate debates dividend growth dividend yield (D/P) DJCS HF index dollars base of returns cost averaging currency carry foreign exchange downgrading bias downside beta DR see diversification return drawdown control duration risk duration timing dynamic strategies equity value strategies portfolio construction risk factors E/P see earnings/price ratio earnings E/P ratio EPS equity returns forecasts growth rates yield see also earnings/price ratio earnings-per-share (EPS) earnings/price (E/P) ratio absolute valuation drivers forward-looking indicators measures choices relative valuation value measures economic growth see also growth efficiency behavioral finance macro-inefficiencies market inefficiency micro-inefficiencies efficient markets hypothesis (EMH) elephant and blind men poem (Saxe) EMBI indices emerging markets carry strategies currency carry debt equity returns future trends growth EMH see efficient markets hypothesis empirical multi-factor finance models endogenous return and risk feedback loops market timing research endowments energy sector commodity momentum trend following volatility selling enhancing returns costs horizon investors risk management skill EPS see earnings per share equilibrium accounting equilibrium model equities 1990—2009 business cycles carry strategies correlation premium empirical “horse races” forward-looking indicators inflation long history momentum sample-specific valuation tactical forecasting ten-year rolling averages value strategies see also stock . . .

Antti Ilmanen Bad Homburg, November 2010 Abbreviations and acronyms AM Arithmetic Mean ATM At The Money (option) AUM Assets Under Management BEI Break-Even Inflation BF Behavioral Finance B/P Book/Price, book-to-market ratio BRP Bond Risk Premium, term premium B-S Black–Scholes C-P BRP Cochrane–Piazzesi Bond Risk Premium CAPM Capital Asset Pricing Model CAY Consumption wealth ratio CB Central Bank CCW Covered Call Writing CDO Collateralized Debt Obligation CDS Credit Default Swap CF Cash Flow CFNAI Chicago Fed National Activity Index CFO Chief Financial Officer CMD Commodity (futures) CPIyoy Consumer Price Inflation year on year CRB Commodity Research Bureau CRP Credit Risk Premium (over Treasury bond) CRRA Constant Relative Risk Aversion CTA Commodity Trading Advisor DDM Dividend Discount Model DJ CS Dow Jones Credit Suisse DMS Dimson–Marsh–Staunton D/P Dividend/Price (ratio), dividend yield DR Diversification Return E( ) Expected (conditional expectation) EMH Efficient Markets Hypothesis E/P Earnings/Price ratio, earnings yield EPS Earnings Per Share ERP Equity Risk Premium ERPB Equity Risk Premium over Bond (Treasury) ERPC Equity Risk Premium over Cash (Treasury bill) F Forward price or futures price FF Fama–French FI Fixed Income FoF Fund of Funds FX Foreign eXchange G Growth rate GARCH Generalized AutoRegressive Conditional Heteroskedasticity GC General Collateral repo rate (money market interest rate) GDP Gross Domestic Product GM Geometric Mean, also compound annual return GP General Partner GSCI Goldman Sachs Commodity Index H Holding-period return HF Hedge Fund HFR Hedge Fund Research HML High Minus Low, a value measure, also VMG HNWI High Net Worth Individual HPA House Price Appreciation (rate) HY High Yield, speculative-rated debt IG Investment Grade (rated debt) ILLIQ Measure of a stock’s illiquidity: average absolute daily return over a month divided by dollar volume IPO Initial Public Offering IR Information Ratio IRP Inflation Risk Premium ISM Business confidence index ITM In The Money (option) JGB Japanese Government Bond K-W BRP Kim–Wright Bond Risk Premium LIBOR London InterBank Offered Rate, a popular bank deposit rate LP Limited Partner LSV Lakonishok–Shleifer–Vishny LtA Limits to Arbitrage LTCM Long-Term Capital Management MA Moving Average MBS (fixed rate, residential) Mortgage-Backed Securities MIT-CRE MIT Center for Real Estate MOM Equity MOMentum proxy MSCI Morgan Stanley Capital International MU Marginal Utility NBER National Bureau of Economic Research NCREIF National Council of Real Estate Investment Fiduciaries OAS Option-Adjusted (credit) Spread OTM Out of The Money (option) P Price P/B Price/Book (valuation ratio) P/E Price/Earnings (valuation ratio) PE Private Equity PEH Pure Expectations Hypothesis PT Prospect Theory r Excess return R Real (rate) RE Real Estate REITs Real Estate Investment Trusts RWH Random Walk Hypothesis S Spot price, spot rate SBRP Survey-based Bond Risk Premium SDF Stochastic Discount Factor SMB Small Minus Big, size premium proxy SR Sharpe Ratio SWF Sovereign Wealth Fund TED Treasury–Eurodollar (deposit) rate spread in money markets TIPS Treasury Inflation-Protected Securities, real bonds UIP Uncovered Interest Parity (hypothesis) VaR Value at Risk VC Venture Capital VIX A popular measure of the implied volatility of S&P 500 index options VMG Value Minus Growth, equity value premium proxy WDRA Wealth-Dependent Risk Aversion X Cash flow Y Yield YC Yield Curve (steepness), term spread YTM Yield To Maturity YTW Yield To Worst Disclaimer Antti Ilmanen is a Senior Portfolio Manager at Brevan Howard, one of Europe’s largest hedge fund managers.

Other studies show that correlation risk is priced in the cross-section of equity returns (stocks with higher sensitivity to rising correlation need to offer higher long-run returns) and in time series (the aggregate market has higher returns following higher average correlations). There is a large literature that goes beyond equities and focuses on implied default correlations based on collateralized debt obligation (CDO) tranche prices in liquid credit default swap (CDS) indices. The manufacturing of CDOs involves two steps: first, many securities are pooled into a diversified portfolio (special purpose vehicle or SPV), then the resulting cash flows are redistributed to tranches of varying seniority within the CDO. Tranches are typically assigned credit ratings from AAA to BBB, except for the unrated, most junior (equity) tranche, which takes the first default losses; higher yield spreads compensate lower seniorities.


pages: 225 words: 11,355

Financial Market Meltdown: Everything You Need to Know to Understand and Survive the Global Credit Crisis by Kevin Mellyn

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asset-backed security, bank run, banking crisis, Bernie Madoff, bonus culture, Bretton Woods, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, disintermediation, diversification, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Francis Fukuyama: the end of history, George Santayana, global reserve currency, Home mortgage interest deduction, Isaac Newton, joint-stock company, liquidity trap, London Interbank Offered Rate, long peace, margin call, market clearing, mass immigration, money market fund, moral hazard, mortgage tax deduction, Northern Rock, offshore financial centre, paradox of thrift, pattern recognition, pension reform, pets.com, Plutocrats, plutocrats, Ponzi scheme, profit maximization, pushing on a string, reserve currency, risk tolerance, risk-adjusted returns, road to serfdom, Ronald Reagan, shareholder value, Silicon Valley, South Sea Bubble, statistical model, The Great Moderation, the new new thing, the payments system, too big to fail, value at risk, very high income, War on Poverty, Y2K, yield curve

These collateralized loan obligations, or CLOs, were joined by collateralized debt obligations, or CDOs, that pooled corporate debt. Obviously, such instruments lose value very quickly when the value of the underlying mortgages, loans, and bonds becomes questionable. Basically, they become ‘‘unsaleable.’’ Buying and selling makes prices, so without such transactions, there is no way to put a value on these instruments. DERIVATIVES PILED ON DERIVATIVES All this would be bad enough, but it gets worse. Banks used derivatives to hedge their bets on many of these structured credit deals. At the extreme end of this complexity within complexity were so-called synthetic CDOs. These structures did not even own a pool of real assets like bonds or loans. Instead, they used something called a credit default swap or CDS to gain ‘‘credit exposure’’ to pools of assets.

See S&L Buffett, Warren, 48, 52, 175 Busts, xv, xx, 16, 18, 27, 67, 80, 98, 104, 121–131, 139–140, 158, 170 buy side, 22–27, 46, 67, 68, 146 ‘‘capital,’’ 4–5, 16, 26–28, 41, 46, 54, 60, 64, 66, 68, 70–74, 93, 99, 103–104, 117, 127, 142–143, 148, 156–160, 165, 184, 189 capital market, 27, 60, 117, 156, 160, 189 CD (Certificate of Deposit), 39, 49, 71, 130, 145–146 CDO (Collateralized Debt Obligation), 73–74 CDS (Credit Default Swap), 73 central bank, 12–13, 69, 74, 83, 102–113, 122–123, 136, 150, 160, 162–165, 173, 185. See also Bank of England, Fed, Federal Reserve System, Board of Governors, Federal Reserve Bank of New York checks, xv, 2, 10–14, 36–37, 84–90, 100, 105, 120, 122–123, 144 clearing, 13–14, 84–85, 91, 100, 105, 168 Index clearing houses, 11, 14, 84–85, 91, 105, 121, 144, 150 CLO (Collateralized Loan Obligation), 73 CMO (Collateralized Mortgage Obligation), 73 coinage, xvi, 105 Cold War effect on international finance, 147 commanding heights (of the economy), 126, 166, 174, 182, 187, 189 commercial paper, 41–42, 65–66, 130, 152 commodity money, xiii Compensating Balances, 144 Comptroller of the Currency, 38, 128, 141 confidence, xix, 12, 22, 28, 44, 80, 103, 112, 121, 129, 135–136, 140–141, 161, 164–165, 168 contracts, 25, 29–32, 36–37, 40–41, 47, 53–57, 73, 80, 98, 119–120, 138, 156, 175, 186 contracts in a box, 29–30, 34–35, 41–47, 54, 78 consumer lending, 61, 63, 65, 70 corporate equities.

This process, called ‘‘asset securitization,’’ made the reckless expansion of consumer debt not only possible but almost irresistible because of buy-side demand. The investment banking wiz kids even invented whole new classes of securities called ‘‘derivatives.’’ Derivatives have no value in themselves but allow investors to ‘‘bet’’ on the value of an asset or contract linked to them. For example, a credit default swap allows investors to make money if a company or country cannot pay its bond holders. The rapid fire invention and roll out of new, untested securities has been central both to the explosive growth of the global financial markets and the shocking meltdown we are now living through. Hedge Funds New providers—often called ‘‘alternative investment vehicles’’— have also sprung up to meet the ‘‘buy-side’’ demand for higher returns on invested money.


pages: 576 words: 105,655

Austerity: The History of a Dangerous Idea by Mark Blyth

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accounting loophole / creative accounting, balance sheet recession, bank run, banking crisis, Black Swan, Bretton Woods, capital controls, Carmen Reinhart, Celtic Tiger, central bank independence, centre right, collateralized debt obligation, correlation does not imply causation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, deindustrialization, disintermediation, diversification, en.wikipedia.org, ending welfare as we know it, Eugene Fama: efficient market hypothesis, eurozone crisis, financial repression, fixed income, floating exchange rates, Fractional reserve banking, full employment, German hyperinflation, Gini coefficient, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, information asymmetry, interest rate swap, invisible hand, Irish property bubble, Joseph Schumpeter, Kenneth Rogoff, liberal capitalism, liquidationism / Banker’s doctrine / the Treasury view, Long Term Capital Management, market bubble, market clearing, Martin Wolf, money market fund, moral hazard, mortgage debt, mortgage tax deduction, Occupy movement, offshore financial centre, paradox of thrift, Philip Mirowski, price stability, quantitative easing, rent-seeking, reserve currency, road to serfdom, savings glut, short selling, structural adjustment programs, The Great Moderation, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, unorthodox policies, value at risk, Washington Consensus, zero-sum game

Tales of Two Small European Countries,” (Giavazzi), 169, 170, 171, 176, 209–210 Canada fiscal adjustment in, 173 Capitalism, Socialism and Democracy, (Schumpeter), 128, 129 Cassel, Gustav, 191 central banks, independence of, 156–158 certificates of deposit (CDs), 234 Chin, Menzie, 11 China, 55 Chowdhury, Anis, 176 Churchill, Winston, 123 and the gold standard, 189 1929 budget speech, 124 Citigroup, 48 Clinton, Bill, 12 Clinton, Hillary, 218 Cochrane, John, 2, 239 Colander, David, 99 collateralized debt obligations, 28, 234 Congressional Research Group, 242 Considine, John, 208 Coolidge, Calvin, 120 Credit Agricole, 87 credit default swaps, 26, 29, 30 Daimler/Mercedes Benz, 132 Darwin’s Dangerous Idea (Dennett), 159 De Grauwe, Paul, 86 debt inflation, 150 default as a way out of financial crises, 183 mortgage, 41, 42, 44, 50 risk, 24 sovereign, 113, 210, 241 See also credit default swaps (CDSs) deflation, 240, 241 demand-side economics, 127 See also supply-side economics Denmark, 207, 209 as a welfare state, 214 austerity in, 17, 169–170, 170–171, 179 expansion, 205, 206, 209 fiscal adjustment in, 173 Dennett, Daniel Darwin’s Dangerous Idea, 159 derivatives, 27–30 credit default swaps, 27–30 special investment vehicles, 29 See also mortgages; real estate Deutsche Bank, 83 devaluation and hyperinflation, 194 as a way out of financial crises, 75, 173, 208, 213 of currency, 76, 77, 147, 169, 171, 188, 191, 197 Diamond, Peter, 243 disintermediation, 23, 49, 232 Dittman, Wilhelm, 195 Dow Jones Industrial Average, 1, 2–3 Duffy, James, 208 Eatwell, John, 42 Economic and Financial Affairs Council of the European Council of Ministers (ECOFIN), 173, 175, 176 economics Adam Smith, 109 Austrian school of, 31, 144 demand-side, 127 Frieburg school of, 135 Germany’s Historical school of, 143 Keynesian, ix, 39, 54 liberal, 99 London School of, 31, 144 macro, 40 neoclassical, 41 neoliberal, 41, 92 public choice, 166 supply-side, 111 zombie, 10, 234 Economics of the Recovery Program, The, (Schumpeter), 128 Economist, The, 69, 166, 216 efficient markets hypothesis, 42 Eichengreen, Barry, 183, 231 Einaudi, Luigi, 165, 167 Eisenhower, Dwight, 243 Englund, Peter, 211 Estonia austerity in, 18, 103, 179, 216–226, 217 fig. 6.1 Eucken, Walter, 135–136 centrally administered economy, 135–136 transaction economy, 135–136 Euro, 74–75, 77 success or failure of, 78–81, 87–93 European banks austerity and, 87 fall of, 84–87 “too big to bail”, 6, 16 European Bond Market, 1 European Central Bank, 54, 55, 84 and austerity, 60, 122 and bailouts, 71–73 and loans to Ireland, 235 and the success of the REBLL states, 216 emergency liquidity assistance program, 4 limitations of, 87–93 long-term refinancing operation, 4, 86 Monthly Bulletin, June 2010, 176 See also Trichet, Jean Claude European Commission, 122 and austerity, 221 and loans to Ireland, 235 and the success of the REBLL states, 216 European Economic Community, 62–64 European Exchange Rate Mechanism, 77 European Union and austerity, 221 and bailouts, 71–73, 208, 221 influence on Europe, 74–75 Eurozone and current economic conditions, 213 current account imbalances, 78 fig. 3.1 ten-year government bond yields, 80 fig. 3.2 exchange-traded funds (ETFs), 234 Fama, Eugene, 55 Fannie Mae, 121 Farrell, Henry, 55 Federal Deposit Insurance Corporation (FDIC), 24 Feldstein, Martin, 55, 78 Ferguson, Niall, 72 Figaro, Le, 201 financial repression, 241 Financial Stability Board, 49 Financial Times, 60 Fisher, Irving, 150 Fitch Ratings, 238 Flandin, Pierre-Étienne, 202 fractional reserve banking, 110 France, 4 and Germany’s nonpayment of Versailles treaty debt, 57 and John Law, 114 and the gold standard, 185, 204 assets of large banks in, 6 austerity in, 17, 126, 178–180 and the global economy in the 1920s and 1930s, 184–189 bond rates in, 6 depression in, 201–202 Eurozone Current Account Imbalances, 78 fig. 3.1 Eurozone Ten-Year Government Bond Yields, 80 fig. 3.2 war debts to the United States, 185 See also Blum, Leon; Flandin, Pierre-Étienne; Laval, Pierre; Poincaré, Raymond Freddie Mac, 121 free option, 29 Freiberg school of economics, 135, 136, 138–139 Frieden, Jeffry, 11 Friedman, Milton, 103, 155, 156, 165, 173 G20 2010 meeting in Toronto, 59–62 Gates, Bill, 7, 8, 13 Gaussian distribution, 33, 34 General Theory (Keynes), 126, 127, 145 Gerber, David, 136 Germany, 2, 16 and repayment war damage in France, 200–201 and the gold standard, 185 and the Treaty of Versailles, 185 as an economic leader, 75–78 austerity in, 17, 25, 57, 59, 101–103, 132–134 and the global economy in the 1920s and 1930s, 178–180, 184–189, 186, 193–197 Bismarkian patriarchal welfare state, 137 Bundesbank, 54, 156, 172, 173 capital drain after World War I, 186 Center Party, 194 Christian Democrats, 137, 139 competition, 137–138 economic ideology of, 56–58, 59–60 entrance into world economy, 134–135 Eurozone Current Account Imbalances, 78 fig. 3.1 Eurozone Ten-Year Government Bond Yields, 80 fig. 3.2 fiscal prudence of, 2, 17, 54 founder’s crisis, 134 German Council of Economic Advisors Report, 169 gold standard and, 196 Historical school of economics, 143 hyperinflation in the 1920s, 56–57, 185, 194, 200, 204 industry in, 132–134 See also BASF, Daimler/Mercedes Benz, Krups, Siemens, ThyssenKrupp ordoliberalism in, 101, 131, 133 origins of, 135–137 order-based policy, 136 National Socialists, 194–195 Nazi period in, 136, 196 Social Democratic Party, 140, 194, 195, 204 social market economy, 139 Stability and Growth Pact, 92, 141 stimulus in, 55–56 See also Freiburg school of economics stop in capital flow from United States in 1929, 190, 194 unemployment in, 196 WTB plan, 195, 196 Giavazzi, Francesco, 179, 205, 206 “Can Severe Fiscal Contractions be Expansionary?

Mortgage-backed securities were already safe investments, but could that safety be maintained while enhancing returns? If you could figure this out, you could make a lot of money. This was achieved by the technique of “tranching the security,” which turned the simple mortgage-backed securities (the bucket of mortgage payments sold onto investors described earlier) into a contract called a “collateralized debt obligation” (CDO).15 The technique combined the mortgage payments of many different bits of real estate, from many different places, in the same security, but it kept them separate by selling different parts of the security to different people via different “tranches” (or tiers). Basically, you take a bit of the east side of Manhattan and blend that with a bit of Arizona suburb and a bit of Baltimore waterfront, and you pay the holders of the different tranches (usually called senior, mezzanine, or equity tranches) different interest rates according to how risky a tranche they bought.

See risk-management techniques Portugal, 3, 4 bailout in, 71–73 Eurozone Current Account Imbalances, 78 fig. 3.1 Eurozone Ten-Year Government Bond Yields, 80 fig. 3.2 government debt 2006–2012, 47 fig. 2.3 slow growth crisis, 68–71 “Positive Theory of Fiscal Deficits and Government Debt in a Democracy, A” (Alesini), 167 Posner, Richard, 55 Prescott, Edward, 55, 157 President’s Conference on Unemployment, 120 Prices and Production (Hayek), 144 Principles of Political Economy (Mill), 116 Quiggin, John, 55 and Australian expectations-augmented austerity, 209 “zombie economics”, 10, 234 Rand, Ayn Atlas Shrugged, 130 rational expectations hypothesis, 42 Real Business Cycle school, 157 real estate “collateralized debt obligation”, 28 “tranching the security”, 28, 30–31 equity, 28 mezzanine, 28 senior, 28 “uncorrelated within their class”, 27–28 REBLL alliance, 103, 178–180, 179–180, 205, 216–226, 217 fig. 6.1 GDP and consumption growth in 2009, 221 table 6.1 See also names of countries recapitalization, 45, 52 Reinhardt, Carmen, 11, 73, 241 Ricardian equivalence, 41, 49 Ricardo, David, 115–117, 117–119, 171 in Germany, 195 risk-management techniques, 49 hedging, 32 long position, 32 options, 32 portfolio diversification, 31 short sell, 32 Ritschl, Albrecht, 193 Road to Serfdom, The (Hayek), 144 Robins, Lionel, 144 Robinson, Joan, 122, 126 Rodrik, Dani, 162, 163 Rogoff, Kenneth, 11, 73 Romania austerity in, 18, 103, 190, 216–226, 217 fig. 6.1, 221 Romney, Mitt, 243 Roosevelt, Franklin Delano, 126 administration policies, 128 balancing the budget, 188 Röpke, Wilhelm, 138 Rothbard, Murray, 148 Sachs, Jeffrey, 60 Saez, Emanuel, 243 Say’s law, 137 Sbrancia, M.


pages: 419 words: 130,627

Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase by Duff McDonald

bank run, Bonfire of the Vanities, centralized clearinghouse, collateralized debt obligation, conceptual framework, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Exxon Valdez, financial innovation, fixed income, housing crisis, interest rate swap, Jeff Bezos, John Meriwether, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, money market fund, moral hazard, negative equity, Northern Rock, profit motive, Renaissance Technologies, risk/return, Rod Stewart played at Stephen Schwarzman birthday party, Saturday Night Live, sovereign wealth fund, statistical model, Steve Ballmer, Steve Jobs, technology bubble, The Chicago School, too big to fail, Vanguard fund, zero-coupon bond, zero-sum game

The users understood precisely what the risks were, but they made the wrong bet—that housing prices wouldn’t plunge across the board, everywhere. There were a lot of people who took the bet; they just didn’t match AIG’s level of recklessness. There have been some suggestions that the interplay between a company’s bonds and its credit default swaps actually exacerbated problems—George Soros wrote convincingly about this phenomenon in the New York Times—but that phenomenon was arguably on the margin of a much larger problem: abandonment of risk management controls in pursuit of higher profits. When it came time for the first big test of credit default swaps—in the aftermath of Lehman Brothers’ bankruptcy—the settlement of those contracts took place without incident on October 21, 2008. Dimon has endorsed the creation of a central clearinghouse so derivatives exposures can be more closely monitored.

To turbocharge the market for credit derivatives, the J.P. Morgan team eventually created a product called a broad index secured trust offering (BISTRO). Complex in its details and accounting, the product was nevertheless simple in essence—it aggregated the odds of default on a whole package of loans, not just on a single credit. Collateralized debt packages had long been around, but BISTRO represented a whole new segment—synthetic collateralized debt obligations (CDOs). Wall Street has an endless ability to slice and dice, though; and as soon as it was created, BISTRO was separated into various “tranches” that carried different levels of risk and return. Investors in the junior tranche would eat the first losses due to any defaults, and therefore earn the highest return. The mezzanine tranche came next, and after that was the senior tranche.

Her response: “So why is everyone so surprised?” (Dimon is fond of Mark Twain’s wry comment that history does not repeat itself, but it does rhyme.) One answer to Laura Dimon’s question is that this time around it wasn’t just one entity (such as Long-Term Capital Management) or one investment product (such as Internet stocks) that melted down. Almost every credit product out there collapsed—subprime mortgages, mortgage-related collateralized debt obligations, asset-backed commercial paper, auction-rate securities, SIVs, Alt-A mortgages, financial insurers, home equity. Among the large commercial and investment banks, only Goldman Sachs and JPMorgan Chase seem to have been in any way prepared for the possibility of disaster. In March 2007, Dimon had written in the company’s 2006 annual report, “Credit losses, both consumer and wholesale, have been extremely low, perhaps among the best we’ll see in our lifetimes.


pages: 479 words: 113,510

Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America by Danielle Dimartino Booth

Affordable Care Act / Obamacare, asset-backed security, bank run, barriers to entry, Basel III, Bernie Sanders, break the buck, Bretton Woods, central bank independence, collateralized debt obligation, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, financial deregulation, financial innovation, fixed income, Flash crash, forward guidance, full employment, George Akerlof, greed is good, high net worth, housing crisis, income inequality, index fund, inflation targeting, interest rate swap, invisible hand, John Meriwether, Joseph Schumpeter, liquidity trap, London Whale, Long Term Capital Management, margin call, market bubble, Mexican peso crisis / tequila crisis, money market fund, moral hazard, Myron Scholes, natural language processing, negative equity, new economy, Northern Rock, obamacare, price stability, pushing on a string, quantitative easing, regulatory arbitrage, Robert Shiller, Robert Shiller, Ronald Reagan, selection bias, short selling, side project, Silicon Valley, The Great Moderation, The Wealth of Nations by Adam Smith, too big to fail, trickle-down economics, yield curve

., 105–7, 112, 115 central banking, 260–61 Chase Manhattan, 14 China, 208, 261 Chomsky, Noam, 9 Chrysler Financial, 169 Citigroup, 53, 110, 121, 128, 166, 168 Cleveland Fed, 36 Clinton, Bill, 16, 86 Clinton, Hillary, 260 “Closing the Gap” (Boston Fed), 21–22 CNBC, 25–26, 107 collateral agents, 127 collateralized debt obligations (CDOs), 15–18, 27–28, 57, 124 Collins, Nancy, 68 Commercial Paper Funding Facility (CPFF), 167, 169 commercial paper market, 141–42 commodity bubble, 216 “From Complacency to Crisis” (Duca, Rosenblum, & DiMartino Booth), 74–75 core PCE inflation rate, 77–78, 83, 247 Corrigan, Gerry, 53 Corzine, Jon, 109 counterparty risk, 108 Countrywide, 100 Courage to Act, The (Bernanke), 251–52 Cox, Michael, 62, 63 creative destruction, 63 credit default swaps (CDSs), 94–95, 98, 105, 124 Credit Suisse, 15 crude oil, 247 Dallas Fed, 36–38, 62–65, 70–73, 82 Dallas Morning News, 18, 21, 31 Dealey, George Bannerman, 44 debt, 9–10, 24–25, 251 Decherd, Robert, 18 “Deflation: Making Sure ‘It’ Doesn’t Happen Here” (Bernanke), 150–51 derivatives, 14, 15–18, 51, 52, 126–29 AIGFP insurance policies for, 137–38 Born’s attempt to regulate, 16–17 CDOs, 15–18, 27–28, 57, 124 Deutsche Bank, 168 Diamond, Peter, 194–95 Dimon, Jamie, 29, 110–12, 114, 134, 135, 226 discount window, 118 District Banks, 36–38, 43–45, 67, 70–72.

I imagined my fellow Wall Streeters going to the cathedral in my neighborhood and lighting candles. Thanks be to God and Greenspan. In August 2000, my firm, DLJ, was purchased by Credit Suisse for $11.5 billion. By January 2001, when we were all called in for that companywide meeting, the Swiss company’s stodgier, more regimented culture had already collided with DLJ’s entrepreneurial spirit. The bankers began describing their new product: a $340 million collateralized debt obligation (CDO), essentially a bond composed of home mortgages sliced into various tranches that produced income streams. Each tranche had been rated by Moody’s, Standard & Poor’s, and Fitch Ratings, the three most important ratings agencies. The AAA rating stood at the top, then AA, and so on down the ratings ladder until the bottom, the “equity” tranche. The highest-rated tranches paid out first, as much as 10 percent, significantly higher than the average yield on a corporate bond with the same rating; the last to pay out was equity.

., 109 Stiglitz, Joseph, 199, 260 stock buybacks, 7 Stockman, David, 196 stock market Bernanke’s “additional stimulus” speech in August 2010 and, 193 Black Monday, 64–65 end of QE2 and, 217–18 flash crash, 189–90 low conviction rallies, 2010, 185, 188 9/11 terrorist attacks impact on, 223–24 percentage of U.S. adults invested in, 8–9 rally of, in April–May 2009, 174 reaction to bad news, late 2009, 181, 184 record lows, in March 2009, 171 TARP bailout bill and, 143 VIX and, 187, 188 Stockton, David, 194 Stress Test (Geithner), 52 stress tests, 170–71 Strong, Benjamin, 53 structured investment vehicles (SIVs), 123–24 subprime mortgages, 21, 22, 27, 28 Summers, Larry, 15–17, 53, 95, 234–35 Supervisory Capital Assessment Program (SCAP), 171 synthetic collateralized debt obligations, 124 systemic risk, 26, 28, 252 System Open Market Account (SOMA), 29, 52 taper tantrum, 233 Tarullo, Daniel, 43, 211, 258–59 Taylor, John, 82, 198 Term Asset-Backed Securities Loan Facility (TALF), 167, 168 Term at the Fed, A (Meyer), 153 Term Auction Facility (TAF), 168 Term Securities Lending Facility (TSLF), 154 Tett, Gillian, 192 Thain, John, 135, 136, 146 Tice, David, 21 Time, 15, 182 Tishman Speyer, 133 Tobin, James, 85–86 Toyota, 241 tri-party repo agreements, 127 troubled asset relief program (TARP), 142–43 Trump, Donald, 9 Tyco, 107 UBS, 120, 168 unemployment, 171, 192, 195, 210 Vasiliauskas, Vitas, 261 Verizon, 169 Vitner, Mark, 40 VIX, 187, 188 Volcker, Paul, 48, 53, 60, 62, 93, 187–88, 219–20, 238 Volcker Rule, 226 Von Mises, Ludwig, 88 Wachovia, 121 Waldman, Maryanne, 222 Wall Street Journal, 106, 119, 167, 175, 177, 217 Warren, Elizabeth, 246, 258 Warsh, Kevin, 113, 181, 193, 197–98, 211, 234 Washington Mutual, 121, 143 wealth effect, 6–7 Wealth of Nations, The (Smith), 125–26 Weill, Sanford, 29, 110 Weintraub, Robert E., 60 Wells Fargo, 178 “When Does Narcissistic Leadership Become Problematic?”


pages: 302 words: 86,614

The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds by Maneet Ahuja, Myron Scholes, Mohamed El-Erian

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activist fund / activist shareholder / activist investor, Asian financial crisis, asset allocation, asset-backed security, backtesting, Bernie Madoff, Bretton Woods, business process, call centre, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, en.wikipedia.org, family office, fixed income, high net worth, interest rate derivative, Isaac Newton, Long Term Capital Management, Marc Andreessen, Mark Zuckerberg, merger arbitrage, Myron Scholes, NetJets, oil shock, pattern recognition, Ponzi scheme, quantitative easing, quantitative trading / quantitative finance, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, short selling, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, systematic trading, zero-sum game

Weinstein joined Deutsche Bank in January 1998, when the market for credit derivatives—financial contracts for hedging (or speculating) against a company’s default—was in its infancy. “Not only was it brand new, but few people understood the mechanics of how to price a credit default swap,” says Weinstein. A CDS is the most common credit derivative. “Foreign exchange derivatives, interest rate derivatives, equity derivatives—those instruments had been around for 25 years before J. P. Morgan and Deutsche began figuring out how to structure and trade credit default swaps.” This was an ideal situation for young Weinstein. For years, while his peers had all followed equities, Weinstein had been fascinated by the complexity of credit. “If you analyze a company and decide you like the stock, all you can really do is buy the stock or a call option on the stock.

About a month later, on February 27, Citigroup announced the U.S. government would be taking a 36 percent equity stake in the company by converting $25 billion in emergency aid into common shares. Citigroup shares dropped 40 percent on the news. In aggregate the aid provided to the bank totaled $45 billion. Because banks are highly leveraged, it is crucial to thoroughly analyze their assets, as a small percentage loss can quickly wipe out the equity. During the financial boom, Citigroup made many speculative investments, particularly in collateralized debt obligations (CDOs), mortgages, derivatives and other types of structured products. When the value of these assets deteriorated, they took enormous write downs, which in turn required them to raise more equity. Investors lined up to purchase equity in Citigroup starting in October 2007 as they thought the decline in the stock price represented a good buying opportunity. However, as the losses mounted and the write-downs increased, the stock price collapsed.

Michael Neumann, a salesman on the Lehman Brothers credit desk, who had sold him CDS contracts on Farmer Mac, suggested that Ackman look at the bond insurers. Ackman zeroed in on MBIA. It was the largest of the bond insurers, the largest guarantor of municipal bonds in the United States. While MBIA had its origins insuring low-risk municipal bonds, in more recent years it had begun to move into the more lucrative business of insuring exotic and highly risky collateralized debt obligations (CDOs) and other structured products. Ackman believed that the company was underreserved relative to the risk it was underwriting, was overleveraged, and was engaging in various accounting devices to shield losses and accelerate gains. He believed that it was poised for a dramatic fall. Ultimately, Ackman concluded that the business, despite its triple-A rating, was likely insolvent.


pages: 192 words: 75,440

Getting a Job in Hedge Funds: An Inside Look at How Funds Hire by Adam Zoia, Aaron Finkel

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backtesting, barriers to entry, collateralized debt obligation, commodity trading advisor, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, family office, fixed income, high net worth, interest rate derivative, interest rate swap, Long Term Capital Management, merger arbitrage, offshore financial centre, random walk, Renaissance Technologies, risk-adjusted returns, rolodex, short selling, side project, statistical arbitrage, systematic trading, unpaid internship, value at risk, yield curve, yield management

c08.indd 100 1/10/08 11:09:05 AM Operations 101 Although pedigree is not as important, funds will pay close attention to undergraduate and graduate school GPAs and SAT scores and want to see excellence in both areas. In addition to academics, hedge funds look for specific product knowledge and will pay up for experience in the more sophisticated products such as derivatives, credit default swaps (CDS), collateralized debt obligations (CDOs), and collateralized loan obligations (CLOs). As with other hedge fund roles, it’s good to know the different hedge fund investment strategies. Hedge funds can be extremely picky when hiring, so whatever you can do to differentiate yourself and show you have additional skills will be helpful. We strongly suggest being very well versed in industry-specific systems.

These funds may also utilize derivatives to leverage returns and to hedge out interest rate and/or market risk. Because they invest in special situations, the performance of these funds is typically not dependent on the direction of the public stock market. Note: This is primarily an equity-based style. Fixed Income Strategies There are many different fixed income funds that invest in various types of debt instruments, including mortgage-backed securities (MBS), collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), convertible bonds, high-yield bonds, municipal bonds, corporate bonds, and different types of global securities. There are diversified funds that may invest in a combination of these securities and also arbitrage funds that seek to profit by exploiting pricing inefficiencies between related fixed income securities while neutralizing exposure to interest rate risk.

Just when I began the firm was creating an alternative investment group, and, luckily for me, I was placed into it. Right off the bat I got exposure to hedge funds. In fact, my first onsite audit was with a fund that specialized in mortgage-backed securities. Even though I worked like a dog and didn’t have much of a life, I gained a working knowledge of products, including mortgage-backed securities, collateralized debt obligations (CDOs), swaps, repurchase agreements, equities, and bonds. The job also opened my eyes to other opportunities and made me want to work doing investment banking or sales and trading. I wasn’t a big fan of the huge corporate atmosphere of the Big Four firms (they work you to the bone without the bonuses of investment banks), and after a couple of years I began to look at other opportunities.


pages: 840 words: 202,245

Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present by Jeff Madrick

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accounting loophole / creative accounting, Asian financial crisis, bank run, Bretton Woods, capital controls, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, desegregation, disintermediation, diversified portfolio, Donald Trump, financial deregulation, fixed income, floating exchange rates, Frederick Winslow Taylor, full employment, George Akerlof, Hyman Minsky, income inequality, index fund, inflation targeting, inventory management, invisible hand, John Meriwether, Kitchen Debate, laissez-faire capitalism, locking in a profit, Long Term Capital Management, market bubble, minimum wage unemployment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Myron Scholes, new economy, North Sea oil, Northern Rock, oil shock, Paul Samuelson, Philip Mirowski, price stability, quantitative easing, Ralph Nader, rent control, road to serfdom, Robert Bork, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, Ronald Reagan: Tear down this wall, shareholder value, short selling, Silicon Valley, Simon Kuznets, technology bubble, Telecommunications Act of 1996, The Chicago School, The Great Moderation, too big to fail, union organizing, V2 rocket, value at risk, Vanguard fund, War on Poverty, Washington Consensus, Y2K, Yom Kippur War

B1. 43 FEW ACCEPTED THE CLAIM: Congressional Oversight Committee, December Oversight Report, Taking Stock: What Has TARP Achieved?, December 9, 2009, http://cop.senate.gov/documents/cop-120909-report.pdf, p. 14. 44 THAT YEAR, THE CDOS PRODUCED: “Collateralized Debt Obligations Face Funding Woes,” New York Times, July 24, 2007, http://www.nytimes.com/2007/07/24/business/ worldbusiness/24iht-mortgage.1.6798554.html. 45 IN A YEAR WHEN: Among other sources, Lowenstein, The End of Wall Street, p. 75. 46 IN 2006, THE NEW YORK TIMES REPORTED: Louise Story, “On Wall Street, Bonuses, Not Profits, Were Real,” New York Times, December 17, 2008, http://www.nytimes.com/2008/12/18/business/18pay.html. 47 BY 2006, THROUGH AGGRESSIVE BORROWING: Tett, Fool’s Gold, pp. 133–36; “Collateralized Debt Obligations Face Funding Woes.” 48 AS THE MARKETS WEAKENED: Louise Story, “On Wall Street,” New York Times, http://www.nytimes.com/2008/12/18/business/18pay.html. 49 WITH WEILL GONE: Gasparino, The Sellout, p. 146. 50 LEVERAGE RATIOS SHOT UP: McDonald and Robinson, A Colossal Failure of Common Sense, p. 287. 51 IN NOVEMBER, HE WAS FORCED OUT: Lowenstein, The End of Wall Street, p. 110. 52 EARLY IN 2008: Tett, Fools’ Gold, p. 210. 53 RESIDENTIAL FORECLOSURES WERE DOUBLING: RealtyTrac, Foreclosure Activity Increases 12 Percent in August (September 12, 2008, www.realtytrac.com/contentmanagement/pressrelease.aspx?

But LTCM’s lenders were mostly caught unaware because the hedge funds were not required to make their loan positions known. In 1999, when arguing against the proposal of the head of the Commodities Futures Trading Commission to regulate financial derivatives, Greenspan claimed that unrestricted derivatives trading would stabilize finance, not disrupt it. He had no idea how dangerous the new mortgage-based collateralized debt obligations were, as we shall see, the principal source of overly risky investment in the 2000s. It never occurred to him that investment banks were now creating loans just like the commercial banks he oversaw, but this shadow banking system was not regulated by the one agency designed to make sure U.S. credit was strong, his own. Writing a letter in support of Keating, apart from the outrageous irresponsibility and suspiciously easy payday, was simply an ideological reflex of his at work.

Greenspan, based on his firm market principles, approved strongly of securitization and most derivative products as a way to spread risk—a view traditional market economists like Summers shared. But even when crisis struck in 2008, it was clear the Federal Reserve economists in Washington and New York did not understand how excessive and risky the borrowing now was. In particular, the relatively new collateralized debt obligations (CDOs), a way of packaging risky mortgages for investors willing to make only low-risk investments, was not understood or even investigated. Greenspan’s ultimately naive and dangerous faith in competitive markets showed itself nowhere as damagingly as in the Fed’s failure to be vigilant about the CDOs. Not only did his interest rate increases fail to dampen the financing, but they encouraged Wall Street to take more risks and mortgage brokers to write more bad loans because their profit margins had narrowed.


pages: 584 words: 187,436

More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby

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Andrei Shleifer, Asian financial crisis, asset-backed security, automated trading system, bank run, barriers to entry, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, Bretton Woods, capital controls, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, currency peg, Elliott wave, Eugene Fama: efficient market hypothesis, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, full employment, German hyperinflation, High speed trading, index fund, John Meriwether, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, market clearing, market fundamentalism, merger arbitrage, money market fund, moral hazard, Myron Scholes, natural language processing, Network effects, new economy, Nikolai Kondratiev, pattern recognition, Paul Samuelson, pre–internet, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical arbitrage, statistical model, survivorship bias, technology bubble, The Great Moderation, The Myth of the Rational Market, the new new thing, too big to fail, transaction costs

As to the division of junior from senior debt, Paulson had never seen anything quite like the feast that the mortgage industry served up. Lenders like Daniel Sadek generated mortgages that were sold to Wall Street banks; the banks turned these into mortgage bonds; then other banks bought the bonds, rebundled them, and sliced the resulting “collateralized debt obligation” into layers, the most senior ones rated a rock-solid AAA, the next ones rated AA, and so on down the line to BBB and lower—there might be eighteen tranches in the pyramid. If the mortgages in the collateralized debt obligation paid back 95 percent or more of what they owed, the BBB bonds would be fine, since the first 5 percent of the losses would be absorbed by even more junior tranches. But once non-payments surpassed the 5 percent hurdle, the BBB securities would start suffering losses; and since the BBB tranche was only 1 percent thick, a nonpayment rate of 6 percent would take the whole lot of them to zero.

All of Wall Street knew that their reliance on short-term funding, coupled with extremely high leverage, made them vulnerable to a bank run; and the Morgan and Goldman stock prices began to show up permanently at the top of the CNBC screen, in what traders called the “death watch.”25 The trouble at the giant insurer AIG only made things worse. By writing credit default swaps, AIG had sold protection against the danger that all manner of bonds might go into default—it was the kind of crazy risk taking you got when you located an ambitious trading operation inside the bosom of a well-capitalized firm, imbuing the traders with a heady sense of invulnerability. Inevitably, AIG’s credit default swaps lost billions when the likelihood of default spiked up amid the crisis following Lehman. On Tuesday, September 16, the government was forced to rescue the firm, lending it an astonishing $85 billion. The day after that, rumors that Morgan Stanley was exposed to AIG’s mess helped to drive Morgan’s stock down 42 percent by the middle of the afternoon.

This contrast points to a third reason why the banks fared poorly in the credit bubble: Those multiple profit centers distracted executives. The banks’ proprietary trading desks coexisted alongside departments that advised on mergers, underwrote securities, and managed clients’ funds; sometimes the scramble for fees from these advisory businesses blurred the banks’ investment choices. Again, the subprime story illustrated this problem. Merrill Lynch is said to have sold $70 billion worth of subprime collateralized debt obligations, or CDOs, earning a fee of 1.25 percent each time, or $875 million. Merrill’s bosses obsessed about their standing in the mortgage league tables: The chief executive, Stan O’Neal, was prepared to finance home lenders at no profit in order to be first in line to buy their mortgages.14 To feed their CDO production lines, Merrill and its rivals kept plenty of mortgage bonds on hand; so when demand for CDOs collapsed in early 2007, the banks were stuck with billions of unsold inventory that they had to take onto their balance sheets.


pages: 317 words: 84,400

Automate This: How Algorithms Came to Rule Our World by Christopher Steiner

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23andMe, Ada Lovelace, airport security, Al Roth, algorithmic trading, backtesting, big-box store, Black-Scholes formula, call centre, cloud computing, collateralized debt obligation, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, Donald Trump, Douglas Hofstadter, dumpster diving, Flash crash, Gödel, Escher, Bach, High speed trading, Howard Rheingold, index fund, Isaac Newton, John Markoff, John Maynard Keynes: technological unemployment, knowledge economy, late fees, Marc Andreessen, Mark Zuckerberg, market bubble, medical residency, money market fund, Myron Scholes, Narrative Science, PageRank, pattern recognition, Paul Graham, Pierre-Simon Laplace, prediction markets, quantitative hedge fund, Renaissance Technologies, ride hailing / ride sharing, risk tolerance, Sergey Aleynikov, side project, Silicon Valley, Skype, speech recognition, Spread Networks laid a new fibre optics cable between New York and Chicago, transaction costs, upwardly mobile, Watson beat the top human players on Jeopardy!, Y Combinator

Because Li didn’t have piles of historical default data on subprime mortgages (it simply didn’t exist), he built his copula on data that did exist: historical prices of credit default swaps, which result in a payment to the owner of the swap if the underlying securities (mortgages in this case) go into default. But the CDS market was, as we now well know, egregiously mispriced by the humans who traded the swaps and set the prices. Nevertheless, Wall Street embraced Li’s formula as stone-solid fact. The copula should have been one arrow in the quiver of analysts and rating agencies who examined and stamped their approval on mortgage-backed securities. Instead, it became the only arrow. The resultant boom in collateralized debt obligations and the housing market bubble came straight from bankers’ misuse of what should have been a harmless algorithm.

Wadhwa eventually got away and founded Relativity Technologies, which made software to help companies migrate from older code bases to newer ones such as C++ and Java. He has since become one of the leading voices of tech education from positions not only at Duke but also at Emory and Stanford. As a new faculty member at Duke, Wadhwa watched as many of his brightest students ended up on Wall Street, conjuring up the very instruments that would lead the world to the brink of economic collapse—collateralized debt obligations, the Gaussian copula (a fine formula that was misused by the Street), and trading algorithms that could go wild at any moment. This was in 2007, the all-time height of the stock market. Financial-sector companies were pulling in cash like a vacuum sucks dust. To ensure their spot at the top of the heap, the finance firms needed two things: friends in Washington and the best quantitative brains money could buy.

The rate among experienced engineers, in fact, dropped by more than 60 percent since the early 1980s, when Wall Street started snatching up technical minds as fast as it could.5 The authors, Paul Kedrosky and Dane Stangler, write: The financial services industry used to consider it a point of pride to hire hungry and eager young high school and college graduates, planning to train them on the job in sales, trading, research, and investment banking. While that practice continues, even if in smaller numbers, the difference now is that most of the industry’s profits come from the creation, sales, and trading of complex products, like the collateralized debt obligations (CDOs) that played a central role in the recent financial crisis. These new products require significant financial engineering, often entailing the recruitment of master’s- and doctoral-level new graduates of science, engineering, math, and physics programs. Their talents have made them well-suited to the design of these complex instruments, in return for which they often make starting salaries five times or more what their salaries would have been had they stayed in their own fields and pursued employment with more tangible societal benefits.


pages: 207 words: 86,639

The New Economics: A Bigger Picture by David Boyle, Andrew Simms

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Asian financial crisis, back-to-the-land, banking crisis, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, Bretton Woods, capital controls, carbon footprint, clean water, collateralized debt obligation, colonial rule, Community Supported Agriculture, congestion charging, corporate raider, corporate social responsibility, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, delayed gratification, deskilling, en.wikipedia.org, energy transition, financial deregulation, financial exclusion, financial innovation, full employment, garden city movement, happiness index / gross national happiness, if you build it, they will come, income inequality, informal economy, Intergovernmental Panel on Climate Change (IPCC), Jane Jacobs, land reform, light touch regulation, loss aversion, mega-rich, microcredit, Mikhail Gorbachev, mortgage debt, neoliberal agenda, new economy, North Sea oil, Northern Rock, offshore financial centre, oil shock, peak oil, pensions crisis, profit motive, purchasing power parity, quantitative easing, Ronald Reagan, seigniorage, Simon Kuznets, sovereign wealth fund, special drawing rights, The Wealth of Nations by Adam Smith, Thomas L Friedman, too big to fail, trickle-down economics, Vilfredo Pareto, Washington Consensus, wealth creators, working-age population

We also want to acknowledge the enormous patience of our families while we struggle away at the computer, now and always: Sarah, Robin and William (David’s family) and Rachel and Scarlett (Andrew’s family). Without them we couldn’t manage it or be who we are today. David Boyle Andrew Simms List of Acronyms and Abbreviations CDCU CDFI CDO CEO CHP CND Democs DIY DTQ EBCU Escos GDP GM GPI HPI IMF IP ISEW km Lets LM3 m MDGs MDP MDR-TB mph nef NHS RESOLVE SDRs community development credit union community development finance institution collateralized debt obligation chief executive officer combined heat and power Campaign for Nuclear Disarmament deliberative meeting of citizens do-it-yourself domestic tradable quota emissions-backed currency unit energy service companies gross domestic product genetically modified Genuine Progress Indicator Happy Planet Index International Monetary Fund intellectual property Index of Sustainable Economic Welfare kilometre Local exchange and trading systems Local Money 3 metre Millennium Development Goals Measure of Domestic Progress multi-drug resistant tuberculosis miles per hour New Economics Foundation National Health Service Research Group on Lifestyles Values and Environment special drawing rights xii SERs SIV SROI T-bills TEQ TOES TRIPS WEEE THE NEW ECONOMICS special emission rights structured investment vehicle social return on investment Treasury bills tradeable emissions quota The Other Economic Summit Trade-Related Aspects of Intellectual Property Waste Electrical and Electronic Equipment (Directive) 1 The Economic Problem Man talks of a battle with nature, forgetting that if he won the battle, he would find himself on the losing side.

Then they could lend money from the sale to more investors and so on. The disastrous model used by so many lenders meant bundling up their mortgages and selling them on, then using the proceeds to lend more. It meant that banks and other investors would buy the SIVs, getting the full value of the repayments over the years. The SIVs were then taken apart and reassembled into parcels called collateralized debt obligations (CDOs) and sold to hedge funds, which sold them on all over the world. Because these CDOs included debts from a range of different markets, they were believed to be insulated against risk: the mortgages might cause problems, but the other loans would offset the risk. That is how the credit ratings agencies Moodys and Standard & Poor saw it, giving them AAA ratings. 6 THE NEW ECONOMICS The trouble was that, once the truth about the sub-prime loans – M.

www.neweconomics.org Index absolute poverty 81, 81–2 advertising 46–7 agriculture 26, 34, 119, 138 aid 34, 113, 136 AIDS 70, 111, 135, 148 altruism 65, 72 Annan, Kofi 110–11 anti-trust action 89–90, 116, 133 Argentina 26, 57, 58, 139 assets 15, 60, 105, 136–7, 153 of African-Americans 141, 142 people as 15, 57–8, 128–9, 130, 131 Audi 101 authenticity 2, 73, 74, 74–5 bancor (currency) 61 Bangladesh 3, 112, 141, 143–4 banking system 6, 7, 58–9, 147 see also banks bankruptcy 147 banks 6, 120, 139, 142, 146, 153 breaking up 57, 90, 146 money creation by 56, 58–9, 84, 90, 138, 147 see also financial crises barriers to development 138–43 barter 58, 59, 60, 154 behaviour 15, 29, 35, 67–8, 71 Belloc, Hilaire 19–20, 21 berkshares 57, 151–2 Beveridge, Sir William 19, 127 Bhutan 43 big currencies 53, 54, 55–6, 58, 59 biocapacity 12, 114, 158 Black Hawk (Colorado) 14, 15, 152 ‘black money’ 81 Blair administration 9, 41 Blake, William 18 blood donation 65, 70 Boesky, Ivan 135, 142 borrowing by governments 49–50, 58, 62, 141 see also debt Bowling Alone (Putnam, 2001) 126–7 Breed, Colin 125 Bretton Woods 148 Buddhist economics 18, 21, 22 Buffett, Warren 7 built-in obsolescence 98, 100, 101 Bush, George W. 28, 96, 154 business 74, 156 Butler, R. A. (Richard Austen, ‘Rab’) 36, 38, 40 Cahn, Edgar 54, 58, 88, 123, 127, 131 Campaign for Real Ale 118 Canada 51–2, 57 capital 89 capitalism 20, 155 carbon emission entitlements 45, 90, 117–18, 148 carbon emissions 114, 117, 148 carbon taxes 117 caring 86–7, 89, 91, 92, 132 182 THE NEW ECONOMICS Carville, James 27 casinos 14–15 cathedrals 79, 81 CDOs (collateralized debt obligations) 5–6 Central America 32–3 charities 13, 58, 129 Charles, Prince of Wales 23, 100 Chesterton, G.K. (Gilbert Keith) 18, 20, 21, 81 Chicago (Illinois) 87, 127, 131 chief executives 19, 141, 142 children 4, 46–7, 82, 86, 87 Chile 51 China 28, 50, 60, 82, 100, 116, 154 CHP (combined heat and power) plants 102, 103 cities 3, 61, 75, 80, 105–6, 110, 116 and energy 102, 103 traffic speeds 65–6 citizen’s incomes 45, 58, 73, 91–2, 148 Clarke, Otto 21 classical economics 28–9, 34–5, 44, 67, 89, 123 assumptions 71, 72, 85 Cleveland (Ohio) 6 climate change 3–4, 40, 96, 112, 115 tackling 45, 90, 155, 157 Clinton, Bill 27, 52, 145 co-generation of energy 102, 103 co-production 88–9, 127–31, 132, 158, 159 Cobb, Clifford 39, 40–1 Cobb, John 22, 40–1 collateralized debt obligations (CDOs) 5–6 Colombia 33, 51 Columbus, Christopher 139 combined heat and power see CHP commodities 11, 57, 139 currencies based on 60, 90, 120 commons 79, 82, 113, 148 communications technologies 58, 59, 78, 158 communities 2, 27, 42, 43, 89, 92 assets 57–8, 106 investing in 118 money in 103–5, 107, 124, 151–2 Wal-mart and 124–5 community 32, 33, 54, 89, 158 community banks 26, 145 community land trusts 46, 73, 151 Community Way model 58 community-supported agriculture 26, 119 companies 74–5, 84, 137–8, 142–3 see also corporations comparative advantage 26, 75, 109, 116 competition 90 regulation 85, 113, 125, 126, 133 complementary currencies 26, 57–8, 59, 62, 154 consumerism 20, 44, 132 consumers 44, 67–8 consumption 11, 34, 39–40, 100, 158 ‘defensive’ 37 contributing, need for 128–9 conventional economics 10–12, 82, 97, 127 cooperatives 20, 26, 153 ‘core economy’ 54–5, 88, 89, 127, 158 corporate debt 84, 142–3 corporate power 20, 28, 85 corporate raiders 84, 142 corporate responsibility 26, 153–4 corporations 4, 8, 13, 82, 90, 116, 142, 158 tax gap 52, 137, 157 Costa Rica 99 Country Party 18 crashes 1, 51, 91 2008–9 crash 2, 3, 5, 6–7, 8, 15, 84, 85, 154–5 creativity 38, 46, 75, 79, 91 credit 91, 145–6 see also debt credit cards 84 credit crunch 3, 91, 144, 157 credit unions 26, 144, 145, 146 crime 10, 35, 37, 38, 87, 127, 128 crises, fundamental 3–5 Cuba 95–7, 101, 105 culture 43, 44, 111, 115, 127, 158 INDEX 183 currencies 26, 55, 56–8, 81 barter currencies 58, 59 based on commodities 60, 90, 120 based on emissions rights 90, 148 big 53, 54, 55–6, 58, 59 complementary 26, 57–8, 59, 62, 154 global 56, 61, 120, 147–8 local 26, 27, 56, 57, 58, 60, 151–2, 153 multiple 58, 59–60, 60, 90 regional 58, 59, 60 domestic tradeable quotas (DTQs) 117–18 Douthwaite, Richard 56–7, 148 Downs-Thomson Paradox 66 downshifting 2, 4–5, 11, 35, 69, 73 Drexel Burnham Lambert 142 drugs, generic 113, 116, 117 DTQs (domestic tradeable quotas) 117–18 Dublin (Ireland) 52, 106 DuPont 85 dynamic equilibrium 43, 44 Daly, Herman 22, 23, 40–1, 43, 97 Dawnay, Emma 71 debt 4, 7, 11–12, 81, 83–4 cancellation 137, 148 corporate 84, 142–3 and development 138–43 GM crops and 91, 119, 140 Malawi 135–6 medieval freedom from 79, 80–1 money creation 7, 8, 11, 56, 60, 84, 90, 138 national 49–50, 83, 84, 139, 141 personal 7, 36, 83–4, 91, 140, 141 repayments 90, 137 small-scale 143–4 see also sub-prime loans decentralized energy generation 102–3, 106, 114, 155 decision making 67–8, 71, 158 ‘defensive consumption’ 37 democracy 31, 55, 91, 141, 158 demurrage 57 depression 4, 10, 11, 35, 38, 68, 75, 83 deregulation 8, 12, 22, 28 developing countries 11, 81, 136–8, 143 development 24, 27, 116, 138–43 development projects 82 Dickens, Charles 36 Diggers 18 Disney 141 Distributism 19–21, 29 District of Columbia School of Law 131 diversity 82, 90, 152 Earth, Apollo pictures of 101–2 EBCU (emissions-backed currency unit) 148 ecological debt 113–14 ecological footprints 31, 33, 34, 112 ecological issues 3–4, 12, 25 economic activity 25, 148 economic development 24, 27, 116, 138–43 economic growth see growth economic indicators, alternative 26 economic institutions 29, 82, 153, 154 economic processes 97–8, 99 economic system 2, 11, 21–2, 23, 29, 112, 138 and poverty 13–14, 18, 29, 81–2, 154 economics 10–12, 18, 19, 29, 72–3, 98 assumptions 10, 25, 28, 29, 69, 71, 72, 82, 85, 97, 99, 115 medieval 78–80, 80–1 post-autistic 9–10, 71–2 and psychology 67–8, 71, 72–3 as a science 15, 34–5, 98, 152 and sustainability 24 see also classical economics; conventional economics; new economics economy 12, 26, 84–5, 158 creating poverty 13–14, 18, 29, 81, 154 ecosystems 99, 112, 114 Edison, Thomas 58, 90, 147 education 13, 33, 35, 46, 113 efficiency 4, 13, 99, 100, 123, 126, 131–2 E.F.

When the Money Runs Out: The End of Western Affluence by Stephen D. King

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Albert Einstein, Asian financial crisis, asset-backed security, banking crisis, Basel III, Berlin Wall, Bernie Madoff, British Empire, capital controls, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, congestion charging, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, cross-subsidies, debt deflation, Deng Xiaoping, Diane Coyle, endowment effect, eurozone crisis, Fall of the Berlin Wall, financial innovation, financial repression, fixed income, floating exchange rates, full employment, George Akerlof, German hyperinflation, Hyman Minsky, income inequality, income per capita, inflation targeting, invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, joint-stock company, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, London Interbank Offered Rate, loss aversion, market clearing, mass immigration, moral hazard, mortgage debt, new economy, New Urbanism, Nick Leeson, Northern Rock, Occupy movement, oil shale / tar sands, oil shock, old age dependency ratio, price mechanism, price stability, quantitative easing, railway mania, rent-seeking, reserve currency, rising living standards, South Sea Bubble, sovereign wealth fund, technology bubble, The Market for Lemons, The Spirit Level, The Wealth of Nations by Adam Smith, Thomas Malthus, Tobin tax, too big to fail, trade route, trickle-down economics, Washington Consensus, women in the workforce, working-age population

And the Norwegian savers had no reason to think their savings had been invested in the Arizonan real estate market, where some subprime borrowers never 133 4099.indd 133 29/03/13 2:23 PM When the Money Runs Out intended to repay their loans. This disconnect, however, supposedly didn’t matter. Financial innovation had led to the growth of credit risk transfer instruments – including credit default swaps and structured credit products such as collateralized debt obligations – which allowed hitherto unmanageable risks to be spread ever more thinly. This, though, meant that the financial institutions that originated credits no longer had to hold them on their books. Instead, credits could be repackaged and sold off into the capital markets, allowing a distant but ultimately fragile link to be created between the subprime mortgage customer in Arizona and the contributor to a Norwegian pension fund.

Between 2007 and 2012, 30 4099.indd 30 29/03/13 2:23 PM Taking Progress for Granted approaching 500 US banks had failed (including the aptly named Cape Fear Bank in Wilmington, North Carolina). That compared with only 24 failures in the previous six years.17 Capital markets ultimately are responsible for linking savers with investors. Yet the financial crisis revealed that the linkages were often tenuous – person A put her savings in pension fund B, which then purchased a bundle of pieces of paper known as collateralized debt obligations from bank C, which had assembled the bundle via investments in mortgage-­backed securities – some of dubious quality – issued by banks D, E and F, which, in turn, had used the money raised to lend to homebuyers G, H and I, one or more of whom had a dubious credit history and, hence, was ‘subprime’. Person A had no direct connection with the homebuyers – indeed, the saver was likely to be thousands of miles away from the ultimate borrower – but the indirect connection was there, nevertheless.

Based on our collective belief in continuously rising living standards, we have spent the last half-­century watching our financial wealth and our political and economic ‘rights’ accumulate at an incredible pace. We all, directly or indirectly, own pieces of paper or rely on political promises that make claims on future economic prosperity. The pieces of paper range from cash through to government bonds, from equities through to property deeds and from asset-­backed securities through to collateralized debt obligations. 34 4099.indd 34 29/03/13 2:23 PM Taking Progress for Granted The language deployed may vary from the very simple to the incredibly complicated but these pieces of paper all have one thing in common: they represent claims on assumed future economic success. They are all manifestations of the same act of faith: namely that the future will be better than the present and vastly superior to the past.


pages: 345 words: 86,394

Frequently Asked Questions in Quantitative Finance by Paul Wilmott

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Albert Einstein, asset allocation, beat the dealer, Black-Scholes formula, Brownian motion, butterfly effect, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discrete time, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Myron Scholes, Norbert Wiener, Paul Samuelson, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, urban planning, value at risk, volatility arbitrage, volatility smile, Wiener process, yield curve, zero-coupon bond

Calibration does not typically involve looking at the dynamics or time series of the underlying. See page 191. Callable A contract which the issuer or writer can buy back (call). The amount he has to pay and the dates on which he can exercise this right will be specified in the contract. Cap A fixed-income contract paying the holder when the underlying interest rate exceeds a specified level. See page 313. CDO A Collateralized Debt Obligation is a pool of debt instruments securitized into one financial instrument. See page 315. CDS A Credit Default Swap is a contract used as insurance against a credit event. One party pays interest to another for a prescribed time or until default of the underlying instrument. See page 317. CFA Chartered Financial Analyst. A professional designation offered by the CFA Institute for successfully completing three examinations. The syllabus includes aspects of corporate and quantitative finance, economics and ethics.

Although B, G and M have their names associated with this idea many others worked on it simultaneously. 2000 Li As already mentioned, the 1990s saw an explosion in the number of credit instruments available, and also in the growth of derivatives with multiple underlyings. It’s not a great step to imagine contracts depending of the default of many underlyings. Examples of these are the ubiquitous Collateralized Debt Obligations (CDOs). But to price such complicated instruments requires a model for the interaction of many companies during the process of default. A probabilistic approach based on copulas was proposed by David Li (2000). The copula approach allows one to join together (hence the word ‘copula’) default models for individual companies in isolation to make a model for the probabilities of their joint default.

Constant Maturity Swap (CMS) is a fixed-income swap. In the vanilla swap the floating leg is a rate with the same maturity as the period between payments. However, in the CMS the floating leg is of longer maturity. This apparently trivial difference turns the swap from a simple instrument, one that can be valued in terms of bonds without resort to any model, into a model-dependent instrument. Collateralized Debt Obligation (CDO) is a pool of debt instruments securitized into one financial instrument. The pool may consist of hundreds of individual debt instruments. They are exposed to credit risk, as well as interest risk, of the underlying instruments. CDOs are issued in several tranches which divide up the pool of debt into instruments with varying degrees of exposure to credit risk. One can buy different tranches so as to gain exposure to different levels of loss.


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Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das

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accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, beat the dealer, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, commoditize, complexity theory, computerized trading, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Edward Thorp, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, John Meriwether, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, mega-rich, merger arbitrage, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mutually assured destruction, Myron Scholes, new economy, New Journalism, Nick Leeson, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, Right to Buy, risk-adjusted returns, risk/return, Satyajit Das, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, the new new thing, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

In 1997, the Asian century was still- DAS_C02.QXP 8/7/06 4:22 PM Page 45 1 N Financial WMDs – derivatives demagoguery 45 born. In 1998, Russia defaulted. In 2001, Argentina completed its transition from first world to third world economy under the weight of debts that the country would never be able to service, let alone repay. Credit derivative products emerged. Credit default swaps and collateralized debt obligations (CDOs) allowed investors to take on credit risk. On schedule, in 2001, the CDO market collapsed, leaving the investors to nurse sizeable losses. In between, there were dalliances with gold, weather and catastrophe bonds that kept the markets busy. Forbidden fruit Back at the training programme, I generally finished my class for trainees by taking them through a structured product – an inverse floater, which I used to illustrate structured products.

Regulations required insurance companies holding junk bonds to provide a lot of reserves against the investment. To get around the rules, insurance companies repackaged the high yield assets into CBOs and transferred the riskier parts to their holding companies (which did not have to hold reserves). Now, CBOs in a more modern form were used to repackage credit risk for investors. It was even given a new name – CDO (Collateralized Debt Obligations). Imitation and flattery In the 1970s, mortgage securitization developed in the US. Banks originally had written mortgage loans, then they had waited 30 years for the homeowners to pay it back. Now, banks wrote the loan and once they had a bunch they sold them to a special purpose vehicle (SPV). The SPV paid the bank for the mortgages it bought. It issued bonds in the market to raise the cash.

However, the text is different. 6 ‘What Worries Warren’ (3 March 2003) Fortune. 13_INDEX.QXD 17/2/06 4:44 pm Page 325 Index accounting rules 139, 221, 228, 257 Accounting Standards Board 33 accrual accounting 139 active fund management 111 actuaries 107–10, 205, 289 Advance Corporation Tax 242 agency business 123–4, 129 agency theory 117 airline profits 140–1 Alaska 319 Allen, Woody 20 Allied Irish Bank 143 Allied Lyons 98 alternative investment strategies 112, 308 American Express 291 analysts, role of 62–4 anchor effect 136 Anderson, Rolf 92–4 annuities 204–5 ANZ Bank 277 Aquinas, Thomas 137 arbitrage 33, 38–40, 99, 114, 137–8, 171–2, 245–8, 253–5, 290, 293–6 arbitration 307 Argentina 45 arithmophobia 177 ‘armpit theory’ 303 Armstrong World Industries 274 arrears assets 225 Ashanti Goldfields 97–8, 114 Asian financial crisis (1997) 4, 9, 44–5, 115, 144, 166, 172, 207, 235, 245, 252, 310, 319 asset consultants 115–17, 281 ‘asset growth’ strategy 255 asset swaps 230–2 assets under management (AUM) 113–4, 117 assignment of loans 267–8 AT&T 275 attribution of earnings 148 auditors 144 Australia 222–4, 254–5, 261–2 back office functions 65–6 back-to-back loans 35, 40 backwardation 96 Banca Popolare di Intra 298 Bank of America 298, 303 Bank of International Settlements 50–1, 281 Bank of Japan 220 Bankers’ Trust (BT) 59, 72, 101–2, 149, 217–18, 232, 268–71, 298, 301, 319 banking regulations 155, 159, 162, 164, 281, 286, 288 banking services 34; see also commercial banks; investment banks bankruptcy 276–7 Banque Paribas 37–8, 232 Barclays Bank 121–2, 297–8 13_INDEX.QXD 17/2/06 326 4:44 pm Page 326 Index Baring, Peter 151 Baring Brothers 51, 143, 151–2, 155 ‘Basel 2’ proposal 159 basis risk 28, 42, 274 Bear Stearns 173 bearer eurodollar collateralized securities (BECS) 231–3 ‘behavioural finance’ 136 Berkshire Hathaway 19 Bermudan options 205, 227 Bernstein, Peter 167 binomial option pricing model 196 Bismarck, Otto von 108 Black, Fischer 22, 42, 160, 185, 189–90, 193, 195, 197, 209, 215 Black–Scholes formula for option pricing 22, 185, 194–5 Black–Scholes–Merton model 160, 189–93, 196–7 ‘black swan’ hypothesis 130 Blair, Tony 223 Bogle, John 116 Bohr, Niels 122 Bond, Sir John 148 ‘bond floor’ concept 251–4 bonding 75–6, 168, 181 bonuses 146–51, 244, 262, 284–5 Brady Commission 203 brand awareness and brand equity 124, 236 Brazil 302 Bretton Woods system 33 bribery 80, 303 British Sky Broadcasting (BSB) 247–8 Brittain, Alfred 72 broad index secured trust offerings (BISTROs) 284–5 brokers 69, 309 Brown, Robert 161 bubbles 210, 310, 319 Buconero 299 Buffet, Warren 12, 19–20, 50, 110–11, 136, 173, 246, 316 business process reorganization 72 business risk 159 Business Week 130 buy-backs 249 ‘call’ options 25, 90, 99, 101, 131, 190, 196 callable bonds 227–9, 256 capital asset pricing model (CAPM) 111 capital flow 30 capital guarantees 257–8 capital structure arbitrage 296 Capote, Truman 87 carbon trading 320 ‘carry cost’ model 188 ‘carry’ trades 131–3, 171 cash accounting 139 catastrophe bonds 212, 320 caveat emptor principle 27, 272 Cayman Islands 233–4 Cazenove (company) 152 CDO2 292 Cemex 249–50 chaos theory 209, 312 Chase Manhattan Bank 143, 299 Chicago Board Options Exchange 195 Chicago Board of Trade (CBOT) 25–6, 34 chief risk officers 177 China 23–5, 276, 302–4 China Club, Hong Kong 318 Chinese walls 249, 261, 280 chrematophobia 177 Citibank and Citigroup 37–8, 43, 71, 79, 94, 134–5, 149, 174, 238–9 Citron, Robert 124–5, 212–17 client relationships 58–9 Clinton, Bill 223 Coats, Craig 168–9 collateral requirements 215–16 collateralized bond obligations (CBOs) 282 collateralized debt obligations (CDOs) 45, 282–99 13_INDEX.QXD 17/2/06 4:44 pm Page 327 Index collateralized fund obligations (CFOs) 292 collateralized loan obligations (CLOs) 283–5, 288 commercial banks 265–7 commoditization 236 commodity collateralized obligations (CCOs) 292 commodity prices 304 Commonwealth Bank of Australia 255 compliance officers 65 computer systems 54, 155, 197–8 concentration risk 271, 287 conferences with clients 59 confidence levels 164 confidentiality 226 Conseco 279–80 contagion crises 291 contango 96 contingent conversion convertibles (co-cos) 257 contingent payment convertibles (co-pays) 257 Continental Illinois 34 ‘convergence’ trading 170 convertible bonds 250–60 correlations 163–6, 294–5; see also default correlations corruption 303 CORVUS 297 Cox, John 196–7 credit cycle 291 credit default swaps (CDSs) 271–84, 293, 299 credit derivatives 129, 150, 265–72, 282, 295, 299–300 Credit Derivatives Market Practices Committee 273, 275, 280–1 credit models 294, 296 credit ratings 256–7, 270, 287–8, 297–8, 304 credit reserves 140 credit risk 158, 265–74, 281–95, 299 327 credit spreads 114, 172–5, 296 Credit Suisse 70, 106, 167 credit trading 293–5 CRH Capital 309 critical events 164–6 Croesus 137 cross-ruffing 142 cubic splines 189 currency options 98, 218, 319 custom repackaged asset vehicles (CRAVEs) 233 daily earning at risk (DEAR) concept 160 Daiwa Bank 142 Daiwa Europe 277 Danish Oil and Natural Gas 296 data scrubbing 142 dealers, work of 87–8, 124–8, 133, 167, 206, 229–37, 262, 295–6; see also traders ‘death swap’ strategy 110 decentralization 72 decision-making, scientific 182 default correlations 270–1 defaults 277–9, 287, 291, 293, 296, 299 DEFCON scale 156–7 ‘Delta 1’ options 243 delta hedging 42, 200 Deming, W.E. 98, 101 Denmark 38 deregulation, financial 34 derivatives trading 5–6, 12–14, 18–72, 79, 88–9, 99–115, 123–31, 139–41, 150, 153, 155, 175, 184–9, 206–8, 211–14, 217–19, 230, 233, 257, 262–3, 307, 316, 319–20; see also equity derivatives Derman, Emmanuel 185, 198–9 Deutsche Bank 70, 104, 150, 247–8, 274, 277 devaluations 80–1, 89, 203–4, 319 13_INDEX.QXD 17/2/06 4:44 pm Page 328 328 Index dilution of share capital 241 DINKs 313 Disney Corporation 91–8 diversification 72, 110–11, 166, 299 dividend yield 243 ‘Dr Evil’ trade 135 dollar premium 35 downsizing 73 Drexel Burnham Lambert (DBL) 282 dual currency bonds 220–3; see also reverse dual currency bonds earthquakes, bonds linked to 212 efficient markets hypothesis 22, 31, 111, 203 electronic trading 126–30, 134 ‘embeddos’ 218 emerging markets 3–4, 44, 115, 132–3, 142, 212, 226, 297 Enron 54, 142, 250, 298 enterprise risk management (ERM) 176 equity capital management 249 equity collateralized obligations (ECOs) 292 equity derivatives 241–2, 246–9, 257–62 equity index 137–8 equity investment, retail market in 258–9 equity investors’ risk 286–8 equity options 253–4 equity swaps 247–8 euro currency 171, 206, 237 European Bank for Reconstruction and Development 297 European currency units 93 European Union 247–8 Exchange Rate Mechanism, European 204 exchangeable bonds 260 expatriate postings 81–2 expert witnesses 310–12 extrapolation 189, 205 extreme value theory 166 fads of management science 72–4 ‘fairway bonds’ 225 Fama, Eugene 22, 111, 194 ‘fat tail’ events 163–4 Federal Accounting Standards Board 266 Federal Home Loans Bank 213 Federal National Mortgage Association 213 Federal Reserve Bank 20, 173 Federal Reserve Board 132 ‘Ferraris’ 232 financial engineering 228, 230, 233, 249–50, 262, 269 Financial Services Authority (FSA), Japan 106, 238 Financial Services Authority (FSA), UK 15, 135 firewalls 235–6 firing of staff 84–5 First Interstate Ltd 34–5 ‘flat’ organizations 72 ‘flat’ positions 159 floaters 231–2; see also inverse floaters ‘flow’ trading 60–1, 129 Ford Motors 282, 296 forecasting 135–6, 190 forward contracts 24–33, 90, 97, 124, 131, 188 fugu fish 239 fund management 109–17, 286, 300 futures see forward contracts Galbraith, John Kenneth 121 gamma risk 200–2, 294 Gauss, Carl Friedrich 160–2 General Motors 279, 296 General Reinsurance 20 geometric Brownian motion (GBM) 161 Ghana 98 Gibson Greeting Cards 44 Glass-Steagall Act 34 gold borrowings 132 13_INDEX.QXD 17/2/06 4:44 pm Page 329 Index gold sales 97, 137 Goldman Sachs 34, 71, 93, 150, 173, 185 ‘golfing holiday bonds’ 224 Greenspan, Alan 6, 9, 19–21, 29, 43, 47, 50, 53, 62, 132, 159, 170, 215, 223, 308 Greenwich NatWest 298 Gross, Bill 19 Guangdong International Trust and Investment Corporation (GITIC) 276–7 guaranteed annuity option (GAO) contracts 204–5 Gutenfreund, John 168–9 gyosei shido 106 Haghani, Victor 168 Hamanaka, Yasuo 142 Hamburgische Landesbank 297 Hammersmith and Fulham, London Borough of 66–7 ‘hara-kiri’ swaps 39 Hartley, L.P. 163 Hawkins, Greg 168 ‘heaven and hell’ bonds 218 hedge funds 44, 88–9, 113–14, 167, 170–5, 200–2, 206, 253–4, 262–3, 282, 292, 296, 300, 308–9 hedge ratio 264 hedging 24–8, 31, 38–42, 60, 87–100, 184, 195–200, 205–7, 214, 221, 229, 252, 269, 281, 293–4, 310 Heisenberg, Werner 122 ‘hell bonds’ 218 Herman, Clement (‘Crem’) 45–9, 77, 84, 309 Herodotus 137, 178 high net worth individuals (HNWIs) 237–8, 286 Hilibrand, Lawrence 168 Hill Samuel 231–2 329 The Hitchhiker’s Guide to the Galaxy 189 Homer, Sidney 184 Hong Kong 9, 303–4 ‘hot tubbing’ 311–12 HSBC Bank 148 HSH Nordbank 297–8 Hudson, Kevin 102 Hufschmid, Hans 77–8 IBM 36, 218, 260 ICI 34 Iguchi, Toshihude 142 incubators 309 independent valuation 142 indexed currency option notes (ICONs) 218 India 302 Indonesia 5, 9, 19, 26, 55, 80–2, 105, 146, 219–20, 252, 305 initial public offerings 33, 64, 261 inside information and insider trading 133, 241, 248–9 insurance companies 107–10, 117, 119, 150, 192–3, 204–5, 221, 223, 282, 286, 300; see also reinsurance companies insurance law 272 Intel 260 intellectual property in financial products 226 Intercontinental Hotels Group (IHG) 285–6 International Accounting Standards 33 International Securities Market Association 106 International Swap Dealers Association (ISDA) 273, 275, 279, 281 Internet stock and the Internet boom 64, 112, 259, 261, 310, 319 interpolation of interest rates 141–2, 189 inverse floaters 46–51, 213–16, 225, 232–3 13_INDEX.QXD 17/2/06 4:44 pm Page 330 330 Index investment banks 34–8, 62, 64, 67, 71, 127–8, 172, 198, 206, 216–17, 234, 265–7, 298, 309 investment managers 43–4 investment styles 111–14 irrational decisions 136 Italy 106–7 Ito’s Lemma 194 Japan 39, 43, 82–3, 92, 94, 98–9, 101, 106, 132, 142, 145–6, 157, 212, 217–25, 228, 269–70 Jensen, Michael 117 Jett, Joseph 143 JP Morgan (company) 72, 150, 152, 160, 162, 249–50, 268–9, 284–5, 299; see also Morgan Guaranty junk bonds 231, 279, 282, 291, 296–7 JWM Associates 175 Kahneman, Daniel 136 Kaplanis, Costas 174 Kassouf, Sheen 253 Kaufman, Henry 62 Kerkorian, Kirk 296 Keynes, J.M. 167, 175, 198 Keynesianism 5 Kidder Peabody 143 Kleinwort Benson 40 Korea 9, 226, 278 Kozeny, Viktor 121 Krasker, William 168 Kreiger, Andy 319 Kyoto Protocol 320 Lavin, Jack 102 law of large numbers 192 Leeson, Nick 51, 131, 143, 151 legal opinions 47, 219–20, 235, 273–4 Leibowitz, Martin 184 Leland, Hayne 42, 202 Lend Lease Corporation 261–2 leptokurtic conditions 163 leverage 31–2, 48–50, 54, 99, 102–3, 114, 131–2, 171–5, 213–14, 247, 270–3, 291, 295, 305, 308 Lewis, Kenneth 303 Lewis, Michael 77–8 life insurance 204–5 Lintner, John 111 liquidity options 175 liquidity risk 158, 173 litigation 297–8 Ljunggren, Bernt 38–40 London Inter-Bank Offered Rate (LIBOR) 6, 37 ‘long first coupon’ strategy 39 Long Term Capital Management (LTCM) 44, 51, 62, 77–8, 84, 114, 166–75, 187, 206, 210, 215–18, 263–4, 309–10 Long Term Credit Bank of Japan 94 LOR (company) 202 Louisiana Purchase 319 low exercise price options (LEPOs) 261 Maastricht Treaty and criteria 106–7 McLuhan, Marshall 134 McNamara, Robert 182 macro-economic indicators, derivatives linked to 319 Mahathir Mohammed 31 Malaysia 9 management consultants 72–3 Manchester United 152 mandatory convertibles 255 Marakanond, Rerngchai 302 margin calls 97–8, 175 ‘market neutral’ investment strategy 114 market risk 158, 173, 265 marketable eurodollar collateralized securities (MECS) 232 Markowitz, Harry 110 mark-to-market accounting 10, 100, 139–41, 145, 150, 174, 215–16, 228, 244, 266, 292, 295, 298 Marx, Groucho 24, 57, 67, 117, 308 13_INDEX.QXD 17/2/06 4:44 pm Page 331 Index mathematics applied to financial instruments 209–10; see also ‘quants’ matrix structures 72 Meckling, Herbert 117 Melamed, Leo 34, 211 merchant banks 38 Meriwether, John 167–9, 172–5 Merrill Lynch 124, 150, 217, 232 Merton, Robert 22, 42, 168–70, 175, 185, 189–90, 193–7, 210 Messier, Marie 247 Metallgesellschaft 95–7 Mexico 44 mezzanine finance 285–8, 291–7 MG Refining and Marketing 95–8, 114 Microsoft 53 Mill, Stuart 130 Miller, Merton 22, 101, 194 Milliken, Michael 282 Ministry of Finance, Japan 222 misogyny 75–7 mis-selling 238, 297–8 Mitchell, Edison 70 Mitchell & Butler 275–6 models financial 42–3, 141–2, 163–4, 173–5, 181–4, 189, 198–9, 205–10 of business processes 73–5 see also credit models Modest, David 168 momentum investment 111 monetization 260–1 monopolies in financial trading 124 moral hazard 151, 280, 291 Morgan Guaranty 37–8, 221, 232 Morgan Stanley 76, 150 mortgage-backed securities (MBSs) 282–3 Moscow, City of 277 moves of staff between firms 150, 244 Mozer, Paul 169 Mullins, David 168–70 multi-skilling 73 331 Mumbai 3 Murdoch, Rupert 247 Nabisco 220 Napoleon 113 NASDAQ index 64, 112 Nash, Ogden 306 National Australia Bank 144, 178 National Rifle Association 29 NatWest Bank 144–5, 198 Niederhoffer, Victor 130 ‘Nero’ 7, 31, 45–9, 60, 77, 82–3, 88–9, 110, 118–19, 125, 128, 292 NERVA 297 New Zealand 319 Newman, Frank 104 news, financial 133–4 News Corporation 247 Newton, Isaac 162, 210 Nippon Credit Bank 106, 271 Nixon, Richard 33 Nomura Securities 218 normal distribution 160–3, 193, 199 Northern Electric 248 O’Brien, John 202 Occam, William 188 off-balance sheet transactions 32–3, 99, 234, 273, 282 ‘offsites’ 74–5 oil prices 30, 33, 89–90, 95–7 ‘omitted variable’ bias 209–10 operational risk 158, 176 opinion shopping 47 options 9, 21–2, 25–6, 32, 42, 90, 98, 124, 197, 229 pricing 185, 189–98, 202 Orange County 16, 44, 50, 124–57, 212–17, 232–3 orphan subsidiaries 234 over-the-counter (OTC) market 26, 34, 53, 95, 124, 126 overvaluation 64 13_INDEX.QXD 17/2/06 4:44 pm Page 332 332 Index ‘overwhelming force’ strategy 134–5 Owen, Martin 145 ownership, ‘legal’ and ‘economic’ 247 parallel loans 35 pari-mutuel auction system 319 Parkinson’s Law 136 Parmalat 250, 298–9 Partnoy, Frank 87 pension funds 43, 108–10, 115, 204–5, 255 People’s Bank of China (PBOC) 276–7 Peters’ Principle 71 petrodollars 71 Pétrus (restaurant) 121 Philippines, the 9 phobophobia 177 Piga, Gustavo 106 PIMCO 19 Plaza Accord 38, 94, 99, 220 plutophobia 177 pollution quotas 320 ‘portable alpha’ strategy 115 portfolio insurance 112, 202–3, 294 power reverse dual currency (PRDC) bonds 226–30 PowerPoint 75 preferred exchangeable resettable listed shares (PERLS) 255 presentations of business models 75 to clients 57, 185 prime brokerage 309 Prince, Charles 238 privatization 205 privity of contract 273 Proctor & Gamble (P&G) 44, 101–4, 155, 298, 301 product disclosure statements (PDSs) 48–9 profit smoothing 140 ‘programme’ issuers 234–5 proprietary (‘prop’) trading 60, 62, 64, 130, 174, 254 publicly available information (PAI) 277 ‘puff’ effect 148 purchasing power parity theory 92 ‘put’ options 90, 131, 256 ‘quants’ 183–9, 198, 208, 294 Raabe, Matthew 217 Ramsay, Gordon 121 range notes 225 real estate 91, 219 regulatory arbitrage 33 reinsurance companies 288–9 ‘relative value’ trading 131, 170–1, 310 Reliance Insurance 91–2 repackaging (‘repack’) business 230–6, 282, 290 replication in option pricing 195–9, 202 dynamic 200 research provided to clients 58, 62–4, 184 reserves, use of 140 reset preference shares 254–7 restructuring of loans 279–81 retail equity products 258–9 reverse convertibles 258–9 reverse dual currency bonds 223–30 ‘revolver’ loans 284–5 risk, financial, types of 158 risk adjusted return on capital (RAROC) 268, 290 risk conservation principle 229–30 risk management 65, 153–79, 184, 187, 201, 267 risk models 163–4, 173–5 riskless portfolios 196–7 RJ Reynolds (company) 220–1 rogue traders 176, 313–16 Rosenfield, Eric 168 Ross, Stephen 196–7, 202 Roth, Don 38 Rothschild, Mayer Amshel 267 Royal Bank of Scotland 298 Rubinstein, Mark 42, 196–7 13_INDEX.QXD 17/2/06 4:44 pm Page 333 Index Rumsfeld, Donald 12, 134, 306 Rusnak, John 143 Russia 45, 80, 166, 172–3, 274, 302 sales staff 55–60, 64–5, 125, 129, 217 Salomon Brothers 20, 36, 54, 62, 167–9, 174, 184 Sandor, Richard 34 Sanford, Charles 72, 269 Sanford, Eugene 269 Schieffelin, Allison 76 Scholes, Myron 22, 42, 168–71, 175, 185, 189–90, 193–7, 263–4 Seagram Group 247 Securities and Exchange Commission, US 64, 304 Securities and Futures Authority, UK 249 securitization 282–90 ‘security design’ 254–7 self-regulation 155 sex discrimination 76 share options 250–1 Sharpe, William 111 short selling 30–1, 114 Singapore 9 single-tranche CDOs 293–4, 299 ‘Sisters of Perpetual Ecstasy’ 234 SITCOMs 313 Six Continents (6C) 275–6 ‘smile’ effect 145 ‘snake’ currency system 203 ‘softing’ arrangements 117 Solon 137 Soros, George 44, 130, 253, 318–19 South Sea Bubble 210 special purpose asset repackaging companies (SPARCs) 233 special purpose vehicles (SPVs) 231–4, 282–6, 290, 293 speculation 29–31, 42, 67, 87, 108, 130 ‘spinning’ 64 333 Spitzer, Eliot 64 spread 41, 103; see also credit spreads stack hedges 96 Stamenson, Michael 124–5 standard deviation 161, 193, 195, 199 Steinberg, Sol 91 stock market booms 258, 260 stock market crashes 42–3, 168, 203, 257, 259, 319 straddles or strangles 131 strategy in banking 70 stress testing 164–6 stripping of convertible bonds 253–4 structured investment products 44, 112, 115, 118, 128, 211–39, 298 structured note asset packages (SNAPs) 233 Stuart SC 18, 307, 316–18 Styblo Bleder, Tanya 153 Suharto, Thojib 81–2 Sumitomo Corporation 100, 142 Sun Tzu 61 Svensk Exportkredit (SEK) 38–9 swaps 5–10, 26, 35–40, 107, 188, 211; see also equity swaps ‘swaptions’ 205–6 Swiss Bank Corporation (SBC) 248–9 Swiss banks 108, 305 ‘Swiss cheese theory’ 176 synthetic securitization 284–5, 288–90 systemic risk 151 Takeover Panel 248–9 Taleb, Nassim 130, 136, 167 target redemption notes 225–6 tax and tax credits 171, 242–7, 260–3 Taylor, Frederick 98, 101 team-building exercises 76 team moves 149 technical analysis 60–1, 135 television programmes about money 53, 62–3 Thailand 9, 80, 302–5 13_INDEX.QXD 17/2/06 4:44 pm Page 334 334 Index Thatcher, Margaret 205 Thorp, Edward 253 tobashi trades 105–7 Tokyo Disneyland 92, 212 top managers 72–3 total return swaps 246–8, 269 tracking error 138 traders in financial products 59–65, 129–31, 135–6, 140, 148, 151, 168, 185–6, 198; see also dealers trading limits 42, 157, 201 trading rooms 53–4, 64, 68, 75–7, 184–7, 208 Trafalgar House 248 tranching 286–9, 292, 296 transparency 26, 117, 126, 129–30, 310 Treynor, Jack 111 trust investment enhanced return securities (TIERS) 216, 233 trust obligation participating securities (TOPS) 232 TXU Europe 279 UBS Global Asset Management 110, 150, 263–4, 274 uncertainty principle 122–3 unique selling propositions 118 unit trusts 109 university education 187 unspecified fund obligations (UFOs) 292 ‘upfronting’ of income 139, 151 Valéry, Paul 163 valuation 64, 142–6 value at risk (VAR) concept 160–7, 173 value investing 111 Vanguard 116 vanity bonds 230 variance 161 Vietnam War 182, 195 Virgin Islands 233–4 Vivendi 247–8 volatility of bond prices 197 of interest rates 144–5 of share prices 161–8, 172–5, 192–3, 199 Volcker, Paul 20, 33 ‘warehouses’ 40–2, 139 warrants arbitrage 99–101 weather, bonds linked to 212, 320 Weatherstone, Dennis 72, 268 Weil, Gotscal & Manges 298 Weill, Sandy 174 Westdeutsche Genosenschafts Zentralbank 143 Westminster Group 34–5 Westpac 261–2 Wheat, Allen 70, 72, 106, 167 Wojniflower, Albert 62 World Bank 4, 36, 38 World Food Programme 320 Worldcom 250, 298 Wriston, Walter 71 WTI (West Texas Intermediate) contracts 28–30 yield curves 103, 188–9, 213, 215 yield enhancement 112, 213, 269 ‘yield hogs’ 43 zaiteku 98–101, 104–5 zero coupon bonds 221–2, 257–8


pages: 261 words: 81,802

The Trouble With Billionaires by Linda McQuaig

battle of ideas, Bernie Madoff, Big bang: deregulation of the City of London, British Empire, Build a better mousetrap, carried interest, collateralized debt obligation, computer age, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Douglas Engelbart, Douglas Engelbart, employer provided health coverage, financial deregulation, fixed income, full employment, George Akerlof, Gini coefficient, income inequality, Intergovernmental Panel on Climate Change (IPCC), invention of the telephone, invention of the wheel, invisible hand, Isaac Newton, Jacquard loom, Jacquard loom, Joseph-Marie Jacquard, laissez-faire capitalism, land tenure, Mark Zuckerberg, market bubble, Martin Wolf, mega-rich, minimum wage unemployment, Mont Pelerin Society, Naomi Klein, neoliberal agenda, Northern Rock, offshore financial centre, Paul Samuelson, Plutocrats, plutocrats, Ponzi scheme, pre–internet, price mechanism, purchasing power parity, RAND corporation, rent-seeking, rising living standards, road to serfdom, Ronald Reagan, The Chicago School, The Spirit Level, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, trickle-down economics, Vanguard fund, very high income, wealth creators, women in the workforce

It’s worth considering whether the mindset that led Wall Street types to abandon all sanity and morality – mixing together toxic brews of junk mortgages, car loans and credit card debts and then selling pieces of these sickly concoctions to unknowing ‘investors’ – is partly the result of the overstimulation of their greed impulses. When the broader public first became aware of collateral debt obligations and credit default swaps during the financial meltdown in the autumn of 2008, the most common reaction was bewilderment. The hypercharged Wall Street world was so removed from the regular world most people inhabit – where pay bears some relationship to hours worked, effort and results – that it seemed baffling and indecipherable. How did grown men and women make decisions that were not just over-the-top greedy but were so evidently irresponsible and threatening to the well-being of so many others, including themselves?

A few bettors had already been badly burned, spending too much on premiums and eventually pulling out of the game, frustrated and bitter that the housing market hadn’t yet imploded. Paulson too had been betting on a housing collapse, but he’d assembled a big enough war chest from his wealthy hedge fund clients to keep playing, despite the continued buoyancy of the housing market. After the meeting with Shilling, he was convinced that now was the time to go really big. One frustration for Paulson was that there just weren’t enough of these stocks, known as collateral debt obligations (CDO), to bet against. So he decided to become proactive. He approached a number of investment banks with the request that they create more CDOs to sell to clients, so that he could then take out ‘insurance’ betting that these would fail. The arrangement Paulson had in mind was rife with potential conflicts of interest. He clearly wanted to help pick the mortgages that would make up the new CDOs.

Still, that made sense, since a stock could decline in value, so an investor holding the stock might want to protect himself from the possibility of such a decline. What was unusual here was that the Wall Street types were taking out insurance on something in which they had no personal stake, on something that involved other people’s assets. It was like buying insurance on a car owned by a stranger, in the hope of collecting money if the stranger’s car crashed. This ‘insurance’ – known as a credit default swap (CDS) – was simply a bet. The fate of thousands of mortgage holders and their dreams of homeownership had become an opportunity for Wall Street hotshots to roll the dice, in the hope of winning a jackpot. In some ways, this form of gambling wasn’t very risky, because the most the bettor could lose would be the cost of his premiums. (For $1 million a year in CDS premiums, it was possible to insure some $100 million ‌worth of these mortgage stocks.)2 The problem was that it was impossible to know exactly when the housing market would collapse and cause the mortgage stocks to tumble in value.


pages: 741 words: 179,454

Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

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affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, financial independence, financial innovation, financial thriller, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, information asymmetry, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, John Meriwether, joint-stock company, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, Kevin Kelly, labour market flexibility, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, mega-rich, merger arbitrage, Mikhail Gorbachev, Milgram experiment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, Naomi Klein, negative equity, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, Paul Samuelson, pets.com, Philip Mirowski, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, Richard Thaler, Right to Buy, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, Satyajit Das, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, survivorship bias, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, the new new thing, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond, zero-sum game

The higher return available on securitized bonds relative to ordinary securities of similar quality was attractive. Synthetic Stuff In the 1990s, securitization underwent a makeover, being rebranded CDOs (collateralized debt obligations), a term subsuming various types of underlying loans and securitization formats. In 1997 JP Morgan introduced synthetic securitization, overcoming the unwieldy need to transfer the underlying loans to the SPV and also lowering the cost of transferring the risk. Instead of selling the loans, the lender now purchased credit insurance against the risk of loss using a credit default swap (CDS). The structure is shown in Figure 11.3. The bank purchased separate credit insurance policies from the SPV on each loan it wanted to transfer. As in a traditional ABS structure, the SPV issued securities.

In practice, risk was spreading like a virulent virus through the financial system, ending up in unknown places in the hands of investors, who did not understand the complex risks that they assumed. As Iceland imploded during the financial crisis, traders speculated that the Icelandic banks’ fatal dalliance with structured finance was simply confusion between the word c-o-d (an area of Icelandic expertise) and the non-piscine c-d-o (collateralized debt obligations). Get Copula-ed Assorted statisticians, mathematicians, scientists, and MBAs with little knowledge of banking now shaped packages of loans into complicated objets d’art. They built simplified models to predict patterns of cash flows from the underlying loans. In the ultra-rational world of efficient markets, prepayments were assumed to be linked to interest rates adjusted for behavioral nuances.

., 44, 341, 346 2001 tax cuts, 298 business schools, 308-313 bonuses, 317-318 compensation, 313-320 BusinessWeek, 170 buy and flick, 139 Byrd, Richard Evelyn, 256 Byrne, David, 46 Byrne, Rhonda, 45 C Caesar, 295 calculators, 122 call options, 209 Volkswagen (VW), 257 Callan, Erin, 288, 329 Calomiris, Charles, 273 Canadian dollars, 21 Canary Wharf, 79 Cantor, Eddie, 338 capital definition of, 280 flows, 205 gains, 160 injections into banks, 348-350 introductions, 247 leveraged, 244 Modigliani-Miller propositions, 119 structure arbitrage, 242 velocity of, 69 capital asset pricing model (CAPM), 117 capitalism, 102 Capitalism: A Love Story, 165 Capitalism: The Unknown Ideal, 297 CAPM (capital asset pricing model), 173 Capra, Frank, 65 carceral continuum, 312 careers certifications, 309-310 finance, 308-313 bonuses, 317-318 compensation, 313-320 Carlyle Group, The, 154, 163, 318 Carlyle, Thomas, 102 Carnegie Mellon University, 119 Carr, Fred, 145 Carroll, Lewis, 31 CARS (certificate for automobile receivables), 173 Carter, Jimmy, 74, 364 Caruso-Cabrera, Michelle, 95 Casablanca, 77, 311 Case, Steve, 58 cash flow, 138 forecasting, 160 General Electric (GE), 61 cash for clunkers, 348 Cassano, Joseph, 232 Cat’s Cradle, 339 catastrophe risk, 232 Catillo, Bernal Díaz del, 131 Cavendish Laboratory (Cambridge, England), 101 Cayman Islands, 220 Cayne, James, 318 CBOs (collateralized bond obligations), 173 CDOs (collateralized debt obligations), 173, 176 defaults of, 284 celebrity central bankers, age of, 297-300 celebrity financiers, 324-326 Celtic tiger, 83. See also Ireland Centaurus Energy, 319 Center for Research in Security Prices (CRSP), 131 Centlivre, Susannah, 75 central banks, 309 age of celebrity central bankers, 297-300 dissenters, 300-302 regulations, 279-281 risk transfers, 281-282 Central Intelligence Agency (CIA), 310 CEOs (chief executive officers) earnings, 323-324 knowledge of business operations, 292-293 Cerberus, 162 certifications, finance, 309-310 CFA (certified financial analyst), 309 Chains or Chain Link, 269 chains, mortgage, 183 Chancellor, Edward, 161 Chanos, Jim, 161 chaos theory, 274 Chase Manhattan Bank, 79 Chassagne-Montrachet, 304 Cheney, Dick, 265 Chesterton, G.K., 226 Chettle, Geoff, 228 Chicago, 104-105 Chicago Board of Option Exchange (CBOE), 122 Chicago Interpretation, the, 104, 130 Chicxulub crater, 339 Chiemgauer, 35 China, 82 Chinese Communist Party, 350 Chinese paper, 144 Chinese renminbi, 21 Chinese walls, 66 debt, purchase of American dollars, 87 as a financial center, 84-85 global credit process, 88 growth of, 86 relationship with America, 87 slowdown in economic activity, 350-351 China Aviation Oil (Singapore) Corporation, 56 Chinalco, 59 chits, 22 A Chorus Line, 164 Christianity, 65 Christie’s, 323 Chrysler, 162 Building, 79 purchase by Fiat, 344 Cioffi, Ralph, 191, 365 circulation of money, 32 Citadel Funds, 196, 241, 256 Citibank, 71 Citicorp Venture Capital, 154 Citicorp, merger of with Travelers, 75 Cities Services, 137 CitiGroup, 41, 75-77, 165, 290, 315 Center, 79 Todd Thompson, 93 City, the (London), 79 CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey, and South Africa), 91 civilization, 38 Clarke, David, 159 Clarkson, Brian, 284 clickety-clicks, 39.


pages: 524 words: 143,993

The Shifts and the Shocks: What We've Learned--And Have Still to Learn--From the Financial Crisis by Martin Wolf

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air freight, anti-communist, Asian financial crisis, asset allocation, asset-backed security, balance sheet recession, bank run, banking crisis, banks create money, Basel III, Ben Bernanke: helicopter money, Berlin Wall, Black Swan, bonus culture, break the buck, Bretton Woods, call centre, capital asset pricing model, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collateralized debt obligation, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, debt deflation, deglobalization, Deng Xiaoping, diversification, double entry bookkeeping, en.wikipedia.org, Erik Brynjolfsson, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, fiat currency, financial deregulation, financial innovation, financial repression, floating exchange rates, forward guidance, Fractional reserve banking, full employment, global rebalancing, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, inflation targeting, information asymmetry, invisible hand, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, light touch regulation, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, mandatory minimum, margin call, market bubble, market clearing, market fragmentation, Martin Wolf, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mortgage debt, negative equity, new economy, North Sea oil, Northern Rock, open economy, paradox of thrift, Paul Samuelson, price stability, private sector deleveraging, purchasing power parity, pushing on a string, quantitative easing, Real Time Gross Settlement, regulatory arbitrage, reserve currency, Richard Feynman, Richard Feynman, risk-adjusted returns, risk/return, road to serfdom, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, Second Machine Age, secular stagnation, shareholder value, short selling, sovereign wealth fund, special drawing rights, The Chicago School, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, too big to fail, Tyler Cowen: Great Stagnation, very high income, winner-take-all economy, zero-sum game

It was true of households and companies, particularly investors in property, property developers and those engaged in leveraged buy-outs. With more debt relative to equity, and overvalued asset prices, the outcome was extreme vulnerability to crisis. In addition, the market-based financial system embedded an enormous amount of leverage inside financial instruments. Collateralized debt obligations (CDOs) are an excellent example, with leverage inherent in the process of tranching cash inflows. Synthetic CDOs, which are created by pooling and tranching credit-default swaps on asset-backed securities and other bonds, involve much the same process. Think of the simplest possible CDO, one in which the underlying interest payments and mortgage repayments are divided into just two securities: the lower risk of these two securities would be entitled to receive the first 50 per cent of all the payments and repayments; the higher risk of these securities would get the rest.

The most important innovation was, arguably, in the allegedly mathematically rigorous pricing of derivatives – financial assets that ‘derive’ their value from the prices of underlying assets, such as stocks or bonds, indices, or interest rates.30 But, it should be noted, Nassim Nicholas Taleb, famous for the ‘Black Swan’ (an unforecastable event), views the theories underlying the pricing of derivatives as intellectually fraudulent.31 But, aided by rising computing power, this almost universally accepted intellectual innovation led to an explosion in the invention and trading of ever more sophisticated products, including the infamous collateralized debt obligations (CDOs), synthetic collateralized debt obligations and CDOs squared, which triggered the global financial crisis of 2007–08. (These instruments are explained further below.) According to the Bank for International Settlements, between June 1998 and June 2008 the notional value of outstanding over-the-counter derivatives exploded from $72tn to $673tn (whereupon it stagnated), the latter being just under eleven times global gross product.

While the European Central Bank did stand behind the banks of these countries as a lender of last resort, it definitely did not stand behind their public debt. 32. John B. Taylor, ‘The Financial Crisis and the Policy Response: An Empirical Analysis of What Went Wrong’, National Bureau of Economic Research Working Paper 14631, January 2009, www.nber.org. 33. Ferguson and Johnson note that ‘prices of credit default swaps on the four largest American banks, controlling some 40 per cent of all deposits, for example, all rose like rockets before falling back when Paulson, Bernanke and Geithner reversed course two days later and once again embraced single payer by bailing out AIG. The same holds for credit default swaps of Goldman Sachs and Morgan Stanley, the two most important remaining investment banks … Another excellent general indicator of stress, the “option adjusted” spread on broad investment grade debt – what banks had to pay to raise new capital – also shows a sharp rise as Lehman gave up the ghost.’


pages: 180 words: 61,340

Boomerang: Travels in the New Third World by Michael Lewis

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Berlin Wall, Bernie Madoff, Carmen Reinhart, Celtic Tiger, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, fiat currency, financial thriller, full employment, German hyperinflation, Irish property bubble, Kenneth Rogoff, offshore financial centre, pension reform, Ponzi scheme, Ronald Reagan, Ronald Reagan: Tear down this wall, South Sea Bubble, the new new thing, tulip mania, women in the workforce

I’d become interested in a tiny handful of investors who had made their fortunes from the collapse of the subprime mortgage market. Back in 2004, the biggest Wall Street investment banks had created the instrument of their own destruction, the credit default swap on the subprime mortgage bond. The credit default swap enabled investors to bet against the price of any given bond—to “short” it. It was an insurance policy, but with a twist: the buyer didn’t need to own the insured asset. No insurance company can legally sell you fire protection on another person’s house, but the financial markets can and will sell you default insurance on another person’s investments. Hundreds of investors had dabbled in the credit default swap market—a lot of people had thought, at least in passing, that the debt-fueled U.S. housing boom was unsustainable—but only fifteen or so had gone all in, and placed enormous bets that vast tracts of American finance would go up in flames.

The Germans in Düsseldorf had one critical job: to advise this offshore vehicle they had created about which bonds it should buy. “We are one of the last to get our money out of Rhineland,” Röthig told Risk magazine, “but we’re so confident of our ability to advise it in the right way that we still make a profit.” Röthig further explained that IKB had invested in special tools to analyze the complicated bonds, called collateralized debt obligations (CDOs), that Wall Street was now peddling. “I would say it has proven a worthwhile investment because we have not faced a loss so far,” he said. In February 2004 all this seemed like a good idea—so good that lots of other German banks copied IKB, and either rented IKB’s conduit or set up their own offshore vehicles to buy subprime mortgage bonds. “It sounds like quite a profitable strategy,” the man from Moody’s who had awarded Rhineland’s commercial paper a triple-A rating told Risk magazine.

“Let’s say it takes five years and not two,” he said. “Let’s say it takes seven years. Should I wait until I see the whites of their eyes before I position myself, or should I position myself now? The answer is now. Because the moment people think it [national default] is a possibility, it’s expensive. If you wait, you have to pay up for the risk.” When we met, he had just bought his first credit default swaps on the countries he and his team of analysts viewed as the most likely to be unable to pay off their debts: Greece, Ireland, Italy, Switzerland, Portugal, and Spain. He made these bets directly with the few big Wall Street firms that he felt were least likely to be allowed to fail—Goldman Sachs, J.P. Morgan, and Morgan Stanley—but, doubting their capacity to withstand a more serious crisis, he demanded that they post collateral on the trades every day.


pages: 593 words: 189,857

Stress Test: Reflections on Financial Crises by Timothy F. Geithner

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Affordable Care Act / Obamacare, asset-backed security, Atul Gawande, bank run, banking crisis, Basel III, Bernie Madoff, Bernie Sanders, break the buck, Buckminster Fuller, Carmen Reinhart, central bank independence, collateralized debt obligation, correlation does not imply causation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, David Brooks, Doomsday Book, eurozone crisis, financial innovation, Flash crash, Goldman Sachs: Vampire Squid, housing crisis, Hyman Minsky, illegal immigration, implied volatility, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, Martin Wolf, McMansion, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mortgage debt, Nate Silver, negative equity, Northern Rock, obamacare, paradox of thrift, pets.com, price stability, profit maximization, pushing on a string, quantitative easing, race to the bottom, RAND corporation, regulatory arbitrage, reserve currency, Saturday Night Live, savings glut, selection bias, short selling, sovereign wealth fund, The Great Moderation, The Signal and the Noise by Nate Silver, Tobin tax, too big to fail, working poor

The measure is based on the implied volatility of options on the S&P 500 index of stocks. The VIX captures investor expectations of near-term stock market volatility—how uncertain investors are about whether and how far the S&P will rise or fall. 4 two complex new Maiden Lane vehicles: Among AIG’s major liquidity needs were their securities lending operations and the credit default swaps written by AIG Financial Products on collateralized debt obligations. Maiden Lane II and III addressed these issues, respectively, by purchasing the underlying collateral from AIG and its counterparties and canceling the CDS contracts that AIG owed against them. This eliminated the risk that these contracts would continue to result in additional margin calls that would further drain AIG’s cash. Seven: Into the Fire 1 hardworking homeowners who were underwater: A home is “underwater” or has “negative equity” when the mortgage debt on the home exceeds its value.

Banks under siege used to stack money in their windows to reassure depositors there was no need to run; when governments put enough “money in the window,” they can reduce the danger they’ll have to use it. The classic example is deposit insurance, Franklin Delano Roosevelt’s response to Depression-era bank runs. Since 1934, the government has guaranteed deposits at banks, so insured depositors who get worried that their bank has problems no longer have an incentive to yank out their money and make the problems worse. Of course, the banking system that FDR inherited didn’t have “collateralized debt obligations,” “asset-backed commercial paper,” or other complexities of twenty-first-century finance. In the panic of 2008, insured bank deposits didn’t run on any significant scale, but all kinds of other frightened money did—and in the digital age, a run doesn’t require any physical running, just a phone call or a click of a mouse. By early 2009, the government had put a lot of money in the window through TARP and other emergency measures.

A WEEK later, the investment bank Merrill Lynch announced $7.9 billion in mortgage-related losses, the largest write-down in Wall Street history. That was almost twice as large a write-down as Merrill had predicted three weeks earlier, leaving the impression that losses were exploding and more unpleasant surprises lay ahead. Merrill CEO Stan O’Neal was forced out, although he did receive a $161.5 million severance to ease the blow. The bulk of Merrill’s losses came from “collateralized debt obligations,” piles of mortgage-backed securities where the income streams had been sliced up and repackaged into smaller streams known as “tranches.” Merrill was a leading manufacturer of CDOs, and it had made billions selling them to investors around the world. But the investors, reaching for yield, had shown little interest in the safest tranches, the “super-senior” CDOs that would pay out in full unless mortgage losses were so severe that investors in every tranche below them were wiped out.


pages: 411 words: 108,119

The Irrational Economist: Making Decisions in a Dangerous World by Erwann Michel-Kerjan, Paul Slovic

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Andrei Shleifer, availability heuristic, bank run, Black Swan, Cass Sunstein, clean water, cognitive dissonance, collateralized debt obligation, complexity theory, conceptual framework, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, cross-subsidies, Daniel Kahneman / Amos Tversky, endowment effect, experimental economics, financial innovation, Fractional reserve banking, George Akerlof, hindsight bias, incomplete markets, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Isaac Newton, iterative process, Kenneth Arrow, Loma Prieta earthquake, London Interbank Offered Rate, market bubble, market clearing, money market fund, moral hazard, mortgage debt, Pareto efficiency, Paul Samuelson, placebo effect, price discrimination, price stability, RAND corporation, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, source of truth, statistical model, stochastic process, The Wealth of Nations by Adam Smith, Thomas Bayes, Thomas Kuhn: the structure of scientific revolutions, too big to fail, transaction costs, ultimatum game, University of East Anglia, urban planning, Vilfredo Pareto

The goal is to make the municipal bond insurer bankruptcy remote from losses that might occur on other insurance lines covered by the same holding company (i.e., with no possible contagion). In addition, the chartering laws have imposed relatively high capital requirements on the firms. Quite irrationally, in recent years, insurance regulators have also allowed municipal bond insurers to provide coverage against default risks on subprime mortgage securitizations and related collateralized debt obligations (CDOs) and credit default swaps (CDSs). It is unclear why the insurance regulators allowed the insurers to mix the relatively limited credit risks on municipal bonds with the high risks on subprime mortgages and their derivatives, since this clearly violated the monoline principle on which the insurers were chartered. Worse yet, losses on the subprime mortgage derivatives now threaten the solvency of the municipal bond insurers.9 The failure of these firms would have significant negative externalities in two regards.

constructed function intertemporal making mistaken models of outcomes of parameter political process, improving pros/cons of sensitive strategic wise See also Rational choice Cleveland, Grover Climate change challenge of characteristics of coal industry and as compound lottery evaluation/management of hazard risk and impact of legitimate policies of mitigation of outcomes of path for policy premiums and Climate negotiations Climate risks Club of Rome Coates, John “Coconut” uncertainty Cognitive activity emotional activity and Cohen, Jonathan Collaboration Collateral debt obligations (CDOs) Commitment prediction and uncertainty and Communication development of theory Compassion collapse of(fig.) Conference of Rio on Environment and Development Consequences actions and decision making and Conservatism, environmental issues and Consumption social welfare and Contracts insurance Convention on the Prevention and Punishment of the Crime of Genocide (1948) Coolidge, Calvin Copenhagen Agreed Outcome Copenhagen Consensus (2004) Cost-of-search hypothesis Costs diffuse Credit default swaps (CDS) Credit instruments Crises Crisis management Dacy, Douglas Damasio, Antonio Darfur genocide Debreu, Gérard Decision analysis (DA) adaptation by challenges for disappointments with principles of training in Decision analytical model(fig.)

LIBOR OIS declined precipitously. However, the shortage of capital in banks also resulted in very high shadow rates (usually not reported to the general public) for use of intermediary capital. This outcome is represented in Figure 20.6 by the black line, which delineates the bond-CDS basis—that is, the difference between the spreads on corporate bonds and the derivative contracts that insure them (i.e., credit default swaps, or CDS).3 Why the bond-CDS spread, and what does it tell us? CDS contracts are relatively liquidly traded contracts that measure the credit risk on bonds. In theory, this basis, the difference between bond and CDS yields, should be near zero, since the cost of insurance against a bond’s default should be about the same as the additional yield demanded by bondholders to compensate them against this same default.


pages: 413 words: 117,782

What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences by Steven G. Mandis

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activist fund / activist shareholder / activist investor, algorithmic trading, Berlin Wall, bonus culture, BRICs, business process, collapse of Lehman Brothers, collateralized debt obligation, commoditize, complexity theory, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, diversification, Emanuel Derman, financial innovation, fixed income, friendly fire, Goldman Sachs: Vampire Squid, high net worth, housing crisis, London Whale, Long Term Capital Management, merger arbitrage, Myron Scholes, new economy, passive investing, performance metric, risk tolerance, Ronald Reagan, Saturday Night Live, Satyajit Das, shareholder value, short selling, sovereign wealth fund, The Nature of the Firm, too big to fail, value at risk

Goldman experiments with e-mail (C). 1997: Paulson says Goldman’s policy of not advising on hostile takeovers is no longer in the firm’s interest, but Corzine resists any change that might damage Goldman’s image. They compromise on an experiment with a test case outside the United States, and Goldman advises Krupp in a successful hostile take-over of Thyssen (O, C). J.P. Morgan develops a proprietary product that helps banks clean up their balance sheets using credit default swaps—the first synthetic collateralized debt obligations (CDOs) (T, C). Morgan Stanley merges with Dean Witter Reynolds, the financial services business of Sears that serves retail clients (C). The acquisition extends Morgan Stanley’s ability to sell stock offerings and makes Morgan Stanley larger. Travelers Group, run by Sandy Weill, purchases Salomon Brothers, a major bond dealer and investment bank, for $9 billion (C).

Earlier theories, Dekker argues, have been tripped up by their tendency to explain instances of failure in complex environments by blaming flawed components rather than the workings of the organizational system as a whole.2 Dekker concludes, by contrast, that failure emerges opportunistically, nonrandomly, from the very webs of relationships that breed success and that are supposed to protect organizations from disaster. Dekker also observes that systems tend to drift in the direction of failure, gradually reducing the safety margin and taking on more risk, because of pressures to optimize the system in order to be more efficient and competitive. We are able to build complex things—deep-sea oil rigs, spaceships, collateralized debt obligations—all of whose properties we can understand in isolation. But with complex systems in competitive, regulated societies—like most organizations—failure is often primarily due to unanticipated interactions and interdependencies of components and factors or forces outside the system, rather than failure of the components themselves. The interactions are unanticipated, and the signals are missed.

FINRA says Goldman did not have the proper procedures in place to make sure that this disclosure was made (R). 2011: In March, former Goldman board member Rajat Gupta is charged by the SEC with insider trading for passing information to the hedge fund Galleon Group that he learned in his capacity as a board member. Six months later he is arrested on criminal charges, soon after the SEC charges another Goldman employee with insider trading. In April, Senator Carl Levin (D.-Mich.) releases the 650-page report of the Senate investigation into the credit crisis (R). It concludes that Goldman misled clients and Congress about the collateralized debt obligations that helped cause the financial crisis. The report urges regulators to identify any violations of law in the activities of Goldman leading up to the financial crisis. The report asserts that conflicts of interest led Goldman to place its financial interests before those of its clients. The report is the result of a two-year probe by the Permanent Subcommittee on Investigations. In May, the report is referred to the Department of Justice and the SEC.


pages: 364 words: 99,613

Servant Economy: Where America's Elite Is Sending the Middle Class by Jeff Faux

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back-to-the-land, Bernie Sanders, Black Swan, Bretton Woods, BRICs, British Empire, call centre, centre right, cognitive dissonance, collateralized debt obligation, collective bargaining, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, David Brooks, David Ricardo: comparative advantage, falling living standards, financial deregulation, financial innovation, full employment, hiring and firing, Howard Zinn, Hyman Minsky, illegal immigration, indoor plumbing, informal economy, invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, lake wobegon effect, Long Term Capital Management, market fundamentalism, Martin Wolf, McMansion, medical malpractice, mortgage debt, Myron Scholes, Naomi Klein, new economy, oil shock, old-boy network, Paul Samuelson, Plutocrats, plutocrats, price mechanism, price stability, private military company, Ralph Nader, reserve currency, rising living standards, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, school vouchers, Silicon Valley, single-payer health, South China Sea, statistical model, Steve Jobs, Thomas L Friedman, Thorstein Veblen, too big to fail, trade route, Triangle Shirtwaist Factory, union organizing, upwardly mobile, urban renewal, War on Poverty, We are the 99%, working poor, Yogi Berra, Yom Kippur War

See social mobility Clay, Henry Clinton, Bill on education financial meltdown of 2008 and fiscal policy 1992 election of Reagan’s influence on Clinton, Hillary Coehlo, Tony Cognizant Technology Solutions Corporation Colbert, Steve collateralized debt obligations (CDO) college education for-profit free trade policy and Obama on servant economy and See also education Colombia, U.S. military spending and Commission on Wartime Contracting Commodities Futures Trading Commission (CFTC) communism China and Marx Soviet Union and in the United States Complex, The (True) Congressional Budget Office (CBO) Congress of Industrial Organizaitons (CIO) consumer debt. See subprime mortgage bubble (2000–2008) Consumer Financial Protection Agency Coolidge, Calvin Cooper, Keysha Cordesman, Anthony H. Coughlin, Father Charles Council of Economic Advisors credit default swaps Crocker, David Cuomo, Andrew Cuomo, Mario currency dollar pound sterling ruble trade deficit and yuan Daley, William Danner, Mark Davis-Bacon Act de Beauvoir, Simone Debs, Eugene Dell Corporation Democratic Party.

With money on all sides of every trade, it was hard for many players to tell at the end of the day whether they’d lost or won. At the end of 2007, the market for these swaps was estimated at $45.5 trillion—roughly twice as large as all U.S. stock markets combined. The country’s financial markets had gone from being decontrolled to being uncontrollable. But as long as the market expanded, the profits seemed enormous and apparently insured against loss. The operating margins at the giant insurer AIG on collateralized debt obligation (CDO) insurance rose steadily; by 2002 the margin was 44 percent of revenue, and by 2005, 83 percent. The profits of the unit that sold CDOs rose from $737 million in 1999 to $3.26 billion in 2005. Fat bonuses, lavish parties, and padded expense accounts for exotic travel followed. The credit boom built on subprime mortgages also provided real, if temporary, benefits to a large number of Americans who never bought a derivative.

This was American ingenuity at its best for all the world to see and admire. The commentators assured their audiences that by spreading risks among more people, the miracle of “diversity” was actually turning bad loans into good ones. And there was nothing to worry about, they said, for the banks were buying insurance policies against default. In fact, these policies were quickly transformed into a set of even murkier derivatives called credit default swaps, which are bets on price movements of securities that in turn are bets on the default rate of loans held by other people. These swaps were marketed to hedge funds, pension managers, and, in some cases, back to the banks that were being insured in the first place. With money on all sides of every trade, it was hard for many players to tell at the end of the day whether they’d lost or won.


pages: 376 words: 109,092

Paper Promises by Philip Coggan

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accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, balance sheet recession, bank run, banking crisis, barriers to entry, Berlin Wall, Bernie Madoff, Black Swan, Bretton Woods, British Empire, call centre, capital controls, Carmen Reinhart, carried interest, Celtic Tiger, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, debt deflation, delayed gratification, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, falling living standards, fear of failure, financial innovation, financial repression, fixed income, floating exchange rates, full employment, German hyperinflation, global reserve currency, hiring and firing, Hyman Minsky, income inequality, inflation targeting, Isaac Newton, John Meriwether, joint-stock company, Kenneth Rogoff, labour market flexibility, light touch regulation, Long Term Capital Management, manufacturing employment, market bubble, market clearing, Martin Wolf, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, Myron Scholes, negative equity, Nick Leeson, Northern Rock, oil shale / tar sands, paradox of thrift, peak oil, pension reform, Plutocrats, plutocrats, Ponzi scheme, price stability, principal–agent problem, purchasing power parity, quantitative easing, QWERTY keyboard, railway mania, regulatory arbitrage, reserve currency, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, short selling, South Sea Bubble, sovereign wealth fund, special drawing rights, The Chicago School, The Great Moderation, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, The Wealth of Nations by Adam Smith, time value of money, too big to fail, trade route, tulip mania, value at risk, Washington Consensus, women in the workforce, zero-sum game

Business Week Butler, Eamonn Calder, Lendol California Callaghan, Jim Calvin, John Canada Canadian Tar Sands capital controls capital economics capital flows capital ratios carried interest carry trade Carville, James Cassano, Joseph Cato Institute Cayne, Jimmy CDU Party ‘Celtic tiger’ central bank reserves Cesarino, Filippo ‘Chapter’ Charlemagne Charles I, King of England cheques/checks chief executive pay Chile China Churchill, Winston civil war (English) civil war (US) Citigroup clearing union Clientilism Clinton, Bill CNBC collateralized debt obligations commerical banks commercial property commodity prices Compagnie D’Occident comparative advantage conduits confederacy Congdon, Tim Congress, US Connally, John Conservative Party Consols Constantine, Emperor of Rome consumer price inflation continental bonds convergence trade convertibility of gold suspended Coolidge, Calvin copper Cottarelli, Carlo Council of Nicea Cowen, Brian cowrie shells Credit Anstalt credit cards credit crisis of 2007 – 8 credit crunch credit default swaps ‘cross of gold’ speech Cunliffe committee Currency Board currency wars Dante Alighieri David Copperfield Davies, Glyn debasing the currency debit cards debt ceiling debt clock debt deflation spiral debt trap debtors vs creditors, battle defaults defined contribution pension deflation Defoe, Daniel Delors, Jacques Democratic convention of 1896 Democratic Party Democratic Republic of Congo demographics denarii Denmark deposit insurance depreciation of currencies derivatives Deutsche Bank Deutschmark devaluation Dickens, Charles Dionysius of Syracuse Dodd – Frank bill dollar, US Dow Jones Industrial Average drachma Duke, Elizabeth Dumas, Charles Duncan, Richard Durst, Seymour Dutch Republic East Germany East Indies companies Economist Edward III, King of England Edwards, Albert efficient-market theory Egypt Eichengreen, Barry electronic money embedded energy energy efficiency estate agents Estates General Ethelred the Unready euro eurobonds eurodollar market European Central Bank European Commission European Financial Stability Facility European Monetary System European Union eurozone Exchange Rate Mechanism, European exorbitant privilege farmers Federal Reserve Federal Reserve Bank of Philadelphia Federalist party fertility rate ‘fiat money’ Fiji final salary pension Financial Services Authority Financial Times Finland First Bank of the United States First World War fiscal policy fiscal union Fisher, Irving fixed exchange rates floating currencies florin Florio, Jim Ford, Gerald Ford, Henry Ford Motor Company Foreign & Colonial Trust foreign direct investment foreign exchange reserves Forni, Lorenzo Forsyte Saga France Francis I, King of France Franco-Prussian War Franklin, Benjamin French Revolution Friedman, Milton Fuld, Dick futures markets Galbraith, John Kenneth Galsworthy, John GATT Gaulle, Charles de Geithner, Tim General Electric General Motors general strike of 1926 Genghis Khan Genoa conference George V, King of England Germany gilts Gladstone, William Glass – Steagall Act Gleneagles summit Glorious Revolution GMO Gokhale, Jagadeesh gold gold exchange standard gold pool gold standard Goldman Sachs goldsmiths Goodhart, Charles Goodhart’s Law Goschen, George Gottschalk, Jan government bonds government debt Graham, Frank Granada Grantham, Jeremy Great Compression Great Depression Great Moderation Great Society Greece Greenspan, Alan Gresham, Sir Thomas Gresham’s Law Gross, Bill G7 nations G20 meeting Guinea Habsburgs Haiti Haldane, Andrew Hamilton, Alexander Hammurabi of Babylon Havenstein, Rudolf von Hayek, Friedrich Heavily Indebted Poor Countries initiative hedge funds Henderson, Arthur Henry VIII, King of England Hien Tsung, Chinese emperor Hitler, Adolf Hoar, George Frisbie Hohenzollern monarchy Holy Roman Empire Homer, Sydney Hoover, Herbert House of Representatives houses Hume, David Hussein, Saddam Hutchinson, Thomas Hyde, H.

The mortgage payments on the loans were used to pay the interest on the bonds. As defaults rose, the sub-prime lenders found it more difficult to get finance. Their business model was built on getting rid of the mortgages as quickly as they created them; in the absence of the cashflow from sales, they were unable to meet their debts. The problem then rippled through the chain. The mortgage-backed securities had been bundled into other securities called ‘collateralized debt obligations’ (CDOs). These were designed to give investors a diversified pool of high-yield assets. Such assets were attractive as an ironic consequence of the great moderation; yields on cash and government bonds were low so investors were happy to chase higher returns. These CDOs had been organized in tranches, like a kind of trifle. Each layer had different rights and expected returns. The so-called equity layer was the riskiest; it paid the highest yield but suffered the first losses when the bonds in the portfolio defaulted.

Such banks were dependent on funding from the wholesale market; in other words, from other banks and institutions. As mortgage-related losses spread, each bank was determined to secure its own funding and equally determined not to be exposed to firms in trouble. Rumour fed upon rumour; the weak banks saw their share prices plunge and the cost of insuring their debt surge. That insurance was in the form of another derivative, called a ‘credit default swap’ (CDS). The name was more complicated than the concept: Party A worries that a bond issuer might default on its interest payments, so it pays Party B a regular payment, like an insurance premium, as protection against this eventuality. If the bond issuer does default, Party B will compensate Party A for its losses, just as an insurer will cover fire damage. What made CDSs controversial is that investors did not need to own the bond to insure against its default.


pages: 272 words: 19,172

Hedge Fund Market Wizards by Jack D. Schwager

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asset-backed security, backtesting, banking crisis, barriers to entry, beat the dealer, Bernie Madoff, Black-Scholes formula, British Empire, Claude Shannon: information theory, cloud computing, collateralized debt obligation, commodity trading advisor, computerized trading, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, diversification, diversified portfolio, Edward Thorp, family office, financial independence, fixed income, Flash crash, hindsight bias, implied volatility, index fund, intangible asset, James Dyson, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, money market fund, oil shock, pattern recognition, pets.com, Ponzi scheme, private sector deleveraging, quantitative easing, quantitative trading / quantitative finance, Right to Buy, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Rubik’s Cube, Sharpe ratio, short selling, statistical arbitrage, Steve Jobs, systematic trading, technology bubble, transaction costs, value at risk, yield curve

Cornwall Capital’s primary strategy for shorting the housing bubble was buying credit default swaps (CDS) on the AA tranches of CDOs. The buyer of CDS makes ongoing premium payments (equivalent to the bond interest rate payments) to the seller for protection against the risk of default in the underlying security. How did you get involved in trading the subprime mortgage market? I first became aware of the opportunity in October 2006 when a friend sent us a write-up of a presentation made by Paul Singer of Elliot Associates. Singer walked through the sleight-of-hand that banks used to amalgamate the riskiest tranches of subprime mortgage-backed securitizations (MBS)—the BBB tranches that investors were starting to shy away from—into a new collateralized debt obligation (CDO), the majority of which was rated AA or higher. 9 Singer demonstrated that housing prices didn’t have to fall for the AA tranches of these CDOs to fail; they simply had to stop rising.

See Options Canadian Natural Resources Capital One Cap rate Carry currencies Casino (film) Casino games. See Gambling Catalyst theory Category-based thinking Celanese Chinese coal market Chipotle Citigroup Clark, Steve Claugus, Thomas Collateralized debt obligations (CDOs) Commissions Commodity Trading Advisors (CTAs). See also Ramsey, Scott; Woodriff, Jaffray Company conference calls The Complete Turtle Trader (Covel) Computer strategies, early Concept stocks Constraining monthly losses Contrarian investing Convertible bond arbitrage Copart (CPRT) Cornwall Capital Corporate bonds Correlation Countertrend vs. trend methodologies Credit default swaps (CDSs) Credit expansion/deleveraging cycle Credit spreads Dalio, Ray Holy Grail of investing template for understanding economies Daly, Kevin Data mining Davidge, Nick Deleveraging cycles Delta hedging Delta neutral hedging Depression gauge Discretionary trading.

There was no historical precedent for such low-quality mortgages. It is easy to see how the BBB tranche of a bond formed from these low-quality mortgages would be extremely vulnerable to a complete loss. The story, however, does not end there. The BBB tranches were difficult to sell. Wall Street alchemists came up with a solution that magically transformed the BBB tranches into AAA. They created a new securitization called a collateralized debt obligation (CDO) that consisted entirely of the BBB tranches of many mortgage bonds.7 CDOs also employed a tranche structure. Typically 75 percent to 80 percent of a CDO was rated AAA, even though it consisted of 100 percent BBB tranches. Although the CDO tranche structure was similar to that employed by subprime mortgage bonds consisting of individual mortgages, there was an important difference.


pages: 252 words: 72,473

Weapons of Math Destruction: How Big Data Increases Inequality and Threatens Democracy by Cathy O'Neil

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Affordable Care Act / Obamacare, Bernie Madoff, big data - Walmart - Pop Tarts, call centre, carried interest, cloud computing, collateralized debt obligation, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, Emanuel Derman, housing crisis, I will remember that I didn’t make the world, and it doesn’t satisfy my equations, illegal immigration, Internet of things, late fees, mass incarceration, medical bankruptcy, Moneyball by Michael Lewis explains big data, new economy, obamacare, Occupy movement, offshore financial centre, payday loans, peer-to-peer lending, Peter Thiel, Ponzi scheme, prediction markets, price discrimination, quantitative hedge fund, Ralph Nader, RAND corporation, recommendation engine, Rubik’s Cube, Sharpe ratio, statistical model, Tim Cook: Apple, too big to fail, Unsafe at Any Speed, Upton Sinclair, Watson beat the top human players on Jeopardy!, working poor

But this time the power of modern computing fueled fraud at a scale unequaled in history. The damage was compounded by other vast markets that had grown up around the mortgage-backed securities: credit default swaps and synthetic collateralized debt obligations, or CDOs. Credit default swaps were small insurance policies that transferred the risk on a bond. The swaps gave banks and hedge funds alike a sense of security, since they could supposedly use them to balance risk. But if the entities holding these insurance policies go belly up, as many did, the chain reaction blows holes through the global economy. Synthetic CDOs went one step further: they were contracts whose value depended on the performance of credit default swaps and mortgage-backed securities. They allowed financial engineers to leverage up their bets even more. The overheated (and then collapsing) market featured $3 trillion of subprime mortgages by 2007, and the market around it—including the credit default swaps and synthetic CDOs, which magnified the risks—was twenty times as big.

The overheated (and then collapsing) market featured $3 trillion of subprime mortgages by 2007, and the market around it—including the credit default swaps and synthetic CDOs, which magnified the risks—was twenty times as big. No national economy could compare. Paradoxically, the supposedly powerful algorithms that created the market, the ones that analyzed the risk in tranches of debt and sorted them into securities, turned out to be useless when it came time to clean up the mess and calculate what all the paper was actually worth. The math could multiply the horseshit, but it could not decipher it. This was a job for human beings. Only people could sift through the mortgages, picking out the false promises and wishful thinking and putting real dollar values on the loans. It was a painstaking process, because people—unlike WMDs—cannot scale their work exponentially, and for much of the industry it was a low priority.

This is a result of the way we define a trader’s prowess, namely by his “Sharpe ratio,” which is calculated as the profits he generates divided by the risks in his portfolio. This ratio is crucial to a trader’s career, his annual bonus, his very sense of being. If you disembody those traders and consider them as a set of algorithms, those algorithms are relentlessly focused on optimizing the Sharpe ratio. Ideally, it will climb, or at least never fall too low. So if one of the risk reports on credit default swaps bumped up the risk calculation on one of a trader’s key holdings, his Sharpe ratio would tumble. This could cost him hundreds of thousands of dollars when it came time to calculate his year-end bonus. I soon realized that I was in the rubber-stamp business. In 2011 it was time to move again, and I saw a huge growth market for mathematicians like me. In the time it took me to type two words into my résumé, I was a newly proclaimed Data Scientist, and ready to plunge into the Internet economy.


pages: 493 words: 132,290

Vultures' Picnic: In Pursuit of Petroleum Pigs, Power Pirates, and High-Finance Carnivores by Greg Palast

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anti-communist, back-to-the-land, bank run, Berlin Wall, Bernie Madoff, British Empire, capital asset pricing model, capital controls, centre right, Chelsea Manning, clean water, collateralized debt obligation, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, Donald Trump, energy security, Exxon Valdez, invisible hand, means of production, Myron Scholes, offshore financial centre, random walk, Ronald Reagan, sensible shoes, transfer pricing, uranium enrichment, Washington Consensus, Yogi Berra

If an unelected junta of bankers drafts America’s trade position, well, here’s the number to call. And so the law of international finance became Lawlessness. ATHENS In May 2010, the end-game ended for Greece. The new financial products were packaged, polished to a shine, and sold to government pension funds all over the planet. The bankers sold blind sacks of sub-prime mortgages, sliced and mixed up, as Collateralized Debt Obligations (CDOs) and other fetid concoctions. The Financial Services Agreement was rockin’! But when opened, buyers found the bags were filled with financial feces. Government pensions and sovereign funds, from Finland to Qatar, lost trillions. The bags were toxic to bank balance sheets and several failed. However, in most cases, bankers could get a refill of capital juice from governments fearful of full-bore financial collapse.

The new President, Lula, resisted, despite the gun of bankruptcy threats in his face and the deals Brazil signed before he was sworn in. But Lula told the IMF to jam it and body-blocked privatizations, especially of the state-owned banks. Instead of begging international financiers for scraps, he opened the vaults of the state bank and lent out over half a trillion dollars for factories, farms, infrastructure—but not for one real for derivatives, hostile takeovers or collateralized debt obligations. During his two terms in office, Lula’s state banks gave their citizen-owners more credit than the IMF gave to over hun-dered nations. And Brazil’s economy went from the swamp to the stars. Then Brazil struck oil, lots of it, in deep Atlantic waters. In the old days, that is, a decade ago, Chevron, Shell, and BP would have been onto those reservoirs like ticks, sucking up Brazil’s oil.

In May 2010, after the banks burned, Greece’s Prime Minister George Papandreou said, “Everyone in Greece, whether three years old or ninety-eight years old, now knows what a spread is.” If you’re not a Greek three-year-old, I’ll let you in on it. A spread is the extra interest demanded by speculators and banks to insure against a nation’s bankruptcy and default. When sold as a derivative, the bankruptcy insurance is called a credit default swap (CDS).25 How much does this insurance cost? If you have to ask, you can’t afford it. In 2010 and 2011, the “spread” for Greece hit as much as 10 percent versus German debt. That is, Germany could borrow at 5 percent while Greece paid 15 percent. (At the same time, U.S. banks had the right to borrow for next to nothing, less than 1 percent, from the U.S. Federal Reserve.) On Greece’s roughly $100 billion debt, the extra vigorish demanded by lenders raised the interest payments to $14,000 a year per family, over half a year’s salary for the average Greek worker.


pages: 662 words: 180,546

Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown by Philip Mirowski

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Alvin Roth, Andrei Shleifer, asset-backed security, bank run, barriers to entry, Basel III, Berlin Wall, Bernie Madoff, Bernie Sanders, Black Swan, blue-collar work, Bretton Woods, Brownian motion, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, constrained optimization, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, dark matter, David Brooks, David Graeber, debt deflation, deindustrialization, Edward Glaeser, Eugene Fama: efficient market hypothesis, experimental economics, facts on the ground, Fall of the Berlin Wall, financial deregulation, financial innovation, Flash crash, full employment, George Akerlof, Goldman Sachs: Vampire Squid, Hernando de Soto, housing crisis, Hyman Minsky, illegal immigration, income inequality, incomplete markets, information asymmetry, invisible hand, Jean Tirole, joint-stock company, Kenneth Arrow, Kenneth Rogoff, knowledge economy, l'esprit de l'escalier, labor-force participation, liberal capitalism, liquidity trap, loose coupling, manufacturing employment, market clearing, market design, market fundamentalism, Martin Wolf, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Naomi Klein, Nash equilibrium, night-watchman state, Northern Rock, Occupy movement, offshore financial centre, oil shock, Pareto efficiency, Paul Samuelson, payday loans, Philip Mirowski, Ponzi scheme, precariat, prediction markets, price mechanism, profit motive, quantitative easing, race to the bottom, random walk, rent-seeking, Richard Thaler, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, savings glut, school choice, sealed-bid auction, Silicon Valley, South Sea Bubble, Steven Levy, technoutopianism, The Chicago School, The Great Moderation, the map is not the territory, The Myth of the Rational Market, the scientific method, The Wisdom of Crowds, theory of mind, Thomas Kuhn: the structure of scientific revolutions, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, Vilfredo Pareto, War on Poverty, Washington Consensus, We are the 99%, working poor

39 See MacKenzie and Demos, “Credit Default Swap Trading Drops.” This estimate may be limited in its geographic range, and is probably too low. 40 Miller, “Financial Innovation.” 41 Some examples of the “social studies of finance” are MacKenzie, An Engine, Not a Camera; MacKenzie et al., Do Economists Make Markets?; and Preda and Knorr-Cetina, Handbook of the Sociology of Finance. The critique of the role of science studies in helping reify this interpretation of financial innovation can be found in Engelen et al., “Reconceptualizing Financial Innovation.” 42 I refer here to a paper by Donald MacKenzie (“The Credit Crisis as a Problem in the Sociology of Knowledge”), who argues that a shift in cultures of evaluation within the ratings agencies, from older corporate collateralized debt obligations to the newer CDOs composed of mortgage-backed securities, accounted for a number of “slips” when it came to evaluation of the dangers posed by the latter.

It takes some thick skin not to cringe at the performance of four famous economists at the January 2010 meetings of the American Economics Association in Atlanta, in a session expressly titled, “How Should the Financial Crisis Change How We Teach Economics?”21 Three out of the four could not even be bothered to actually address the posited question, so concerned were they to foster the impression that they personally had not been caught with their pants down by the crisis. The fourth thought that simply augmenting his existing textbook with another chapter defining collateralized debt obligations and some simple orthodox finance theory would do the trick. Things got even worse in the subsequent year, with figures such as Alan Blinder and John B. Taylor touting new editions of their undergraduate macrotheory textbooks by reassuring instructors that the crisis did not require them to change anything they had been teaching for years.22 No second thoughts for us foxes, thank you.

Matt Taibbi had some fun pointing out that even wives of the rich and famous were bestowed enormous opportunities to enrich themselves off TALF, a program nominally instituted to support the rancid securities the Fed had permitted to proliferate over the previous decade.56 But few have acknowledged that this was precisely the Depression remedy promoted by Milton Friedman: keep the rich from suffering writedowns or defaulting on their debts so the so-called money supply does not contract inordinately, and everything else will just work itself out fine. Yves Smith has made the important point that Bernanke tends to justify the sites and instances where the Fed has intervened largely by insisting that private contracts have to be respected; but this is yet another Big Lie from Foggy Bottom. If the contracts favored the banks, such as the credit default swaps written by AIG, then it was permissible to stretch the Fed legal charter by essentially nationalizing an insurance company, or purchasing mortgage-backed securities. (Saving AIG reveals the Bernanke excuse that “we had no legal authority” to save Lehman to be bootless.) However, whenever it was the banks themselves that violated sanctity of contract, from the total travesty of riding roughshod over the chain of title in mortgage securitization, to the defrauding of clients and investors, to reverse long-established principles of creditor hierarchy, then the Fed looked the other way.


pages: 124 words: 39,011

Beyond Outrage: Expanded Edition: What Has Gone Wrong With Our Economy and Our Democracy, and How to Fix It by Robert B. Reich

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2013 Report for America's Infrastructure - American Society of Civil Engineers - 19 March 2013, affirmative action, banking crisis, carried interest, collateralized debt obligation, collective bargaining, Credit Default Swap, credit default swaps / collateralized debt obligations, desegregation, full employment, Home mortgage interest deduction, job automation, Mahatma Gandhi, minimum wage unemployment, money market fund, new economy, Occupy movement, offshore financial centre, Plutocrats, plutocrats, Ponzi scheme, race to the bottom, Ronald Reagan, single-payer health, special drawing rights, The Wealth of Nations by Adam Smith, Tim Cook: Apple, too big to fail, trickle-down economics, women in the workforce, working poor, zero-sum game

S&P’s intrusion into American politics is also ironic because much of our current debt is directly or indirectly due to S&P’s failure (along with the failures of the two other major credit-rating agencies, Fitch and Moody’s) to do its job before the financial meltdown. Until the eve of the collapse, S&P gave triple-A ratings to some of the Street’s riskiest packages of mortgage-backed securities and collateralized debt obligations. Had S&P fulfilled its responsibility and warned investors of how much risk Wall Street was taking on, the housing and debt bubbles wouldn’t have become so large, and their bursts wouldn’t have brought down much of the economy. You and I and other taxpayers wouldn’t have had to bail out Wall Street; millions of Americans would have spent the subsequent years working instead of collecting unemployment insurance; the government wouldn’t have had to inject the economy with a massive stimulus to save millions of other jobs; and far more tax revenue would have been pouring into the Treasury from individuals and businesses.

The Street has also bet on or insured all sorts of derivatives—in effect, bets placed on the outcomes of other trades—emanating from Europe, on energy, currency, interest rates, and foreign exchange swaps. If a German or French bank goes down, the ripple effects are incalculable. The oracles of Wall Street said they weren’t worried, because most of the Street’s exposure to European banks was insured through “credit-default swaps” that would offset any losses. Wall Street’s amnesia was breathtaking. Just four years before, AIG nearly collapsed because it couldn’t make payments on its swap contracts that were supposed to insure big Wall Street banks against losses on their bets. American taxpayers had to bail out AIG as well as the big banks. One of the many ironies surrounding Wall Street’s equanimity in the face of the European debt crisis was that some badly indebted European nations (Ireland is the best example) went deeply into debt in the first place by bailing out their banks from the crisis that began on Wall Street.


pages: 278 words: 82,069

Meltdown: How Greed and Corruption Shattered Our Financial System and How We Can Recover by Katrina Vanden Heuvel, William Greider

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Asian financial crisis, banking crisis, Bretton Woods, capital controls, carried interest, central bank independence, centre right, collateralized debt obligation, conceptual framework, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, declining real wages, deindustrialization, Exxon Valdez, falling living standards, financial deregulation, financial innovation, Financial Instability Hypothesis, fixed income, floating exchange rates, full employment, housing crisis, Howard Zinn, Hyman Minsky, income inequality, information asymmetry, John Meriwether, kremlinology, Long Term Capital Management, margin call, market bubble, market fundamentalism, McMansion, money market fund, mortgage debt, Naomi Klein, new economy, offshore financial centre, payday loans, pets.com, Plutocrats, plutocrats, Ponzi scheme, price stability, pushing on a string, race to the bottom, Ralph Nader, rent control, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, sovereign wealth fund, structural adjustment programs, The Great Moderation, too big to fail, trade liberalization, transcontinental railway, trickle-down economics, union organizing, wage slave, Washington Consensus, women in the workforce, working poor, Y2K

This applies not only to particular institutions like Bear Stearns, or even to mortgage mega-firms like Fannie and Freddie, but to finance in general. When it seemed necessary, public monies were indeed funneled in the general direction of the banking/brokerage community to shore up the whole rickety structure. This allowed one burst bubble—the dot-com debacle—to be replaced by another, namely our late, lamented mortgage/collateralized-debt-obligation bonanza, just now dramatically going down the tubes. Backstopping the present bailout is the ever-credulous, put-upon American public with its presumably inexhaustible resources. Even while Washington was instituting the periodic “socialization” of bad debts, it was systematically abandoning the New Deal’s commitment to regulation. That, of course, was in the very period when financial markets became ever more arcane, ever less comprehensible even to their Frankensteinian inventors, and ever more in need of monitoring.

The result was a frenzied bid-ding up of prices for a bewildering maze of arcane securities that neither buyers nor sellers could accurately value. Giant Ponzi scheme? Not to worry, responded the Wall Street geniuses. By spreading risks among more people, the miracle of “diversity” was actually turning bad loans into good ones. Anyway, banks were buying insurance policies against default, which in turn were transformed into a set of even murkier securities called “credit default swaps” and marketed to hedge funds, pension managers and in some cases back to the banks that were being insured in the first place. At the end of 2007 the market for these swaps was estimated at $45.5 trillion—roughly twice as large as all U.S. stock markets combined. This huge pyramid of debt was made possible by thirty years of relentless deregulation of financial markets, culminating in the 1999 repeal of the Glass-Steagall Act, which had prohibited banks from dealing in high-risk securities.

Probably there is also need for new rules on reserve requirements across the board and restrictions on the use of insured deposits. Above all, trading in complex derivatives—the main cause of the current disaster—has to be completely overhauled, at once. Derivatives have to be standardized and move to public exchanges that collectively guarantee them. Failure to do this will just start the whole nonsense over again. Just imagine being told a year from now that losses on credit default swaps written by firms that were bailed out under the new plan require the United States to pony up still more cash. Congressional Options It is fine for Democrats to hold out for mortgage relief and for another stimulus package. The best way to do the first, probably, is by reviving something like the Home Owners Loan Corporation that worked so well in the New Deal. That bought mortgages from people who were in danger of losing their houses and converted them into obligations that they could afford to repay.


pages: 202 words: 66,742

The Payoff by Jeff Connaughton

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algorithmic trading, bank run, banking crisis, Bernie Madoff, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, cuban missile crisis, desegregation, Flash crash, locking in a profit, London Interbank Offered Rate, London Whale, Long Term Capital Management, naked short selling, Neil Kinnock, Plutocrats, plutocrats, Ponzi scheme, risk tolerance, Robert Bork, short selling, Silicon Valley, too big to fail, two-sided market, young professional

When investigating complex fraud perpetrated by sophisticated, well-advised actors able to bury disclosures in mountains of paper, anything less than timely and full commitment won’t be enough. Increasingly, it looked like this third possibility was the sad answer to our question. 6: WHAT HAD GONE WRONG? FINALLY, IN APRIL 2010, the SEC announced that it had a case. It filed charges against Goldman Sachs for the Abacus collateralized debt obligation. The case alleged that Goldman had failed to disclose the involvement of a hedge fund (which intended to short, or bet against, the security) in the portfolio selection process. This news gave us hope that the SEC was back on the job and that even the most powerful on Wall Street would be held accountable. In Ted’s eyes, Khuzami, who oversaw the case against Goldman, was a hero. Until the day he left office, Ted would continue to encourage and defend Khuzami.

Clinton’s economic team (including Rubin and Summers) had fought to ensure that derivatives would remain unregulated. We knew that policymakers had pushed banks and quasi-agencies like Fannie Mae and Freddie Mac to make housing affordable; that subprime mortgages were pooled and securitized; that the rating agencies blew it and gave these pools AAA ratings; and that banks were leveraging thirty- and fifty-to-one and buying up these soon-to-be-toxic assets. Credit default swaps were being written and traded to hedge these risks without any understanding of who was writing how much and without any regulation or oversight. As Ted liked to say, Washington’s decades-long infatuation with deregulation had pulled all the referees off the football field. Then, the executives trusted to act in the best interests of shareholders had convinced themselves, against all reason and instinct, that they could engineer risk out of the system.

Ted reported back that Bernanke and Geithner were very concerned. On March 2, AIG had reported it had recorded a $61 billion loss in the fourth quarter of 2008. The next day, Treasury had announced an additional $30 billion in assistance to AIG, on top of the $150 billion it had already extended. Ted and others were wondering, “How could AIG lose $61 billion?” Bernanke and Geithner simply didn’t know who held the credit-default swaps. There were similar problems in England, in Iceland, and at the Bank of Scotland. Ted said: “It was like a friend of mine who has this oak tree out in front of his house, a gigantic tree, and the tree is surrounded by a driveway. The roots were coming up and knocking out the driveway. But when they tried to put a new driveway in, they didn’t know where the roots went. The roots went all over.


pages: 317 words: 106,130

The New Science of Asset Allocation: Risk Management in a Multi-Asset World by Thomas Schneeweis, Garry B. Crowder, Hossein Kazemi

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asset allocation, backtesting, Bernie Madoff, Black Swan, capital asset pricing model, collateralized debt obligation, commodity trading advisor, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index fund, interest rate swap, invisible hand, market microstructure, merger arbitrage, moral hazard, Myron Scholes, passive investing, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, statistical model, survivorship bias, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve, zero-sum game

In the 1970s, markets expanded to provide a range of risk management tools (currency futures, bond futures, and stock options, to name a few) that permitted managers to move significantly away from long only based portfolio analysis. In the 1980s, stock index futures and index options were developed. New forms of dynamic risk management, such as portfolio insurance, also came into existence. In the 1990s, new asset sectors such as mortgages, new approaches to asset management such as hedge funds, and a wider range of investment vehicles such as Collateralized Debt Obligations (CDOs) were developed. By 2000, financial engineers had come into their own, developing even more complex invest- xiv PREFACE ment instruments and vehicles, each designed to further cauterize and trade market risk. Unfortunately, few investors considered that each of these new investment forms or vehicles fundamentally changed the relationship between assets and how those assets would perform and respond in extreme economic environments.

To go beyond that point is to either enter the world of the absurd or court unintended consequences without preparation. In Chapter 3, we speak to this point as we examine certain theories that provide very real value within their parameters, but have been misused or are not allowed to die a proper death because they serve an unintended and sometimes misguided purpose. We have also seen this phenomenon at work in the current market. The Collateralized Debt Obligation (CDOs) is first and foremost an asset allocation product and was first designed by JP Morgan to assist its clients in securitizing certain obligations. In designing this program, the bank also designed risk control features that assured a workable understanding of the bank’s obligations as well as those of its clients. We have witnessed the awful destruction of wealth tied to this asset allocation product when discretion and proper risk controls are removed from its design.

See CAPM (Capital Asset Pricing Model) Capital International Stock Indices, 168 Capital Market Line (CML), 5–6 CAPM (Capital Asset Pricing Model), 4–6, 18, 62–63 acceptance of, 28 and efficient market hypothesis, 6–10 and market risk, 43 Cash flow, 98 Casualty insurance, 98 CISDM CTA indices, 149, 150, 261, 262 CISDM ELS index, 193 CISDM Fund of Fund indices, 267, 268 CISDM Hedge Fund indices, 55, 131, 142, 144, 145, 185 CISDM indices, 259, 260, 261, 262, 263 Clustering, volatility, 95 Collar strategy, 234 Collateralized debt obligations (CDOs), 228, 229 Commodities, 59, 61, 65, 129, 130, 143–148, 160–165 benchmarks, 179–185, 275 futures, 12 Index return and risk performance, 162–163 volatility, 182, 185 Commodity Futures Trading Commission (CFTC), 11 Commodity pool operators (CPOs), 143 Commodity Research Bureau, 265, 266 Commodity risk, 196 Commodity trading advisors. See CTAs (commodity trading advisors) Conditional model, 41 Conditional performance evaluation, 53–54 Constant proportional portfolio insurance (CPPI), 107 Convexity, 49–50 Core allocation, 110–133 Correlation analysis, 34, 116 Correlations, 24, 68–69, 214 between Barclays Capital U.S.


pages: 300 words: 78,475

Third World America: How Our Politicians Are Abandoning the Middle Class and Betraying the American Dream by Arianna Huffington

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American Society of Civil Engineers: Report Card, Bernie Madoff, Bernie Sanders, call centre, carried interest, citizen journalism, clean water, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, David Brooks, extreme commuting, Exxon Valdez, full employment, greed is good, housing crisis, immigration reform, invisible hand, knowledge economy, laissez-faire capitalism, late fees, market bubble, market fundamentalism, Martin Wolf, medical bankruptcy, microcredit, new economy, New Journalism, offshore financial centre, Ponzi scheme, Report Card for America’s Infrastructure, Richard Florida, Ronald Reagan, Rosa Parks, single-payer health, smart grid, The Wealth of Nations by Adam Smith, too big to fail, transcontinental railway, trickle-down economics, winner-take-all economy, working poor, Works Progress Administration

As Mauldin says of the old—and still dominant—order on Wall Street: “Let’s be very clear.71 This was purely gambling. No money was invested in mortgages or any productive enterprise. This was one group betting against another, and a lot of these deals were done all over New York and London.” Mauldin goes on to question why large institutional investors were even gambling on such things as synthetic collateralized debt obligations in the first place: “This is an investment that had no productive capital at work and no remotely socially redeeming value.72 It did not go to fund mortgages or buy capital equipment or build malls or office buildings.” Commenting on our looming debt crisis, Princeton economist Alan Blinder noted that “in 1980 [policymakers] knew about the year 2010 but that was really far away.”73 Well, it’s not anymore, and given that much of our deficit problem is about huge numbers of workers born decades ago now hitting retirement age, Blinder quipped, “The long run is now the short run and they’re combining.”

We’ve just seen the way middle-class incomes had fallen behind expenses over the past three decades. How is it that more and more Americans were able to buy more and more houses—even as incomes stagnated? By taking on more debt, of course, provided by an underregulated army of lenders pitching seductive new mortgage vehicles. By 2005, subprime mortgages had skyrocketed to 20 percent of the market.63 Fueling the boom was the development of securitized mortgages—including collateralized debt obligations (CDOs)—in which mortgages of varying degrees of risk were bundled together in “tranches” and sold to investors.64 Since lenders were selling off the risk to someone else, they felt much freer to make loans to borrowers who never would have been able to qualify for a prime mortgage. The Fed did its part, too, contributing extremely low interest rates and lax oversight to the increasingly toxic housing mix.

The economic collapse has not killed people, but it has gradually destroyed the lives of millions of Americans. All three calamities occurred because elected officials who should have been enforcing a regulatory system that protects working families instead allowed the system to protect the corporations it was meant to watch over. Most of the systemic breakdowns that led to the regulatory failure at Upper Big Branch and on the BP rig were the same ones that led to the housing bubble, credit-default swaps, toxic derivatives—and, by extension, the bank bailout, long-term unemployment, and the rapid decline of America’s middle class. Days after the Upper Big Branch disaster, the New York Times described the Mine Safety and Health Administration (MSHA), the regulatory agency that so atrociously failed the Upper Big Branch miners, this way: it is “fundamentally weak in several areas”; “the fines it levies are relatively small, and many go uncollected for years”; “it lacks subpoena power, a basic investigatory tool”; “its investigators are not technically law enforcement officers”; “its criminal sanctions are weak”; “fines remain so low that they are mere rounding errors on the bottom lines” of the companies being regulated; and it shows a “reluctance to flex all of its powers.”23 In an eerie echo, in the wake of the Deepwater Horizon disaster, the Wall Street Journal described the Minerals Management Service (MMS), the government agency that oversees offshore drilling, this way: it “doesn’t write or implement most safety regulations, having gradually shifted such responsibilities to the oil industry itself”; it “seldom referred safety or environmental violations to the Justice Department for criminal prosecution, even when it should have done so”; and it “got out of the business of telling companies what training was necessary for workers involved in keeping wells from gushing out of control.”24 Florida senator Bill Nelson summed it up: “If MMS wasn’t asleep at the wheel, it sure was letting Big Oil do most of the driving.”25 Chris Oynes, the Interior Department’s top official overseeing offshore oil and gas drilling, announced his retirement shortly after the disastrous explosion, and Elizabeth Birnbaum, the head of MMS, was forced out thirty-seven days after the spill began—just another pair of resignations that came too late to make a difference.26, 27 The problem isn’t a shortage of regulators.


pages: 461 words: 128,421

The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street by Justin Fox

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activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, asset allocation, asset-backed security, bank run, beat the dealer, Benoit Mandelbrot, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, card file, Cass Sunstein, collateralized debt obligation, complexity theory, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, discovery of the americas, diversification, diversified portfolio, Edward Glaeser, Edward Thorp, endowment effect, Eugene Fama: efficient market hypothesis, experimental economics, financial innovation, Financial Instability Hypothesis, fixed income, floating exchange rates, George Akerlof, Henri Poincaré, Hyman Minsky, implied volatility, impulse control, index arbitrage, index card, index fund, information asymmetry, invisible hand, Isaac Newton, John Meriwether, John Nash: game theory, John von Neumann, joint-stock company, Joseph Schumpeter, Kenneth Arrow, libertarian paternalism, linear programming, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market design, Myron Scholes, New Journalism, Nikolai Kondratiev, Paul Lévy, Paul Samuelson, pension reform, performance metric, Ponzi scheme, prediction markets, pushing on a string, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, road to serfdom, Robert Bork, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, shareholder value, Sharpe ratio, short selling, side project, Silicon Valley, South Sea Bubble, statistical model, The Chicago School, The Myth of the Rational Market, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, Thorstein Veblen, Tobin tax, transaction costs, tulip mania, value at risk, Vanguard fund, Vilfredo Pareto, volatility smile, Yogi Berra

They bought the mortgages from brokers and other mortgage lenders and packaged them into mortgage-backed securities. Perversely, Fannie and Freddie were allowed to buy these, and acquired tens of billions of dollars in subprime-mortgage-backed securities to meet affordable housing goals set by Congress. The Wall Street firms also repackaged mortgage securities into collateralized debt obligations (CDOs) that allowed them to transmute even the dodgiest subprime mortgages into triple-A debt. The new derivatives called credit default swaps, which allowed CDO packagers and buyers to offload some of their risks, allowed for even more credit creation. Backing up all this packaging and repackaging and derivatization were options-theory-based risk models that were, of course, only as good as the information fed into them. In many cases, because the securitization of these kinds of loans was so new, the models relied on only two or three years of historical data.

., 248–49 Chaos (Gleick), 70, 234 chaos theory, 67, 134, 301–2, 304 Chase Financial Policy, 163–64 Chicago Board of Options Exchange, 145 Chicago Board of Trade, 40 Chicago Mercantile Exchange, 145, 194, 219,227–28, 230 Chicago Tribune, 35–36 Cisco Systems, 261–62, 262–63, 278, 284 Citrin, Robert, 362n. 17 Clinton, Bill, 244 CNA Financial, 125 Coca-Cola, 270–71 coin-flip game, 26, 212–13 collateralized debt obligations (CDOs), 314 Collins, Jim, 284 Colorado Springs, Colorado, 35–36 Columbia Business School, 211 Columbia University, 47–48 Commodities Corp., 223–24 commodities market, 20, 39–40, 69–72, 133, 145, 194–95 Commodity Futures Trading Commission, 244 Common Stocks as Long-Term Investments (Smith), 22 competition, 160, 181, 353–54n. 25 complexity theory, 134, 301–2, 304 Complexity (Waldrop), 302 computers, 29, 86–87, 99–101, 204, 219, 224, 232, 234, 303–4 The Condition of the Working-Class in England in 1844 (Engels), 369n. 1 conglomerates, 120, 166 Convertible Hedge Associates, 218 Cootner, Paul, 71, 134, 223 corporations, 4, 14, 66, 137, 153–55, 159–61, 351–52n. 2 Corrigan, Gerald, 243 Council of Institutional Investors, 272–73 Cowles, Alfred, III, 35–39, 42, 43, 51–52, 55, 68, 70, 98, 111, 323 Cowles Commission for Research in Economics, 37, 51–53, 65, 76–78, 89, 341n. 9 Cowles Foundation, 55, 58 credit default swaps, 314 credit markets, xii, 317 currency markets, 92–93, 145, 236, 241, 250 Darwin, Charles, 9 De Bondt, Werner, 187, 201, 206, 296 Debreu, Gerard, 77–78, 150, 344n. 9 debt, 25, 170, 313–15 decision theory, 177–78 deflation, 11, 19–20 DeLong, Brad, 251 demand curves, 39 Department of Applied Economics (Cambridge), 64 deregulation, 152, 258, 320 derivatives, xii, xiv, 150–52, 220–21, 235, 236–37 dice games, 27.

His ideas began to have some impact in his lifetime, and after his death in 1947, they took off. Books directly or indirectly descended from Fisher’s work now adorn the desks of hedge fund managers, pension consultants, financial advisers, and do-it-yourself investors. The increasingly dominant quantitative side of the financial world—that strange wonderland of portfolio optimization software, enhanced indexing, asset allocators, credit default swaps, betas, alphas, and “model-derived” valuations—is a territory where Professor Fisher would feel intellectually right at home. He is perhaps not the father, but certainly a father of modern Wall Street. Hardly anyone calls him that, though. Economists honor Fisher for his theoretical breakthroughs, but outside the discipline his chief claim to lasting fame is the horrendous stock market advice he proffered in the late 1920s.


pages: 320 words: 87,853

The Black Box Society: The Secret Algorithms That Control Money and Information by Frank Pasquale

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Affordable Care Act / Obamacare, algorithmic trading, Amazon Mechanical Turk, American Legislative Exchange Council, asset-backed security, Atul Gawande, bank run, barriers to entry, basic income, Berlin Wall, Bernie Madoff, Black Swan, bonus culture, Brian Krebs, call centre, Capital in the Twenty-First Century by Thomas Piketty, Chelsea Manning, Chuck Templeton: OpenTable, cloud computing, collateralized debt obligation, computerized markets, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, cryptocurrency, Debian, don't be evil, drone strike, Edward Snowden, en.wikipedia.org, Fall of the Berlin Wall, Filter Bubble, financial innovation, financial thriller, fixed income, Flash crash, full employment, Goldman Sachs: Vampire Squid, Google Earth, Hernando de Soto, High speed trading, hiring and firing, housing crisis, informal economy, information asymmetry, information retrieval, interest rate swap, Internet of things, invisible hand, Jaron Lanier, Jeff Bezos, job automation, Julian Assange, Kevin Kelly, knowledge worker, Kodak vs Instagram, kremlinology, late fees, London Interbank Offered Rate, London Whale, Marc Andreessen, Mark Zuckerberg, mobile money, moral hazard, new economy, Nicholas Carr, offshore financial centre, PageRank, pattern recognition, Philip Mirowski, precariat, profit maximization, profit motive, quantitative easing, race to the bottom, recommendation engine, regulatory arbitrage, risk-adjusted returns, Satyajit Das, search engine result page, shareholder value, Silicon Valley, Snapchat, Spread Networks laid a new fibre optics cable between New York and Chicago, statistical arbitrage, statistical model, Steven Levy, the scientific method, too big to fail, transaction costs, two-sided market, universal basic income, Upton Sinclair, value at risk, WikiLeaks, zero-sum game

That’s the Holy Grail of today’s Wall Street: guaranteed returns.60 The problem is that as this experiment got under way, a key insurer started doing the same thing— assuming it had a “sure thing” going. Recall that, in the 1990s, it was big news for AIG to lose less than a tenth of a billion dollars on swaps. By 2008, AIG had amassed a credit default swap portfolio of tens of billions of dollars and was happily collecting premiums from fi rms who wanted to insure their shaky securities.61 It had nowhere near that amount of money at hand.62 Those who had bought insurance from AIG confidently registered on their own balance sheets a guarantee that any lost revenue would be made up by AIG’s credit default swaps.63 The fantasy here was that a private entity like AIG could take on the essentially public function of an agency like the FDIC: to make the insured whole even after catastrophic failures of their counterparties.

Sometimes the buyer may be desperate, and sometimes the seller might be. In the aggregate, this “noise” should cancel out as a clear price signal emerges. The inventors of credit default swaps hoped that their derivative could achieve in debt markets what stock exchanges were (theoretically) realizing in equity markets.109 The ultimate goal was to set exact prices on a wide array of financial risks. The financial engineers saw this as a great triumph of human ingenuity, a technology of risk commodification that would vastly expand societal capabilities to plan and invest. In the giddy days of the real estate bubble, investors who bought both a CDO and a credit default swap likely felt like Midas, guaranteed gains no matter how the future turned out. As we now know, the price discovery function failed miserably. Complexity, malfeasance, and sometimes outright fraud made a FINANCE’S ALGORITHMS 127 mockery of the fi nely engineered fi nancial future promised by quants.

And the people who were supposed to be assessing the quality of securities built out of such loans were using models that blinded them to what was going on.30 Statistical Legitimacy—The Failure of the Rating Agencies It’s no surprise that financial institutions jumped with both feet at the chance to broker deals between the sellers and buyers of structured securities like MBSes (and combinations of MBSes, often called collateralized debt obligations [CDOs]). They made money no matter what happened to the securities they sold. But why did buyers purchase them so readily? Why did the government not counsel caution? They were novel, untested, and complex in ways that might have made investors very ner vous. Yet rating agencies managed to offer a reassuring seal of approval—thanks to their own, even more deficient modeling.31 FINANCE’S ALGORITHMS 109 There’s a delicate balance between government and the market in America’s investment landscape.


pages: 559 words: 169,094

The Unwinding: An Inner History of the New America by George Packer

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Affordable Care Act / Obamacare, Apple's 1984 Super Bowl advert, bank run, big-box store, citizen journalism, cleantech, collateralized debt obligation, collective bargaining, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, deindustrialization, diversified portfolio, East Village, El Camino Real, Elon Musk, family office, financial independence, financial innovation, fixed income, Flash crash, Henry Ford's grandson gave labor union leader Walter Reuther a tour of the company’s new, automated factory…, housing crisis, income inequality, informal economy, Jane Jacobs, life extension, Long Term Capital Management, low skilled workers, Marc Andreessen, margin call, Mark Zuckerberg, market bubble, market fundamentalism, Maui Hawaii, Menlo Park, Neil Kinnock, new economy, New Journalism, obamacare, Occupy movement, oil shock, peak oil, Peter Thiel, Ponzi scheme, Richard Florida, Robert Bork, Ronald Reagan, Ronald Reagan: Tear down this wall, shareholder value, side project, Silicon Valley, Silicon Valley startup, single-payer health, smart grid, Steve Jobs, strikebreaker, The Death and Life of Great American Cities, the scientific method, too big to fail, union organizing, urban planning, We are the 99%, We wanted flying cars, instead we got 140 characters, white flight, white picket fence, zero-sum game

How else, other than unchecked fraud, could those banks have been “technically insolvent,” with only a handful of insiders knowing the truth? But there were deeper causes—the dismantling of the rules that had kept banking stable for half a century. Connaughton saw Kaufman—seventy years old, with a musty MBA from Wharton—as Rip Van Winkle, waking up in the age of “synthetic collateralized debt obligations” and “naked credit default swaps.” What the hell happened to Glass-Steagall, which maintained a wall between commercial and investment banking? (Passed by Congress in 1933, repealed by Congress in 1999, bipartisan vote, Clinton’s signature.) What about the “uptick rule,” which required investors to wait until a stock rose in price before selling it short? (Instated by the SEC in 1938, abolished by the SEC in 2007.)

In 2004, Kevin left his safe and boring job to join the proprietary trading desk at a big European bank, with zero job security and huge potential—one of the ballsier and more correct decisions of his life. The European bank was about to get into collateralized debt obligations. The stock market determined the size of your apartment and whether you had a Viking stove—who was rich and who wasn’t. The bond market determined if shit worked or everyone was eating sand, who was alive and who wasn’t. Ever since the eighties, credit had been the biggest driver. All the things that would later go wrong, structured credit, default swaps, were good inventions; they mitigated risk or offered financial solutions to companies and investors. The problem was the execution. In the mid-2000s, when there was just too much money on the table, the moral compass moved.

The period when Rubin stood at the top of Wall Street and Washington was the age of inequality—hereditary inequality beyond anything the country had seen since the nineteenth century. In his capacity as resident wise man, he urged Citigroup, as he had once urged Goldman Sachs, to take more trading risks with its huge balance sheet. He also advised that the risks needed to be carefully managed. After that, he didn’t pay much attention while, between 2003 and 2005, Citigroup tripled its issuing of collateralized debt obligations and mortgage-backed securities stuffed full of bad loans from places like Tampa, where people whose incomes had been flat for years had all their wealth in their houses and used them as cash machines. By late 2007, the bank had forty-three billion dollars in CDOs on its books. Most of it turned out to be worthless, and in 2008, when the financial crisis hit, Citigroup practically became a ward of the state.


pages: 339 words: 109,331

The Clash of the Cultures by John C. Bogle

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asset allocation, collateralized debt obligation, commoditize, corporate governance, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, estate planning, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, Flash crash, Hyman Minsky, income inequality, index fund, interest rate swap, invention of the wheel, market bubble, market clearing, money market fund, mortgage debt, new economy, Occupy movement, passive investing, Paul Samuelson, Ponzi scheme, principal–agent problem, profit motive, random walk, rent-seeking, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, short selling, South Sea Bubble, statistical arbitrage, survivorship bias, The Wealth of Nations by Adam Smith, transaction costs, Vanguard fund, William of Occam, zero-sum game

The reality of transaction costs, however, suggests that we should pay more attention to total trading volume—including both purchases and sales—an incredible $5.4 trillion in total transactions, not far from one-and-a-half times the $3.8 trillion of equity fund assets of the group. However high the levels of mutual fund trading in stocks have soared relative to traditional norms, they pale by comparison to the trading volumes of hedge funds, to say nothing of the levels of trading in exotic securities such as interest rate swaps, collateralized debt obligations, derivatives such as futures on commodities, stock indexes, stocks, and even bets on whether a given company will go into bankruptcy (credit default swaps). The aggregate nominal value of these instruments, as I noted in Chapter 1, now exceeds $700 trillion. Yes, what we have come to describe as speculation has clearly come to play the starring role in our nation’s huge financial market colossus, with investment taking only a supporting role, if not a cameo role.

For example, trading in S&P 500-linked futures totaled more than $60 trillion(!) in 2011, five times the S&P 500 Index total market capitalization of $12.5 trillion. We also have credit default swaps, which are essentially bets on whether a corporation can meet the interest payments on its bonds. These credit default swaps alone had a notional value of $33 trillion. Add to this total a slew of other derivatives, whose notional value as 2012 began totaled a cool $708 trillion. By contrast, for what it’s worth, the aggregate capitalization of the world’s stock and bond markets is about $150 trillion, less than one-fourth as much. Is this a great financial system . . . or what! Much of the trading in derivatives—including stock index futures, credit default swaps, and commodities—reflects risk aversion and hedging. However, a substantial portion—perhaps one-half or more—reflects risk seeking, or rank speculation, another component of the whirling dervish of today’s trading activity.


pages: 393 words: 115,263

Planet Ponzi by Mitch Feierstein

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Affordable Care Act / Obamacare, Albert Einstein, Asian financial crisis, asset-backed security, bank run, banking crisis, barriers to entry, Bernie Madoff, break the buck, centre right, collapse of Lehman Brothers, collateralized debt obligation, commoditize, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, disintermediation, diversification, Donald Trump, energy security, eurozone crisis, financial innovation, financial intermediation, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, high net worth, High speed trading, illegal immigration, income inequality, interest rate swap, invention of agriculture, light touch regulation, Long Term Capital Management, mega-rich, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, obamacare, offshore financial centre, oil shock, pensions crisis, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, purchasing power parity, quantitative easing, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, too big to fail, trickle-down economics, value at risk, yield curve

As the mortgage market boomed to a peak of something over $10 trillion, there were investors starting to get anxious about the scale of their exposures. Some of these were motivated by ordinary credit-driven concerns. Others were bullish on the mortgage market but simply had to cap the total volume of their exposures. And so on. There was a huge variety of different motivations. But there was one common solution for their needs: the credit default swap or CDS. Forget about the intricacies of the terminology. Credit default swaps operate exactly like regular insurance‌—‌in this case, insurance against credit risk and default. You pay your premium year after year. If the asset you’ve insured goes bad, then the insurance pays out. So if, for example, you bought a mortgage-backed security full of subprime mortgage assets, you might (when you came to your senses) decide to insure yourself against the possibility of default.

In addition, as we’ll see in due course, I think there are solid reasons for optimism in the medium to longer term. Nevertheless, I want to keep my personal view strictly to one side, so we’ll focus here instead on what the financial markets themselves expect, using the most recent data available. The data we’ll use rely on credit default swaps, which as we’ve already seen are essentially a way to buy insurance against the risk of default. Because these swap prices are publicly displayed, it’s possible to see what insurance premiums are being demanded and paid. Clearly, the higher the premiums charged, the higher is the implicit risk of default. Indeed, it’s possible to use credit default swap pricing to estimate the ‘cumulative probability of default’ for all sovereign debt markets. The cumulative probability of default (CPD) is exactly what it sounds like. It’s the chance that a default happens at some point within a given period‌—‌in our case, we’re looking at the next five years.

Needless to say, however, those taking the least risk also earn the lowest interest rate; those at the most risky, most speculative end of the deal are (in theory) well compensated for the risk they take. (I say ‘in theory,’ because when in practice these edifices of crappy assets collapsed, those at the bottom of the food chain often received nothing at all.) Structures of this sort are known as collateralized debt obligations, or CDOs. When you finally understand the CDO structure and grasp the way that cash flows‌—‌and risks‌—‌cascade down the chain of bondholders, it’s easy to get seduced by the logic of it all. Yet when you stand back and think about it, the logic is extraordinary. Joe and Joella do not look (or smell?) like investment grade borrowers. They have no credit history, no job, no income, no assets and‌—‌I don’t want to be snobby about this, but‌—‌they live in a trailer park and have nothing to do all day but smoke marijuana with Fat Boy.


pages: 283 words: 77,272

With Liberty and Justice for Some: How the Law Is Used to Destroy Equality and Protect the Powerful by Glenn Greenwald

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Ayatollah Khomeini, banking crisis, Bernie Madoff, Clive Stafford Smith, collateralized debt obligation, Corrections Corporation of America, crack epidemic, Credit Default Swap, credit default swaps / collateralized debt obligations, David Brooks, deskilling, financial deregulation, full employment, high net worth, income inequality, Julian Assange, mandatory minimum, nuremberg principles, Ponzi scheme, Project for a New American Century, rolodex, Ronald Reagan, too big to fail, Washington Consensus, WikiLeaks

Like many of the big banks, the ratings agencies have been deemed too big or important to the system to fail.” In her book ECONned, Yves Smith—who spent much of her career on Wall Street, including a stint at Goldman—extensively details the fraudulent accounting practices that preceded the downfall of Lehman Brothers and other banks. As she notes, “What went on at Lehman and AIG, as well as the chicanery in the CDO [collateralized debt obligation] business, by any sensible standard is criminal.” Smith points out in particular the proliferation of the kind of pay-for-play that was exposed in the JPMorgan/Jefferson County case discussed earlier in this chapter. Municipal finance has long been a cesspool, but blatantly corrupt behavior was, not that long ago, for the most part limited to backwaters and bucket-shop operators.

Since 1997, the financial sector has spent a combined total of $3.6 billion on lobbying the federal government. The total lobbying expenses have increased by 260% since 1997. Over that same time financial sector corporate profits have gone through the roof, with the financial sector reporting up to 40% of corporate profits in recent years. Blumenthal offered just a “sampling” of what that money has bought: the deregulation of financial derivatives and credit default swaps, the elimination of the line between investment banks and commercial banks, the increased hardship for those filing for bankruptcy, and the total free hand for Fannie Mae and Freddie Mac to muddle their books and evade responsibility. And all of this has been fueled by the 3,000 or so finance sector lobbyists meeting with, calling up, and emailing congressional offices and executive branch agencies.

(Lederman) Card, Andrew Carney, John Carothers, Thomas Carter, Jimmy CBS network CBS News Center for Labor Market Studies Center for Responsive Politics Central Intelligence Agency (CIA) contractors detainee interrogation videos inspector general’s report of 2004 Iran-Contra and Obama and Plame outing and renditions and torture and warrantless eavesdropping and whistle-blowers and Cheney, Dick Iran-Contra and Iraq war and Libby and torture and warrantless eavesdropping and China Church Committee Citigroup civil rights movement civil suits Clarke, Richard Clinton, Bill campaign of 1992 campaign of 1996 Bush and financial deregulation and impeachment of Iraqgate and law and order and NSA and telecoms and Clinton, Hillary CNBC CNN Español Coats, Dan cocaine Cohen, Richard Cole, David Cole, USS, attacks Columbia Journalism Review Comcast Comey, James Commerce and Labor Department Commodity Future Trading Commission Common Sense (Paine) Communications Act Congressional Quarterly Conrad, Kent Consortium News Consumer Federation of America Contract with America Convention Against Torture Conyers, John Coolidge, Calvin Cordray, Richard Corn, David Corp Watch correctional population Corrections Corporation of America Countrywide Cox, Archibald Cox, Douglas W. Cramer, Bud Crawford, Susan J. credit default swaps credit rating agencies criminal justice Croatia Daily Finance Dark Side, The (Mayer) Davis, Morris Deal Defense Department Democratic Congressional Campaign Committee Democratic Party Bush-era crime and financial elites and law and order and National Convention of 2008 presidential primary of 2007–8 Tammany Hall and Teapot Dome and telecom immunity and U.S. attorney firings and warrantless eavesdropping and Watergate and Democratic Senatorial Campaign Committee Dempsey, Joan Depression of 1930s derivatives Dershowitz, Alan Digby Dimon, Jamie Dissertations on First Principles of Government (Paine) Dodd, Chris Domestic violence Dominican Republic