Boy am I Glad That's Over

And lo, the banks were profitable again and money was lent as manna from heaven and the markets sighed deeply and began their weary climb back up.  Would you like to buy a bridge?  I don't believe anything those banks say about their balance sheets right now, they have powerful incentives to lie about it.  I sincerely hope I'm wrong and that we've turned a corner with the economy in terms of the credit crisis but I find much of the optimism surrounding the Dow's recent uptick ill founded.  History is littered with defunct financial institutions that gave rosy projections until their last breath.  As a matter of fact, isn't that what we saw with Lehman and Bear?  Don't believe the hype.

Or Maybe Not

Hard to tell what is going on in the credit default market. Some argue that there is no significant risk of things spinning out of control because the parties that insured Lehman's bonds were forced to pony up collateral as Lehman's bonds precipitously fell in price (CDS contracts have margin call clauses activated by price drops) and that this payment of collateral has already been written down on the parties balance sheets. Sounds plausible. Others are not so sure. But what scares me about those who say this is no big deal is that they are prefacing their statements with words like "probably" or phrases like "no one really knows." Which brings us back to the central fact that no ones knows WTF is going on in the markets right now. I doubt our wild ride is over.

The Next Wave

We are truly experiencing a post modern financial crisis. Uncertainty abounds. No one knows when the next wave is going to hit, or how big it's going to be. A front runner for churning out the next financial tsunami is the turbulence in the credit default swap market caused by the Lehman Brothers bankruptcy. Credit default swaps are a form of insurance sold to protect the buyer of a fixed income product from a default. In Lehman's case a buyer of Lehman's bonds could, as many apparently did, buy credit default swaps to insure against a Lehman default. By declaring bankruptcy Lehman has essentially defaulted on its bonds and the parties that insured those bonds now have to pay up. But no one knows how big a payment those parties have to make or whether they have the money.

This unknown liability on the part of the insuring parties could in turn set off a chain reaction of defaults by the parties if the combination of their credit default swap liabilities and their other liabilities exceed their assets and they are unable to get credit to meet their obligations because the credit markets are frozen. And if those defaulting counter parties' liabilities are in turn insured by credit default swaps, the next wave is going to get bigger. Lehman's default could lead to the default of parties that insured the Lehman debt, and the default of those parties could lead to the default of additional parties who insured the debts of the Lehman parties. This is one of the reasons the government is bailing out AIG: the concern that the failure of one party in the credit default swap market would lead to a wave of defaults .

It doesn't help that you don't have to own the underlying bond to buy a credit default swap for it. This fact results in the possibility that the liabilities of the Lehman credit default swap counter parties could be greater than the actual debt that Lehman issued if more than one party bought a credit default swap on the same bond.

What makes this whole thing post modern is that no one knows the extent of the Lehman credit default swap party liability because there is no central clearinghouse for credit default swaps that can provide this information. Essentially the credit default market as a whole behaved irrationally in that it acted as if the possibility of a large scale default was non-existent, and thus the necessary market mechanisms to cope with a large scale default never emerged. This was a direct result of a lack of regulation of the derivative markets.