Response for @Epicurean Deal

I can safely say that, of the 400+ people I follow on Twitter, @EpicureanDeal is one of my five favorites (the others: @pkedrosky @robdelaney @zerohedge @BrokeLivingJRB).

So, when @EpicureanDeal offers to share a bottle of wine with anyone who can provide a satisfactory answer to the questions below, I cannot help but take up the offer (though I reserve the right to make the other side of the argument as circumstances warrant).

Can anyone provide a clear, comprehensive account why today’s derivatives environment can’t lead to another AIG? Genuinely interested. +
+ And please *don’t* think you can buy me off with arithmetic (netting). Explain how credit failures cannot propagate through the system.
My intuition is that people rely far too much on collateral and counterparty credit analysis (margin), which can change faster than the +
+ market and counterparties can adjust. Plus margin calls are *known* to cause selling pressure on underlyings, hence downward spirals. +
+ But I am open to having my intuitions proved wrong. Just skeptical that any such regime can protect against leverage-induced death spirals
I have a nagging suspicion there’s a lot of finger-crossing and magical thinking in finance about counterparty credit exposure.

I’d like to start by going over my thoughts on this issue in general, before proceeding to argue the case.

In gambling, the term “freeroll” is widely bandied about. A freeroll is a situation where you can win, but you can’t lose. Used loosely, it also refers to situations where you can win a lot, while risking only a little. From an amoral, self-interested perspective, you want be on a lot of freerolls. You also want to avoid being “freerolled” (meaning that others can potentially gain at your expense, without you obtaining any offsetting compensation).

The finance industry is typically well versed in the economics of adverse selection, and, yet, as a matter of self-preservation, it continuously plays down the importance of principal-agent problems. It’s clear that principal-agent problems are endemic in modern finance. Some of principal-agent tensions are inevitable and will never be rooted out; but some can, and a major function of future financial market reform should be mitigating principal-agent issues where they occur. Some obvious ones: you can’t freeroll the government (if you take customer deposits and you’re government insured, you can’t take risky gambles), transparency has to reign when possible (everything that can be put on exchanges, should be), and financial instruments that increase systematic variance without adding obvious financial benefits (credit default swaps are a possible example) should not be allowed.

In finance, the principles are the government, which is obviously clueless, and diverse shareholders, who mostly can’t be bothered and at any rate are represented by corrupt Boards. The agents are the people working for the principles. All the people you hear from are agents. People don’t graduate from agents to principles; they graduate from agents to beach houses in Maui. So what we hear from the finance industry primarily represents the interests of agents. When scumbags like Jon Corzine completely freeroll the government and everyone else, criticism within the industry has to be somewhat muted, lest comparisons be drawn with other, similar freerolling behavior.

So, in light of the above, the rest of the analysis will take it for granted that the entire derivatives industry, especially that part of it that occurs off exchanges, exists so that agents of firms freeroll principles of firms; that is, make large gambles on which they retain upside but little downside.

Here are the reasons why the derivatives industry, despite being entirely corrupt, will not likely blow up the economy at large:

1. Off-exchange derivative transactions share a similarity with one-to-one betting among individuals; there is rarely an incentive to bet with someone who might not pay you. Uncreditworthy parties might want to do a lot of business in these markets, but, in the current environment, it will be difficult for them to find someone to take the other side of their bets. For catastrophe to happen, someone would have to take the other side of their bets in extreme size; this seems unlikely. Like gamblers, financial market participants are decent at managing counterparty risk.
2. Governments have taken their responsibility as “lender of last resort” to greater lengths than anyone envisioned possible. If a financial firm has a monster loss on a derivatives position, they now have a lot of degrees of freedom in how they handle the problem. They can give the government all of their moderately bad stuff, while using their cash to pay for their derivatives losses.
3. The financial world has grown staggeringly complex, and people no longer have the attention span for it. That said, in today’s financial markets, when a financial firm shows a hint of insolvency, attention focuses intensely on the firm or firms in question (better late than never), and trading volumes in those firms become explosive. Once attention is focused, reality is revealed, or at least it becomes close to becoming revealed. Market participants now are much more vigilant than they were pre-2007. Even in the early stages of the crisis, before the new tendency towards increased market vigilance fully asserted itself, we saw this phenomena of sudden attention, followed by massive trading volumes and revealed reality; Countywide was a huge favorite to be taken down in August 2007 in the absence of massive Fed intervention (followed by BofA’s, possibly government-influenced, takeover bid).
4. Banks reported profits recovered quickly to their pre-crisis levels, and, for the time being, the government charges them very little for borrowing. The combined result is that banks have a lot of cushion for taking derivatives losses, and, if they find themselves digging into a hole, the government makes it easy for them to dig their way out.
5. There are few non-banks who have derivatives books large enough to cause systematic risk.
6. Trading desks at banks might have an incentive, in some cases, to engage in large off-exchange derivatives transactions with hedge funds that are overextended, but all of the hedge funds big enough to warrant concerns about systematic risk have large amounts of insider/principal capital at risk and are not inclined to risk blowing themselves up.
7. Most of the real blow-up scenarios occur when things move in a direction against the interests of governments. The dire derivatives blow-up scenarios have a nuclear war quality about them; if they happen, we’re fucked anyway. For instance, buying credit default swaps on the US government seems like a fools’ game; who’s going to pay you when the time comes, and what good is the money going to do you. The big money is positioned in the same direction as governments, and, if governments lose, either the rules will be re-written, or the societal losses will be so catastrophic that derivatives blow-ups are the last of our worries.

Brandon Adams