The financial crisis

This is my very non-technical understanding of why everything blew up. It’s based on articles from Paul Krugman, Tyler Cowen, newspaper reporting about the crisis, and particularly from This American Life episode 365. While it’s doubtless more complex in the details, it’s not really a tricky story and there’s no math. It just takes some time to untangle.

In the beginning

Back in 1999, the Senate votes 95-0 to deregulate CDSes. [CDS= Credit Default Swap]. At the time, this made perfect sense. Why? Well, let’s figure out what a CDS started as.

Let’s say that you have some money in savings but you’re not happy with the interest rate. If you’re very conservative [as an investor], you put the money in Treasury Bills. They don’t pay much interest, but the government has never failed to repay them and they can always print more cash if they have to. You can also put your money in a bank CD, or you can start looking at stocks and bonds.

Bonds are safer than stock– they’re debt, something like IOUs, and you’re paid off first if the company goes bankrupt. Of course, the buisness could go bankrupt and have nothing left at all, in which case your bonds are worthless… but that’s rare.

The CDS was created as a way to insure bonds. If I buy CompanyX bonds, but worry that CompanyX may oneday go bankrupt, I might look for insurance against that small chance. That insurance is a CDS. Basically, I pay FredCorp a little money every month and they promise to pay me if the company issuing the bond can’t pay it. That’s what was going on in 1999 when they decided that these instruments are complex and restricted to financially savvy people, so there’s no harm in deregulating them.

Why would you buy a CDS in 1999?

If I buy CompanyX bonds, I can make more money when they pay out their dividends than if I bought Treasury Bonds. If I’m a little worried that CompanyX might not make it, I can buy a CDS to insure me. It cuts into my profit a little, but if the dividend minus the CDS payment is higher than the Treasury Bond interest, I make a little more and I’m still completely safe. (Well, 99.9%….)

How it developed

It is now 2004 or 2006– sometime later after CDSes mutate in purpose. CDSes are still unregulated, but the CDS market is a lot bigger. It’s hard to tell how much bigger, because CDSes are private trades between companies, not tracked on a regulated exchange. Some people still use CDSes for their original purpose– to make sure their bonds are insured against a company’s collapse. But there’s a new use for CDSes that promises lots of money, though it’s very risky.

The new strategy is to buy CDSes for buisnesses when you don’t own any bonds. So I’m buying “insurance” against a company’s collapse, even though I don’t own anything that company issued. Why do you do this? Well, you can make a lot of money. The following is a paraphrase of the This American Life example that really illuminates this.

I’m Joe’s Hedge Fund, worth $100 million dollars. I tell people that I’m willing to issue CDSes for CompanyX. I get lots of interested people, who say, I’ll take it. They promise to pay me $20 million a year for my insuring their $1 billion of bonds. I’m very happy– I can double my money in five years. Because there’s no exchange, no one knows how many companies I’ve promised to insure, and because there’s no government oversght, I don’t have to have the $1 billion in case of collapse.

Why does Joe’s Hedge Fund do that?

Did you see that Joe’s Hedge Fund could double in value in just five years? As a CEO, that’s awfully tempting… look at all that growth you can report to investors. Besides CompanyX won’t go out of buisness (fingers crossed), so I’m not really at risk. [Particularly if CompanyX is perceived as “too big to fail”, implying the government will step in and keep them afloat anyway.]

Why do you buy the CDS from Joe’s fund?

For $20 million, you could get $1 billion. It’s a bet– if you’re right, you’ll make 50 times what you invested.

Sounds risky!

There are a lot of things that people did to reduce their risk. One common thing was hedging. Let’s continue the example above. Let’s say Joe’s Hedge Fund doesn’t like having a billion dollars hanging over their heads. They can buy a CDS from someone else. If they buy a $1 billion CDS for CompanyX from FredCorp for $15 million, there’s no risk left. Joe’s Hedge Fund is being paid $20 million at the risk of paying out $1 billion– but if they have to pay out the $1 billion, then FredCorp has to pay them $1 billion, which they can just pass on. See, no risk and an easy $5 million a year!

What brought it all tumbling down?

Well, remember the last paragraph of how it developed? No one knows who is insuring what CDS defaults and some people don’t have the money to pay what they’re insuring. [Remember, Joe’s Hedge Fund has only $100 million when they offer the CDS, well short of the $1 billion that they promise to pay.]

Lehman Brothers was an investment bank that has been around since 1850. It made large investments in the subprime mortgages that have been defaulting at high rates. On September 13, 2008 several companies were gathered to see if anyone wanted to buy Lehman Brothers. No one was interested in the company as a whole. The next morning they filed for bankruptcy.

By this time, the CDS market was insuring over $45 trillion dollars– in the ballpark of the world’s yearly production. One company, AIG, happened to have $400 billion of promises to pay if Lehman Brothers defaulted. They didn’t have the cash on hand, which meant that everyone depending on AIG to pay their part was now short what they needed to pay, even if they’d hedged their bets.

It sounds like it just snowballed from there. Each person’s failure to pay (even though they were insured against just this event!) rolled over onto the next person, who also couldn’t pay…

There were other problems that cropped up from Lehman’s failure, including the losses they inflicted on people who were loaning them a day’s funds on the commercial paper market.

The Engines of our Ingenuity by John Lienhard

An interesting book about a radio show I never heard about. It’s about science and engineering with an emphasis on inventors. It offers a good look at the world and what you can see when you look at it with new eyes.

The dominant theme of the book is about how technology shapes us. Several chapters discuss technology and how we adapt our lives to it– from the telephone, to computers and radio. It’s breezy– while he hints at some of the design considerations, he rarely descends into discussing specific numbers or steps in chemistry.

All in all, it’s a good book to hand people who are interested in invention and science. It’s probably best for non-mathematical adults; the writing’s a little dry and from an older perspective.

Peddling Prosperity by Paul Krugman

After he won his nobel, I thought it’d be good to read some of his books. Fortunately, Tyler Cowen was discussing Krugman’s books and ranking them relative to each other. Peddling Prosperity was his favorite, so I checked it out of the library.

Krugman does a good job of laying out the examples clearly, illustrating what academic economists thought about the big proposals from each side (basically, that both Supply Side and Strategic Trade are exaggerations or misconceptions from non-economists that filled politician’s needs).

Along the way, he provides a lot of clear description of economic thought and application. The review the 70s and 80s data from several different perspectives and testing against several different frameworks did a great job of explaining where the errors crept in– and helped correct some residual misconceptions I still had.

The book is engaging written– I look forward to reading several more.

Perfume: The Story of a Murderer by Patrick Suskind

I just completed this fantastical book set in the late 18th century. It’s well written, an interesting portrait of a character that’s hard to like, though sympathy for him is possible.

Basically, it’s a story of an unwanted kid who has an incredible sense of smell and a disturbing lack of odor. He exists, occasionally acting, frequently justifying long asides about other characters and locations– kind of a stream of consciousness world building interwoven in a sparse story.

The main character tries to get along (usually, until late in the book he starts planning and executing his murders), but fate intervenes, slapping him down. Usually with an illness. Then he moves on to a new phase of his life (apprenticeship, etc.) and the author kills off whoever his last caretaker or boss was, in a completely random way.

In the end it was interesting– a bit of a stretch from my normal reading. Like many period authors (or mystery writers), he spends time talking about a hobby/profession in detail– perfume making in this book. It’s interesting and well done– Grenouille learns about beside us and the info-dump on the process is well done.

Canceled Game: Friday October 24th

Update: Dad’s car has broken down and Ben was ambushed with divorce, etc. paperwork. We’ll cancel this week. We were already going to skip Halloween so parents and kids can enjoy the night together. Is sounds like our next session will be Friday, November 7th.

At the moment, we’re all ready for a game on Friday. Dad’s availability is up in the air, but we’ll move forward even if he can’t make it.

You recently eliminated the fliers, dinged (now level 9), and understand that the elite guard is nearby, running down fleeing gnomes. It sounds bad for your allies…

The Dark Crusade by William H. Hunt

A strong sequel, this book continues the previous series with most of the same main characters, but advanced twenty years. The war against the vuhls has been defensive but basically successful (particularly by the previous book’s standards), but a new group emerges claiming that victory is at hand.

Blazing Star is a splinter group founded by Owen Garret that uses a telepathic wave of aggression to kick the vuhl’s over. The first pages of the book set the situation up… then the Prophet is introduced. The prophet is the Destroyer that the vuhls feared in the last book– seemingly human, his leadership inspires Blazing Star to greatness. After he allies with the navy there’s a lot of vuhl stomping.

Of course, it isn’t that simple. There are a lot of groups interested in the distribution of power in the Solar Empire. Jackie has an interesting relationship with Ch’en’ya, who proves an important ally of Blazing Star– sometimes a strained mother/daughter exasperation, sometimes pure opposition. Meanwhile, other power groups in the Empire and among the Zor scheme for their own slice of power… and Stone comes back to tangle it all further.

Very enjoyable– the best book in the series since the first. (Also interestingly, I went to the author website to see when the next book is due… and it’s not. Evidently it didn’t sell that well, so no more books are forthcoming. It’s interesting how that lack changes the feel of the series.)

The Dark Ascent by Walter H. Hunt

A clear sequel to The Dark Path, it picks up shortly after the previous book ended. This book is stronger, with Jackie making interesting choices. The world changes and unusual talents are revealed. We learn more about the vuhls, but not enough to steal their mystery.

Jackie finds out interesting truths about Zor myths, leading to more choices and a much more flexible feel. The books ends on a high note– and, though it appears to be just an interlude, the next book hops forward 20 years.