Monday, October 13, 2008

So, what happens when the bond markets reopen?


Sure, I’m glad that the DOW rose 900+ points today. But it’s sobering to think about what could happen when the bond markets open tomorrow. That is, could happen, but hopefully doesn’t happen.

Following up on yesterday’s post, readers might want to check out the Oct. 6, 2008 issue of Newsweek. On p. 46 there appears an article “The Monster that Ate Wall Street: How ‘credit default swaps’ – an insurance against bad loans – turned from a smart bet into a killer,” by Matthew Philips. The link is here. Credit default swaps became the financial WMD.

It seems as though Lehman Brothers wrote many of the swap contracts, but AIG really collected the premiums and was on the hook. So, although there are Internet stories (particularly in Business Week) suggesting that your mutual fund or employer’s pension fund could be on the hook too, I’m not sure how this could have been set up.

Nevertheless, Jim Cramer and others have suggested that short sellers purchased a lot of these swaps and could turn on companies at any time. The SEC and government (and perhaps Federal Reserve) would presumably have to be prepared to take more action to prevent “financial terrorism.” It’s not clear if this has any relation to the uptick rule, but it would be necessary to act very quickly to shore up institutions that could simply evaporate.

What seems morally wrong is that “ordinary investors” and retirees do not expect “ordinary” mutual funds and their own pension funds to take hidden reckless risks with their money in ways that are concealed and not discoverable with reasonable individual diligence. (It’s not clear how the Pension Benefit Guaranty Corporation would react with a pension fund that had been blown up this way.) Of course, this is part of the “asymmetry” issue, already known with the Internet, where small entities can have extraordinary influence on things with technological instruments that others do not yet understand.

Other commentators have noted that the mortgage mess alone should not have detonated the entire credit system, which magnified the mortgage problem by at least one sigiificant digit. So having the government renegotiate the upsidedown mortgages (even as John McCain wants), while helpful to individual people, may not make enough difference. The losses tripped an awareness to the recklessness of the entire credit market as a whole, and of our reliance on debt and on living beyond our means. That is, Suze Orman probably got it right. We placed too much emphasis on what we have and do, and not on what we are.

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