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Banks who bought CDS protection from AIG could, and did, hedge against failure of AIG by buying CDS protection against AIG default.  So where’s the problem?

The problem facing the banks had AIG failed has less to do with their $ exposure to AIG and more with their position exposure to AIG. For example, let’s say I buy $100mm of protection from AIG and then I buy protection on AIG to hedge against the case of AIG’s bankruptcy. Let’s say AIG does in fact go bust. In the ideal scenario the collateral plus the AIG hedges offset exactly my CDS MTM exposure against AIG, then the banks don’t actually lose money. However, the problem is that they are now long risk $100mm of protection (because their $100mm short risk position against AIG is now gone). What happens then is the market realizes that a dozen banks have massive long risk positions in much of the same trades that they will all now try to hedge at the same time. Spreads blow up and the banks lose.

There is much more in this interesting article.


NPR had a story this morning about the rise of loan sharking in Italy as a fallout from the credit crisis.  The question to ask is why is the credit crunch affecting banks but not loan sharks?  Credit is credit so why does the credit crisis make lending cheaper for loan sharks than for banks?  Put differently, if loan sharks have an advantage over banks why didn’t they have the same advantage before the crisis?

A simple story is based on a fundamental problem with the way credit markets operate.  The market for credit is like any other market with supply and demand and a price.  The price is the interest rate.  The problem with the credit market is that the price often cannot serve its usual market-clearing purpose.  When the supply of credit goes down, the interest rate should rise to clear the market.  Clearing the market means reducing demand to bring it back in line with the low supply.  The problem is that high interest rates reduce demand by disproportinately driving away borrowers who are good credit risks and leaving a pool of borrowers who are now more risky on average.  This makes lending even more costly, reducing supply, driving the price up again…

The effect is that there may be no way to clear the market by raising interest rates.  Instead credit must be rationed. This is part of the story of the credit crisis.  By itself it doesn’t explain the rise of loan sharks yet because loan sharks face the same problem.

One way to improve rationing is to increase collateral requirements. But borrowers who are already excessively leveraged (the other part of the credit crisis story) will not have additional collateral to compete for the rationed loans.  Here is where the loan shark comes in.  Loan sharks use a form of collateral that banks do not have access to:  kneecaps.  Highly leveraged borrowers who are rationed out of the credit market cannot post collateral to service their debt so they turn to loan sharks.

here are my two simple ways of thinking about fiscal stimulus.

from the perspective of the stimulee:  the federal government is right now the cheapest source of capital.  in fact capital has never been cheaper.  the treasury can borrow at record low interest rates. unfortunately the banking system is not doing its job as an intermediary channeling this credit to the bridge-builders.  so the bridge-builders effectively borrow directly from the source by accepting stimulus dollars and promising to pay them back in the future with taxes.

(of course there is a wedge between the amount i receive in stimulus ($X) and the amount I pay in taxes ($X/N) and this makes me inefficiently eager to accept it.  this is why stimulus should focus on public projects where the benefits are dispersed equally.)

from the perspective of government.  we accept that there are things government should be producing, in particular public projects where the benefits are dispersed equally.  the government has flexibility in the timing of these investments.  since the investment requires coupling labor with the government’s capital, the optimal timing is during times of (otherwise) unemployment when labor is relatively cheap.

so we don’t have to think about multipliers and we don’t have to think about Keynesian effective demand.  The government acting optimally to smooth expenditures should spend a lot now.  Yes, it means spending must be correspondingly reduced in the future and critics would worry that this won’t happen.  But there will come a time when interest rates are higher and it is more costly for the government to borrow and under pretty much any theory you have of how spending is determined, at the margin at least, that will have the effect of reducing spending.

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