Sunday, March 8, 2009

Bailouts Forcing Surge in Systemic Risk

Imagine you're a bank. What do you at this juncture, wind down and go conservative or ramp up and take as much counterparty risk as you could get your hands on?

If you chose the former, you may be doing the responsible thing. But it would also the stupid thing. Here're the smart things you can do to ensure your prosperity, or survival at the very worst, in this wonderfully morally hazardous world:

1. Get your tentacles reached as far as possible, and as deeply as possible, into other banks, preferrably the biggest ones. Encourage your counterparties to do the same, but not directly. Rather, make long-winded chains so as to get around netting. Counterparty risk is your best insurance. The more counterparty risk others take on you, the safer you are.

2. With the counterparty web in place, take as big bets as you can get away with. If you win, you get rich, look smart, and get hailed as hero. If you lose, no worries. Government will bail you out.

This is exactly what many banks have done since the first AIG bailout. The world before Lehman bankruptcy may have been pretty screwed up in retrospect, but it was decidedly more sane than today in one aspect: risk carried at least theorectical downside. Back then, everybody would've stopped trading with AIG, C, and BAC if they had been in situations they're in today. Who in their right mind would trade with somebody who has a stock price of $0.35, with a market cap of less than $1B, and lost $60B in one quarter?

But that was stupid, of course; look what happened to Bear and Lehman. Now people have learned the lesson; let's continue trading. If you can't post collateral, no problem. Government will give you more cash or at least swap your ABCDO Squared Mezzanine into treasuries. Even if they don't, they'll give me more cash or at least swap my ABCDO Squared Equity into Fanny paper, which is about the same thing but worth a lot more.

Can you blame the banks?

Of course not. They're merely acting on their self-interest, which is exactly what they're supposed to do. It's the government's implicit guarantee of all companies that are mysteriously deemed too big to fail. All big banks have already been nationalized, except taxpayers pay all the price and get no control.

I know this question is vein but still, I can't help asking: why is AIG still allowed to trade, and by the same people? Just shut down everything except their insurance business, pay everyone $1M and ask them to please stay away from the office, go to Caribbeans or go fishing, just go. Taxpayers would've saved a LOT of money. And it would've been much more fair, sensible, and with much lessmoral hazard than what the government has done.


Phillip McDoodle said...

Bo why do you believe that "counter party risk" problem is old news, and that it will not effectively enable banks to blackmail the US Gov't into paying whatever is asked/required to avoid systemic collapse?

Thanks - great blog and extremely well thought out analysis.

Bo Peng said...

Thanks, Philip.

My semi-confidence in counterparty risk management first came from the Lehman CDS settlement, which turned out to be somewhat of a non-event, aside from the untold billions of government bailout money channeled through AIG. Now people do require their counterparties to adjust collateral daily and it's usually collateralized at 100% of MTM (plus some historical-vol based adjustments).

In retrospect, the government got scared and bullied into saving Bear because of fear about counterparty risks. It was an unknown unknown. Or rather, the other big banks knew their counterparty exposure to Bear was not adequately collateralized. By the time Lehman was in hot water, the remaining Big Boys thought they had gotten that little wrinkle ironed out (well, except the black hole called AIG -- they just didn't have enough qualified assets to meet the rapidly skyrocketing collateral requirements). So they let Lehman go.

My fear is the new incarnation of counterparty risk has gone beyond simple collateralization. Let's say everybody has their counterparty exposure fully collateralized by assets that they can, if all else fail, cash out at the Fed. Then there's a systemic shock triggered by some big failure. The net settlement amount is $500B. What happens? Substantially all of $500B of collaterals seized would be dumped to the market, causing it to promptly freeze to death. Then a big part would be dumped to the Fed, which means Fed would have to print $500B nominal cash out of thin air in a pinch. Maybe $500B can't impress anyone anymore nowadays. But there's a limit to how much USD we can print before the world abandons the paper, and if/when that happens, it'll be swift and unstoppable. And I think we're already not far from that critical point.