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December 12, 2006


Michael Fuhrman

Points 1, 2, 3 are correct. You begin confusing things in point 4. The buyers of structured credit products tend to be European or Asian buy-and-hold liability managers. These folks do not go out and buy protection against their investments. Point 7, the European/Asian purchasers are not buying on credit, they are not levered, their statutes prohibit this. They are simply looking for additional yield over and above US Treasuries or Bunds and sufficient diversification, precisely what the structured credit products offer. The investors pay for the product up front. If defaults occur they will receive less at redemption then they originally invested. Point 8 reveals your lack of understanding: "only this time the insurers never actually pay for the loans they are insuring." Since when does your automobile insurance company pay YOU to insure YOUR car? The party purchasing insurance pays for the protection.
Yes one can lever using credit protection, but you should investigate the role of prime brokers and their use of collateral support agreements to make daily margin calls on the hedge funds.

Dave Iverson

Thanks Michael,

I'm the first to admit that I'm trying to learn more about how these things work. I'll bounce your notions off both Katy Delay and, hopefully, Doug Noland to see what thay have to offer up.

If others have anything to add in support of either yours or Katy's notions, perchance we can all learn somthing. As I said before, "this is a pretty tough field to understand."

Thanks again.


Katy here, in response to Michael's comments. As to Point 4, I did not say that every buyer leverages their purchase at this point; but in fact whether or not they do does not affect my underlying message, which is that the original bank can now begin lending again. Although I can believe that you are correct about who those buyers of packaged loans are, this does not change my main point about the renewed inflow of credit to the money market. (And just for our education, you might give us the stats and the source of your data concerning who those buyers are.)

As to Point 7, there are intermediary steps that I omitted for simplicity; but it doesn't matter to the logic of the argument whether there are intermediary steps or not. The buyers in No. 4 are probably not the same as the leveraging buyers in No. 7; however, at some point, leveraging does enter into the equation (perhaps at a credit derivative level a few steps away from No. 4), and it is this buying on credit that introduces unsound liquidity to the money market and that has gotten way out of hand, according to our own government and to the published statements of economic surveillance organisms such as the BIS, for example.

About Point 8, of course insurance companies don't pay us to insure our cars. I will take the blame for having expressed myself in such a way as to confuse you. If you put quotations marks around the word "insurers" in your quote, then perhaps it makes more sense. The phrase now becomes: "only this time the 'insurers' [risk purchasers] never actually pay for the loans they are 'insuring' [purchasing.]"

Put another way, the "buyers" of the credit derivative risk don't actually pay for that risk; in reality, they are being paid to "insure" against the risk, in the same way insurers are paid to do so. In the lingo used by the players of this game, instead of talking about the "buying of risk," they call it the "selling of protection," which I find confusing to newcomers because it seems to be bass-ackwards. That's why I chose to reverse it, although of course those who are "in the know" about the concept and the lingo may find that my phraseology adds an unnecessary twist.

I hope this clears up the confusion, and thanks for linking to my blog and inspiring this dialogue.

Dave Iverson

Doug Noland weighs in on Katy Delay's side of Fuhrman/Delay dispute over market kiting. From Noland's Dec. 15 Credit Bubble Bulletin:

"...As we are witnessing these days, rampant Credit inflation drives a Financial Sphere Profits bonanza that only incites greater Credit inflation, Risk Embracement, and speculative excess. There is little in the way of self-correction or adjustment; quite the opposite.

"Indeed, inflating Profits seemingly validate and legitimize audacious practices, certainly including the proliferation of new financial instruments, strategies and leveraging techniques. While overcapacity may eventually weaken profitability in some financial operations (today in mortgages, traditional bank lending, and risk spreads), there is an overwhelming proclivity for boom-time exuberance to impel financial operators (today mortgage brokers, bankers and hedge fund managers) to respond to faltering margins with only greater volumes. Heightened leverage then creates additional system financial Profits that promote only further leveraging (Minsky's Ponzi Finance).

"The powerful propensity for financial Profits to foster progressive Credit inflations is today a much more pressing issue than ever before. From a Financial Sphere perspective, we live these days in an (experimental) environment of unlimited and permanently cheap finance. The Fed no longer controls or even bothers to manage 'money' and Credit expansion. There are no effective bank reserve or capital requirements that check domestic lending or Credit growth. Meanwhile, the proliferation of global securitization markets, derivatives, and leveraged speculation create an unrestrained liquidity-creating mechanism unlike anything available in the past. ..."

You can find Noland's latest here:

Sebastian F

I've found your post very interesting and clearly foreseeing.
I am not a stock market specialist, and yet I got the big picture on hedge funds crisis.
Now, today, do you think this is going to become a deep structural crisis, with rating companies losing their trustworthiness?

Dave Iverson

I think "rating companies" already have lost their credibility. As to "how deep" this crisis becomes, nobody knows. It all reminds me of a favorite quote I gleaned from Joseph Campbell, paraphrasing:

"Those who think they know, don't know.Those who know they don't know, know!" Arthur Schopenhauer

Complex systems are complex, including some inherent tendencies toward unpredictability.

Complex social Systems are both complex and politically wicked, in the sense of wicked problems. http://en.wikipedia.org/wiki/Wicked_problems

Complexes of wicked problems tend to get resolved (when they can be resolved at all), only to well-up into social messes quickly or, sometimes, not so quickly.

When we try to patch up wicked problems via 'quick fixes' we tend to postpone and worsen 'days of reckoning..

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