Felix Salmon

In February 2009, Deutsche Bank announced that its Credit Trading desk had managed to lose €3.4 billion in the fourth quarter of 2008, with €1 billion of those losses directly attributable to the bank’s prop desk.

The losses in the Credit Proprietary Trading business were mainly driven by losses on long positions in the U.S. Automotive sector and by falling corporate and convertible bond prices and basis widening versus the Credit Default Swaps (CDS) established to hedge them.

In English, Deutsche Bank had put on a basis trade: it owned credit instruments, like bonds, and it also owned credit default swaps designed to hedge against those loans. And then the trade blew up.

The Deutsche trader responsible for the monster losses was Boaz Weinstein, who eventually left the bank to start his own hedge fund, Saba Capital. His first job, obviously, was to make sure he didn’t blow up a second time. But his second job, it seems, was to use his experience at Deutsche to be able to notice when someone else was about to blow up on a massive basis trade. In this case, JP Morgan.

Go back to early February, long before the articles about the “London Whale” came out in Bloomberg and the WSJ, and you’ll find Weinstein revealing his biggest trade at the Harbor Investment Conference:

The derivatives trader and legendary hedge fund manager said his trade idea is to buy Investment Grade Series 9 10-Year Index CDS (maturing on 12/20/2017).

“They are very attractive,” he explained adding that they can be bought at a “very good discount.”

At the time, Weinstein didn’t know — or necessarily even suspect — that his big trade would involve a zero-sum bet with one of the biggest hedge funds in the world, JP Morgan’s Chief Investment Office. But over time, as he bought more and more protection but the price stubbornly refused to rise, he began to learn just how big the other size of the trade was. Whale big.

Tracy Alloway and Sam Jones have pieced together the best account yet of what exactly JP Morgan was up to. Yet again, it was a basis trade, although this one was horribly complex even by basis-trade standards. Essentially, that CDX.NA.IG.9 position was a second-order hedge, designed to offset volatility in JP Morgan’s first-order hedge, which was designed to offset credit risk in the rest of the bank’s portfolio.

The first-order hedge itself doesn’t make a great deal of sense — Iksil seems to have bought “tranches” of CDS indices, which would pay off if some (but not all) credits suddenly got into trouble. For a bank which had broad economic exposure to European meltdown and/or a US double dip, that seems like a pretty narrow hedge.

But if the first-order hedge is weird, the second-order hedge is downright scary. Do you remember the notorious Howie Hubler trade at Morgan Stanley, where he made a smart bet against dangerous subprime securities, but then put on a much larger “hedge” which ended up costing him $9 billion? Iksil’s trade seems a bit like that:

Because of the mechanics of the trade, in order to achieve a “market neutral” position, whereby JPMorgan hedged the bet against volatility as best it could and offset the cost of its short positions, the bank had to sell far more units of cheap protection on the IG.9 as a whole than it bought on short, more expensive tranches.

Inevitably things started to go wrong. There are two things you can do when something starts to go wrong in the markets. You can unwind your position at a loss. Or you can try to fix it. Iksil, and Drew, chose the latter:

The two legs of JPMorgan’s trade did not move according to the relationship the bank had expected, meaning the position became imperfectly hedged. Like many credit models before it, JPMorgan appeared to misjudge correlation – one of the hardest market phenomena to accurately capture in mathematics.

In order to try and stay risk neutral, the dynamic hedge required even more long protection to be sold. The bank continued to write swaps on the IG.9, causing a pricing distortion that was spotted by more and more hedge funds seeking profit.

The rest, pretty much, is history.

Iksil, we’re told, is going to leave JP Morgan, while taking his own sweet time doing so: “although a spokeswoman for the bank said Mr. Iksil is still employed, he is no longer trading on behalf on the bank and is expected to be gone by the end of the year”. I’m sure he’ll use the intervening months to feel out his chances of being able to raise a few billion dollars for a hedge fund of his own, and weigh them up against simply joining a fund like Saba. Iksil’s now learned a $2 billion lesson — and as Boaz Weinstein can attest, once learned, those lessons can be surprisingly valuable.

You want proof that JP Morgan was — is — using its Chief Investment Office to gamble with taxpayer-backstopped funds?

The CIO unit also had a lower cost of capital than other parts of the bank, an artificial advantage that gave it an incentive to take more risk and behave in a less disciplined way, people familiar with the unit said.

“It was very large, but was never very transparent, and it wasn’t clear that they had an appropriate funding cost,” said the source with direct knowledge of the CIO.

In any unit of any bank, one of the key drivers of profit and loss is the internal cost of funds. If you’re paying 1% for your funds and earning 3%, then you can claim profits of the difference, 2%. But if your cost of funds is increased to 2%, then your profit is halved at a stroke. For someone like Ina Drew, who was charged with turning hedges into profitable trades, the easiest way to do that would always have been to simply get Jamie Dimon to decrease the CIO’s cost of funds.

And at JP Morgan, just like at any other bank, the cheapest cost of funds is always deposits. JP Morgan has hundreds of billions of dollars in excess deposits just because it’s too big to fail, and has an implicit government backstop. It’s bonkers that it should then be able to take the resulting ultra-low cost of funds, and turn it into eight-figure bonuses to people like Drew, all for taking that money and playing on derivatives indices in London.

As John Macaskill points out, the CIO, by its own faulty measurements, had for the past two quarters more money at risk than JP Morgan’s entire investment bank — and that was with a more lenient risk measurement and with a lower cost of capital. In reality, the CIO’s risk levels were vastly greater than those at the investment bank, as we discovered after the blow-up.

If JP Morgan wants the CIO to be taking that kind of risk, it has to significantly increase the CIO’s internal cost of funds. The CIO is at heart a hedge fund (it’s designed to put on hedges), and JP Morgan should extend it billions on the same kind of terms that it would extend money to top prime-brokerage clients. The CIO’s secret weapon, all these years, has been its artificially low cost of funds. If that number were more realistic, maybe JP Morgan wouldn’t have ended up parking such an insanely enormous amount of money there.

Ina Drew — the JP Morgan executive who famously “loves crises” — is out; it seems the buck for the $2 billion trading loss in her unit has stopped with her. And slowly, a few shapes are beginning to emerge from the fog of what exactly happened here.

For one thing, it’s becoming increasingly obvious that Drew got paid her eight-figure salary in return for being able to pull off a very neat trick: turning hedging operations into a profit center.

Drew’s Chief Investment Office quadrupled in size between 2006 and 2011, reaching $356 billion in total, and it’s easy to see how that happened. On the one hand, it was incredibly profitable, with the London team alone, which oversaw some $200 billion, making $5 billion of profit in 2010, more than 25% of JP Morgan’s net income for the year. At the same time JP Morgan accumulated enormous new deposits in the wake of the financial crisis, both by acquiring banks and by attracting big new clients wanting the safety of a too-big-to-fail bank. Historically, JP Morgan has served big corporations by lending them money, but nowadays, as the cash balances on corporate balance sheets get ever more enormous, the main thing these companies want from JP Morgan is a simple checking account — one where they can be sure that their money is safe.

With lots of deposits coming in, and little corporate demand for loans, it was easy for all that money to find its way to the Chief Investment Office, which could take any amount of liabilities (deposits are liabilities, for a bank) and turn them into assets generating billions of dollars in profits.

But the CIO does much more than just provide profits for JP Morgan. In contrast to the bank’s lending book, the CIO is nimble. Loans, as a rule, have to be held to maturity: that’s the essence of relationship banking. Investments, by contrast, can be sold at any time. Of course, an investment which can be sold at any time has another name: it’s a trade. Thus did the CIO become home to big traders, making huge bets and huge bonuses.

In the past couple of years, of course, that raised its own set of problems: how could this group of traders possibly be Volcker-compliant? The answer lay in Drew’s love of crises: her incredibly valuable ability to prevent losses and even make profits when the world is falling apart. In that sense, the CIO was one big hedge, and in a narrower sense the CIO was the go-to office whenever JP Morgan saw a risk which needed hedging.

Mark Dow has an intriguing thesis this morning:

We know that over the last 2-3 quarters of 2011 we were gripped by the fear of a European financial meltdown and a second recession in the US.

We know that that the Fed’s swap lines and the ECB’s LTRO reversed this market view and crushed credit spreads lower, hurting those who had been buying protection in the previous months.

Against this backdrop, it seems likely to me that the aggressive selling of protection we heard about in April 2012 was actually the unwinding of the hedge that had been accumulated in 2011 and was by then deeply underwater.

In other words, Jamie Dimon, like everybody else, was worried about a Europe-induced financial crisis at the end of 2011, and so he told Drew to put on positions which would protect against such a crisis. She did so — only this time around, the crisis never happened, and Drew’s positions had to be unwound.

That’s where things seem to have gone very, very wrong. Drew prided herself on turning every hedge into a profit center — having her cake and eating it too, basically. We’re deep in the realm of speculation, here, but it’s entirely possible that Drew positioned the CIO, at the end of 2011, to profit from a European meltdown. When that meltdown didn’t happen, simply selling those positions would involve realizing a substantial loss. And so rather than selling the positions, Drew decided to put on new, profitable positions which would offset the old hedge. Enter Bruno Iksil, the London Whale, and his enormous trade.

Iksil’s trade was fundamentally bullish, which would make sense for a trade designed to offset a fundamentally bearish hedge. Of course it wasn’t a perfect offset — there’s no such thing as a perfect hedge. Traders making multi-million-dollar bonuses don’t get paid to design perfect hedges, in any case. Iksil was being paid to put on a trade which would make money for the CIO, even as it was also hedging existing positions.

As with all imperfect hedges, however, especially when they’re big and public, the market can always move against you in exactly the way you don’t want. We don’t know the details of Iksil’s trade, but let’s say that the big underlying position was a bearish position in cash bonds, while Iksil’s trade involved a bullish position in the CDS market. In April, the cash and CDS markets stopped mirroring each other, and started behaving very oddly — you’d see bullish moves in cash bonds, combined with bearish moves in the CDS market. That combination, it seems, turned out to be the one thing that JP Morgan wasn’t hedged against, and the losses in the CIO started mounting rapidly.

How did Iksil’s trade go so horribly, massively, wrong? Partly it’s because his position was so big and so public. When hedge funds worked out what he was doing, they managed to get the word out, using stories in Bloomberg and the WSJ. And then it was just a matter of watching the market do what it always does, when it smells blood: I’m told that Boaz Weinstein’s Saba, for one, made a lot of money taking the other side of Iksil’s trade.

Taking a much bigger-picture view, however, what was really going on here was that JP Morgan had hundreds of billions of dollars in excess deposits, thanks to its too-big-to-fail status. And rather than lending out that money and boosting the economy, Jamie Dimon decided to simply play with it in financial markets, just as a hedge fund would. Here’s Bloomberg:

Dimon pushed Drew’s unit, which invests deposits the bank hasn’t loaned, to seek profit by speculating on higher-yielding assets such as credit derivatives, according to five former executives. The CEO suggested positions, a current executive said.

It’s always dangerous when a CEO suggests positions for an internal hedge fund to take, because the CEO by definition has no risk manager with enough authority to effectively constrain him. Dimon is powerful and secure enough that he’s not going to lose his job over this. But he probably should. Partly because the bank’s risk-management procedures were so weak that a $2 billion loss could suddenly appear out of nowhere. Partly because Dimon became too cocky, and started thinking that his job was to trade the bank’s billions for profit. But mainly because he’s lost sight of what JP Morgan has to be, in a post-crisis world.

Those excess deposits weren’t gifted to Dimon on a plate so that he could gamble them on the CDX NA IG 9. Rather, Dimon’s job is to take those deposits and lend them productively into the real economy. Every extra dollar in the CIO is a sign of his failure to do that. And the $2 billion loss is really just a symptom of what happens when banks get too much money, and don’t really know what to do with it all.

Here’s the chart you’ve all been waiting for, courtesy of Reuters’s very own Scotty Barber: the spread on the CDX NA IG 9 index — the synthetic index on which JP Morgan’s Bruno Iskil was selling enormous amounts of protection — minus the spread on the index’s constituent bonds.

Three things jump out here. Firstly, the basis is negative, not positive. That means that the obvious trade was to buy the underlying bonds and hedge by buying protection on the index. That obvious trade, if held to maturity, should always make money. Iksil was funding that trade, by selling protection on the index.

Secondly, the chart is going up and to the right. Since Iksil was selling protection, that means the market was moving against him. Or, to put it another way, the obvious trade makes money when it expires at zero, and as the chart moves towards zero, Iksil loses money on a mark-to-market basis.

Finally, the move doesn’t seem to be all that huge — only about 30bp in this quarter. Which doesn’t seem remotely enough to cause a $2 billion loss. Still, Iksil managed it somehow.

Update: Many thanks to Sally Kohn for making the chart infinitely better by putting whales on it.

We’re still not much the wiser on exactly how the London Whale managed to lose $2 billion this quarter, but I think Matt Levine has the smartest take. (This is why the blogosphere is so great: it’s full of people who used to do this kind of thing for a living, rather than just people who write about people who do this for a living.)

The key thing to note here is that while the monster hit to the P&L is what got all the headlines, the real problem here lay with JP Morgan’s risk models. A hint of far out of whack they are is given in the difference between the bank’s earnings release, which showed $67 million of value-at-risk in the Whale’s division in the first quarter, and the new SEC filing, which showed that number as actually being $129 million. Here’s Levine:

This was attributed to modeling changes made over the last year, and someone asked on the call “why did you change the VaR model?,” but I’m not convinced that’s exactly the right question. This, I suspect, is not an issue of a thing called a “VaR model” that sits in a central location and spits out numbers for regulators and 10-Qs; rather, this looks like the CIO’s trading desk modelling the actual P&L and risks of the trade wildly wrong. That seems to me like the simplest way to lose a billion dollars without noticing it.

I’d put this another way. JP Morgan’s Bruno Iksil, it seems, managed to find an incredibly profitable way of hedging the bank’s positions. Like any other economically rational actor, when he saw a lot of dollar bills lying on the sidewalk, he decided to pick them up. But in Iksil’s highly-complex world, a dollar bill isn’t really a dollar bill. Instead, it’s the output of a model. And if a trader can’t trust his model, he’s flying blind.

The problem is that pretty much by definition, it’s impossible to model model risk. We now know that Iksil’s model was deeply flawed. And indeed the minute that the rest of the world found out about his positions, they didn’t really pass the smell test: it’s very hard to see how writing an enormous amount of protection on an off-the-run CDX index would hedge anything much.

This is where grown-ups like Jamie Dimon are meant to step in. If they see billions of dollars in super-senior mortgage exposure, or in off-the-run CDX exposure, they’re meant to say “I know that your highfalutin’ models say that these exposures are risk free, but I don’t understand how this isn’t risky, so go unwind this trade”. Dimon has historically been very good at that — very good at refusing to simply trust that superstar traders earning eight-figure bonuses are doing nothing that might blow up in their faces. In this case, however, for some reason, he had blind faith in Iksil — and in Iksil’s models, which proved to be very faulty.

A modern trading desk is a bit like a high-tech airplane: nearly all of the time, you’re better off trusting your instruments than trusting your gut. But at the same time, if your instruments are broken, then trusting them can lead you to fly straight into the ocean.

This is why Basel I turned out to be much more robust than Basel II. Your sophisticated platform needs to be built on a foundation of dumb rules: simple limits on how big any one position can get, on how much exposure you can have to any one counterparty, or in general on any trade which is based on the hypothesis that your desk is smarter than anybody else on Wall Street.

Those kind of rules won’t prevent all blow-ups, of course, but they’ll help. They would have prevented this one, and they would have put an end to Jon Corzine’s disastrous MF Global trades, as well.

The problem is that traders hate dumb rules, because they cap the amount of money they can make. And traders have enormous power at investment banks these days, because they make the lion’s share of the profits. That’s why it’s important that the CEO of an investment bank not be a trader. And certainly it’s crucial that the CEO shouldn’t have his own trading account and buy and sell from his Blackberry during meetings, as Corzine did. That’s just a recipe for disaster.

I’m not sure if it was the biggest quarterly loss of all time, but Merrill Lynch’s $16 billion loss in the fourth quarter of 2008 certainly ranks very high up there in the annals of investment-bank blowups. It happened after the bank had already been taken over by Bank of America, and it was in the middle of the financial crisis, so it didn’t get nearly the amount of attention it deserved. But it was not simply a case of assets plunging in value. Instead, it was, in very large part, a basis trade blowup.

The basis trade is an arbitrage, basically. There are two different ways the market measures credit risk: by looking at credit spreads — the yield on a certain issuer’s bonds, relative to the risk-free rate — or by looking at CDS spreads, which are basically the same thing but set in the derivatives market rather than the cash bond market. Most of the time, CDS spreads and cash spreads are tightly coupled. But sometimes they’re not. And at Merrill, a huge part of that $16 billion loss was reportedly due to a bad basis bet: the basis on many credits became very large and very negative during the financial crisis.

This time around, the basis-trade disaster has happened at JP Morgan, where the famous London Whale seems to have contrived to lose $2 billion on what was meant to be a hedging operation. And once again, although the details are still very murky, the culprit seems to be the CDS-cash basis.

I’ve been meaning to write a post about the CDS-cash basis for a few days now, which is why I happen to have this chart handy, showing the basis for various European banks as of Tuesday May 8.

These are very big numbers, for very big banks: UBS is at 75bp, Deutsche is at 83bp, Natixis is at 116bp, and IKB is at a whopping 392bp. And this is just the banks — other corporates have seen similar price action. The cost of protection has gone up sharply, while the cash bonds are still trading at very low spreads.

Bruno Iksil, the London Whale, had a massive long position on corporate CDS in general, and the CDX.NA.IG.9 index in particular. He was selling protection, betting that credit spreads would go down, rather than up. The position was meant to be a hedge, although it’s a bit unclear how JP Morgan could have some massive short position in corporate debt that it was hedging against. In any case, CDS spreads went up — and credit spreads, in the cash market, didn’t.

Cue a $2 billion loss.

Rarely has a position been as widely publicized as Iksil’s, and I wouldn’t be at all surprised to learn that the credits with the highest basis were precisely the credits CDX.NA.IG.9 index. Whenever a trader has a large and known position, the market is almost certain to move violently against that trader — and that seems to be exactly what happened here. On the conference call, when asked what he should have been watching more closely, Dimon said “trading losses — and newspapers”. It wasn’t a joke. Once your positions become public knowledge, the market will smell blood.

Of course, this loss only goes to show how weak the Volcker Rule is: Dimon is adamant, and probably correct, in saying that Iksil’s bets were Volcker-compliant, despite the fact that they clearly violate the spirit of the rule. Now that we’ve entered election season, Congress isn’t going to step in to tighten things up — but maybe the SEC will pay more attention to Occupy’s letter, now. JP Morgan more or less invented risk management. If they can’t do it, no bank can. And no sensible regulator can ever trust the banks to self-regulate.

Nick Dunbar has a good column today on how derivatives have followed physics from being clean to being messy. Once upon a time, both physics and derivatives had beautiful, simple models: quantum electrodynamics and Black-Scholes, respectively. But nowadays they’re both vastly more complex.

Physics has moved on to quantum chromodynamics, where complex interactions dominate the simpler ones and models get gnarly, while derivatives have found themselves in a world of counterparty risks and debit valuation adjustments and credit support annexes. Put them all together, says Dunbar, and the result is that the “derivative trading books at major banks lurch around like aircraft in a thunderstorm”.

All of which makes me very happy to see Bruce Dorminey’s column about a rather exciting possible application of high-energy physics to global finance. Remember the $1.5 billion being spent on transarctic fiber cables designed to cut a bit of latency between London and Tokyo? Here’s an even better idea: why not get rid of fiber cables entirely, and use neutrinos to transmit information, at the speed of light, right through the center of the earth?

At the very least, this could provide a fantastic revenue bump for physicists working at extremely expensive particle accelerators in a world of fiscal austerity. In order to make this happen, you’d need to either build your own accelerator, or lease some capacity from an existing one. The sums involved are both big enough to make physicists salivate, and small enough that the private sector could raise the money quite easily:

Learned says a one-way, earth-traversing setup might be constructed for as little as a $1 billion.

It also might be possible for a neutrino-communications startup to buy time on an existing accelerator, says Learned, in order to create and point a neutrino beam-line in the needed direction. Otherwise, private particle accelerators would have to be built from scratch.

But Haug contends that if a group of particle physicists had the right plan for the technology, Wall Street money “would be there” to make it happen.

If this was successfully implemented, price information from Sydney could reach New York in just 40.2 milliseconds, compared to the 84.4 milliseconds it takes to send that information on fibers around the surface of the earth. The difference is more than enough time for traders in New York to make real money arbitraging securities listed in both cities.

Indeed, it wouldn’t even need to be a Wall Street bank building this technology. Back in the 1850s, Paul Julius Reuter built the company I work for today by leveraging state-of-the-art low-latency technology: the undersea cable between Calais and Dover. Maybe David Thomson can do the same with neutrinos. He might even be able to find jobs for a few of those physicist-quants laid off by Wall Street in recent years.

John Carney has been plugging away at what on earth Bruno Iskil, the so-called London Whale, might be doing with his reported $100 billion bet on an obscure off-the-run CDX index. Carney’s idea is that this is all part of some kind of inflation-protection trade, but as Ben Walsh says, if you want to protect against inflation, you just buy TIPS. Corporate credit default swaps aren’t going to help you out much on that front.

But thinking about it a bit more, Carney’s CHIPS theory (for Corporate Hedging Inflation-Protected Securities) makes a certain amount of sense. Let’s say that Iksil, with his $360 billion portfolio, wants to make money in the fixed-income markets even as he sees inflation appearing over the next 5 years. It’s never easy for bond investors to make money in the face of inflation, since they’re receiving a fixed income, and that fixed income is effectively being eroded by inflation. And with rates as low as they are today, investors aren’t being paid for the inflation risk they’re taking.

Most normal investors are faced with a choice: they can either get insanely low yields on TIPS, and protect themselves from inflation, or else they can get slightly higher yields on corporate bonds, but leave themselves open to having their money eroded by inflation.

Iksil, however, might have found a way of managing to have his cake and eat it. He buys TIPS — say the 10-year series issued in January 2007, which matures in January 2017. Because those TIPS are now off the run, he gets a slightly higher yield on them.

At the same time, Iksil wants exposure to investment-grade corporate credit risk. If you or I had put our money in TIPS, we couldn’t do that, because, well, our money would be tied up in TIPS. But Iksil works for JP Morgan, so he can get credit risk without having to tie up any money at all. All he needs to do is sell protection on a CDX index which matures at roughly the same time — in this case, Series 9 of the Markit CDX North America Investment Grade Index, which matures in September 2017.

Now the great thing about selling protection, rather than buying bonds, is that it costs you nothing up-front. Quite the opposite, in fact: you get paid for doing it. Iksil is cashing insurance premiums on a basket of corporate debt every six months, and he can add that cashflow to the much more modest cashflow he’s getting on his TIPS. And because he’s JP Morgan, even if the market moves against him, he’s unlikely to have to put up much if any margin.

Put the TIPS and the CDX trade together into a package, and you get what Carney calls CHIPS, or what Pimco managing director Mihir Worah cals CIPS: Corporate Inflation-Linked Securities. (Yeah, I know, that looks more like CILS to me.)

What happens now if inflation picks up before 2017? For one thing, Iksil will make money on his TIPS, which go up in value when inflation rises. But Iksil will also make money on his CDX trade. The yield on a corporate bond is basically made up of two elements, called credit and rates. The rates part is the bit which goes up when inflation appears. But when you’re selling credit protection, you’re stripping out the rates part, and you’re exposing yourself only to the credit part of the equation.

And when inflation appears, corporate credit risk actually goes down, not up. Inflation is bad for lenders; it’s good for borrowers. And it means, generally speaking, that companies are raising their prices and bringing in more money, in nominal terms. Which means they have a higher income with which to pay off their fixed debts. Which means that they’re more likely to be able to pay those debts off in full.

Indeed, if you look at the rate sensitivity of the index that Iksil is buying, his mark-to-market P&L goes up when rates go up. For every basis point that rates rise, Iksil makes a profit, if he has $100 billion of exposure, of roughly $650,000. If yields go up by one percentage point, Iksil has made himself $65 million, just on the CDX part of the trade. Which is quite an achievement for a fixed-income investor in a rising-rates environment. Add in the profit on his TIPS, and he’s making even more.

It’s a big and risky trade — but it’s not one which he’s ever necessarily going to have to unwind. It has a maturity of about 5 years, and JP Morgan is more than big enough to hold a 5-year trade to maturity.

But is that really what he’s doing? There’s one very good reason to believe it’s much more complicated than I’ve laid out: if you look at those TIPS maturing in 2017, there were only $9 billion of them issued in total. And more generally, what Iksil is doing here is basically replicating the kind of corporate credit exposure that JP Morgan has lots of already. This isn’t in any way a hedge of JP Morgan’s existing portfolio; it’s more of a doubling-down on it.

Still, looked at one way, Iksil’s job is to take the assets that JP Morgan hasn’t been able to loan out, and get the kind of return on those assets that JP Morgan would be seeing if it had been able to loan them out. So maybe it makes sense that he’s making a big bet on corporate credit. I just wonder where on earth he could possibly find $100 billion of inflation protection.

Back on March 23, Christopher Whittall explained why we don’t have a good go-to measure of Greece’s creditworthiness, in the wake of its big bond exchange: Greece’s credit default swaps can’t trade yet. There’s something called a 60-day look-back clause in the standard CDS documentation, which means that if a country has defaulted in the past 60 days, somebody who owns credit protection can claim that there has been an event of default and ask to be paid out. Since we’re still well within 60 days of the default event on March 9, anybody buying Greek credit default swaps now could trigger them immediately.

But after today’s news, it’s far from clear that Greek CDS will even start trading after the 60 days are up. It turns out that while Greece managed to swap its old domestic debt into new bonds quite seamlessly and easily, the same’s not true of Greece’s foreign bonds.

In a statement, the Public Debt Management Agency said investors holding 20 of the 36 bonds in question either voted down or otherwise failed to approve key changes to the bond contracts…

Last week euro-zone finance ministers issued a statement which hinted strongly that they would back Greece if it didn’t make the payments on foreign law bonds.

On May 15, Greece must redeem one of those foreign law notes worth €450 million.

Basically, there are now roughly €9 billion of bonds outstanding which are still old bonds which haven’t been swapped. And those bonds are likely to be a real headache for Greece. The obvious thing for Greece to do would be to simply refuse to pay anybody who holds those bonds and didn’t tender into the exchange. I would certainly follow that course, if I were in Greece’s shoes.

But that would mean that there would be a second Greek default — and that going forwards, there would be a semi-permanent stock of defaulted Greek debt out there. In turn, that would make it difficult to trade Greek CDS, since Greece is likely to be in default, on billions of dollars of foreign debt, for as far as the eye can see.

Now it’s possible to ring-fence that debt and say that it doesn’t count towards a CDS trigger. Non-trivial, but possible. The question is whether anybody really has the appetite to do that. Or whether Greece, and the Eurocrats paying its bills, would actually be quite happy if Greek CDS didn’t trade at all from here on in.

Ben Heller, a man who’s been trading CDS since before they were even called CDS, is out of the CDS market.

There have been rumblings about this market for a while: an FT article from March 9 quoted a series of unhappy people on both the buy side and the sell side.

One banker working on the Greek bond deal says: “I almost wanted CDS not to be triggered just so it would kill off the instrument and then we could set about designing something better to replace it.”

But with Heller going on the record about this, the pressure on ISDA to fix what is widely seen as a broken system is surely going to increase. Because he’s not alone.

“Many of the people you know from EMCA,” he tells me at the end of this video, “are people who are very focused on this issue and who are not going to let this one go.”

The world has long forgotten EMCA, an attempt by investors in emerging-market debt to team up and provide a united front in the face of attempted sovereign debt restructurings. But back when it was founded in 2000, it included all the biggest names in the emerging-market debt world, including Heller, who was then at HBK; Mark Siegel, at MassMutual; Abby McKenna, at Morgan Stanley Asset Management; Mark Dow, at MFS; and Mohamed El-Erian, at Pimco. The membership of Dow and El-Erian was particularly important, because they had both worked for many years in the official sector (Dow at Treasury, El-Erian at the IMF), and were taken seriously by policymakers.

EMCA never really got off the ground as an organization, partly because it turned out that policymakers, and their advisers, were more likely to pay attention to individual members than they were to respond seriously to carefully-honed collective statements. But clearly these people retain a certain amount of power: you can see that in the way that Greece’s new 2042 bond got quietly split up into 20 different bonds, each maturing in a different year.

Why did that happen? Because to a certain extent, the market is valuing Greece’s debt by working out how much money Greece is realistically likely to pay its bondholders over time, and then divvying up that value among the bonds outstanding. If some of the bonds have earlier maturities and some have later maturities, then more of the value will end up in the early-maturing debt, and less of it at the end of the yield curve. And so the value of the new 2042 bond is going to be lower, this way, than it would have been if it was the only bond being issued.

Why would creditors want a bond to trade lower? Because this way the 2042 bond becomes the cheapest-to-deliver bond when the CDS auction is held today, and the lower the price of the cheapest-to-deliver bond, the bigger the payout for anybody holding credit protection, including basis traders like Heller.

It seems to me that there were two opposing constituencies in the Greek default. One group, led by European policymakers, were very happy to see the CDS market get broken — they hate CDS, in exactly the same way that CEOs hate short sellers. The other group, led by fixed-income investors, wanted to make sure that the CDS market operated relatively smoothly and that the payouts were fair.

In the end, it seems, the buy-side won — but with the vivid realization that they had gotten lucky. Fixed-income traders never want to rely on luck and fortune when it comes to things as important as default protection. And so Heller, for one, is out of the market completely — unless and until ISDA does a root-and-branch revamp of its documentation. Which, if it happens at all, isn’t going to happen any time soon.

My wonky post last week on how Greece’s default could kill the sovereign CDS market turns out to have been surprisingly popular, especially among policymakers who are worried about whether there’s a serious flaw in the CDS architecture. So today I had a fascinating chat with David Geen, ISDA’s general counsel, to double-check whether there was something I was missing. And it turns out that I was wrong: I wasn’t pessimistic enough. The problem I identified with Greece’s default isn’t just a problem for sovereign CDS: it’s a problem for all CDS.

At heart, the problem is what happens when an issuer swaps out all of its bonds for some new bonds. There’s no reason at all why the new bonds should trade at a massive discount to par — indeed, issuers often like it when their new bonds trade at or near 100 cents on the dollar. But if the CDS auction happens after the bond exchange, and if all of the old bonds are exchanged, then holders of the new bonds are forced to tender new bonds into the exchange, even if they’re trading at 100 cents on the dollar. Which means that holders of old bonds could suffer a huge haircut in the value of their bonds, but still get no payout from their CDS.

This has been an issue in the past. When Anglo Irish Bank restructured its bonds, it amended the old bonds to include a call option which allowed the bank to buy back every €1,000 of bonds for €0.01. That was an effective way of wiping out the value of the old bonds — but it also risked serious damage to the CDS market, since in a CDS auction, the value of a bond is calculated as the price of the bond considered as a percentage of the outstanding principal — and the outstanding principal is considered to be not the face value of the bond but rather the amount of the call option. If Anglo Irish had done the exchange quickly, before a CDS auction was possible, then bondholders would have had to tender bonds with a call option at €0.01 — which would mean that they couldn’t claim any payout on their CDS at all.

In the end, Anglo Irish took pity on the CDS holders, and staggered its restructuring so that there was enough time for ISDA to conduct an auction before the bonds got changed out of all recognition. But hoping that the issuer will act in a friendly manner is not exactly an optimum strategy — especially since, by definition, the issuer will be in the process of going bust.

This is a known issue. In a primer on sovereign state restructurings and credit default swaps dated October 2011, ISDA’s own counsel, Allen & Overy, said as much on page 20.

If an issuer has inserted a right to call at 20%, the outstanding principal would be considered to be 20% of the face value: if it were likely that the call would be exercised, the current value of a bond with a face value of USD100 would be approximately USD20, ie close to 100% of the outstanding principal. If an auction final price was based on this bond, a buyer of protection would receive only a marginal payment in settlement of its credit default swap, rather than a payment reflecting the full diminution in value caused by the restructuring.

The buyer of protection would also lose out in the more straightforward case where all deliverable obligations are redeemed prior to settlement.

This seems unsatisfactory at first blush, particularly as it is effectively the very thing for which protection is bought (the restructuring event) which thwarts the buyer.

This doesn’t just seem unsatisfactory at first blush; it is unsatisfactory. And there is no second blush. Essentially, CDS holders are reduced to hoping that the issuer will be nice, and structure the exchange in such a way as to let them get paid out. But there’s no particular reason why the issuer should do that, especially seeing as how the CDS holders were the people who were effectively shorting the issuer as it tumbled into bankruptcy.

Nearly all issuers in Europe have collective action clauses in their bonds: any of them could ask their bondholders to agree to change the payment terms on all bonds so that call options were introduced or principal amounts reduced. If a supermajority of bondholders did that, then the issuer could change the payment terms immediately, before a CDS auction could be held, and buyers of protection could find that CDS protection to be worthless.

In the past, ISDA has found a slightly kludgy way to deal with this. If you look at the documentation for the CIT auction in 2009, you’ll find this piece of crystalline prose:

If, after the date that is two Business Days after the Notice of Physical Settlement Date, but prior to Delivery, a Deliverable Obligation specified in the Notice of Physical Settlement (or NOPS Amendment Notice, as the case may be) is redeemed and/or cancelled in whole or in part (either in accordance with the terms of the relevant Deliverable Obligation, or otherwise) and, in connection with such redemption and/or cancellation, holders of the Deliverable Obligation receive cash, securities, rights and/or other assets (whether tangible or otherwise) (in each case, whether of the relevant Reference Entity or of a third party) (together, the “Assets”) (such event, an “Asset Exchange”) then, notwithstanding Section 3.4, Buyer’s right to Deliver each relevant Deliverable Obligation shall, to the extent it is the subject of an Asset Exchange, be replaced by a right to Deliver an amount of Relevant Assets equal to, or greater than, but not less than, the Asset Entitlement Amount (together with any part of the Deliverable Obligation that has not been the subject of such Asset Exchange).

I’ll translate that into English for you: the auction might happen after your bonds have been exchanged into something else, which we’ll call Relevant Assets. If that happens, then you’re allowed to consider whatever Relevant Assets you got to be deliverables as far as the auction is concerned. Even if the Relevant Assets are equity rather than debt.

But there’s no indication that this kind of language is going to appear with respect to the Greek restructuring. And there’s no reason for CDS holders to believe that it will appear when bond exchanges happen. And there’s certainly nothing in the existing CDS boilerplate indicating that any such language should ever appear.

If you own protection on a credit, then, you’re very much in a world of caveat emptor. You can trade in and out of CDS and make a good living; these things are, first and foremost, trading vehicles. That’s why they’re more liquid than bonds. But if you have a strategy which involves actually getting paid out on your CDS in the event of default, then you should definitely worry that the payout might not happen, even if the event of default is clear and declared. What’s more, there’s really no good way to hedge that risk.

So far, the CDS market has managed to muddle through, when it comes to restructurings and bond exchanges. But it’s sure to blow up sooner or later. And I’m far from convinced that ISDA and Allen & Overy are capable of reworking the standard documentation to make it more robust to these risks.

Harry Wilson today outs Allen & Overy’s David Benton as the legal mastermind behind the mess that is sovereign CDS documentation. Benton’s certainly coming under a lot of criticism these days, and not just on the ultra-wonky end of the spectrum from people like me. Even Pimco’s Bill Gross seems to have a beef with these rules — and Pimco’s on the Determinations Committee!

“If I were a buyer of protection on Greece and have seen the result this morning in terms of no protection, then I would be upset,” Gross, manager of the world’s largest bond fund, said on CNBC television of the ISDA’s decision.

So when Wilson says that ISDA’s decision not yet to declare default was “controversial”, he’s not wrong. Here, for instance, is Barry Ritholtz:

Here is a question for the crowd: Exactly how brain damaged, foolish and stupid must a trader be to ever buy one of these embarrassingly laughable instruments called derivatives?

The claim that Greece has not defaulted — despite refusing to make good on their obligations in full or on time — is utterly laughable.

And Peter Eavis is back with more CDS criticism, too:

One of the decisions of the swaps association on Thursday underscored how swaps can be disconnected from actions that harm investors’ economic interests. As part of the Greek debt deal, the European Central Bank will be shielded against losses on the Greek bonds it holds, a move that relegates, or subordinates, the claims of private creditors who hold the same bonds.

But the swaps association said the plans to subordinate private creditors do not meet the definition of subordination in the swaps contracts, so they do not have to pay out.

All of which says to me that ISDA and Greece have done an incredibly bad communications job here. Because ISDA’s decision was, clearly, the correct one.

The point here, which is easy to miss, is that credit default swaps only get triggered when there’s a real-world event of default. Yes, the deal with the ECB is indeed going to subordinate private-sector bondholders. And yes, Greece is indeed going to fail to make good on its obligations come March 20. There will be an event of default in Greece. But swaps don’t pay out on future events. They pay out on past events. And Greece hasn’t actually defaulted yet: every payment it has promised to make has, to date, been made in full and on time.

Now there are exceptions to this rule. If a government explicitly repudiates its outstanding debt, then that can count as an event of default even before a payment is missed. But Greece hasn’t actually done that. And most of the time, default swaps only pay out when there’s a default. Which is as it should be.

Is that reason for bondholders to be upset, pace Gross? Absolutely not. If you own a credit default swap on Greece, you own a piece of paper worth about 75 cents on the dollar. If you want to realize that 75 cents right now, you can: you can just sell your CDS. If and when the CDS is officially triggered, there will be an auction, and the CDS will be found to be worth roughly 75 cents on the dollar. In that case, you will wind up with 75 cents whether you like it or not.

In other words, when Greece finally defaults, owners of credit protection will be forced to get a payout. Whereas those owners right now have the option: they can take the payout if they want it, or they can hold on to their CDS position if they would rather do that. I don’t see why having that option would make anybody upset.

This is why the CDS market has been so successful: it’s a liquid, market instrument, which prices in expectations of future default. Ritholtz is right that Greece has refused to make good on its future obligations. And as a result, default protection on Greece is extremely valuable. When that future date comes and goes without a bond payment, the CDS will get triggered, and holders of protection will get a lot of money. There’s nothing broken there.

The subordination question is a bit messier, but it’s fundamentally the same idea. Greece has now created two classes of bonds: the ones held by the ECB, and the ones held by private bondholders. There’s nothing in the documentation of those bonds which might indicate the ECB’s bonds are senior to the private sector’s bonds. Right now, they’re all, legally, pari passu.

Again, in future, that’s not going to be the case. Greece is going to privilege the principal and coupon payments to the ECB, while imposing a massive haircut on the payments due private bondholders. That’s both subordination and an event of default. And when it happens, the CDS will get triggered. And that trigger is priced in to the CDS market.

In many ways it’s the genius of the CDS market — at least in theory — that there’s no rush to trigger CDS, because if you know that the instrument is going to get triggered very soon anyway, it’s going to be worth pretty much the same today as it will be when it’s triggered.

That’s my problem with the way ISDA rules cover bonds covered by CACs. Because of technical issues surrounding the availability of deliverables, it’s possible that if you wait for the default to happen, you’ll be too late to get what by rights should be your payout on the bonds. But this is a separate issue from what Gross and Ritholtz and Eavis are worrying about. They seem to think one of two things: either that Greece has already defaulted, and that therefore the CDS should have been triggered by now, or else that a Greek default is so certain at this point that the CDS should have been triggered by now. The first isn’t true. And the second is silly.

Eavis has another point, which is that default swaps are used for a purpose, and that purpose is to hedge against falling bond valuations. (That’s what he means by “investors’ economic interests”.) He is worried that the payout on the bonds might not be entirely in line with the loss of value on the bonds. And that’s a reasonable worry. But it’s also, right now, a pretty theoretical worry. Because in practice, the value of Greek CDS has tracked the value of Greek bonds extremely closely. In other words, even if there are possible problems with them in theory, they seem to have worked OK in practice.

I’ve got a few questions for ISDA about the way that CDS documentation works in the sovereign context in particular, and I’ll be wonking out about this issue further going forward. Because I think that the combination of CACs and CDSs is potentially extremely dangerous. But what I’m emphatically not worried about is ISDA’s decision not to trigger the CDS just yet. That decision was exactly correct. Even Pimco voted for it.

Alea today posts the timeline for physical settlement of credit default swaps, once a credit event has been declared. He doesn’t say why he’s posting it, but the main thing to note is that it’s likely to take a couple of months between (a) the credit event being declared in Greece, and (b) the final settlement of all credit default swaps on Greece.

And that, in turn, reveals a significant weakness in the architecture of CDS documentation. It may or may not be a big deal, this time round. But market participants have already been spooked by the possibility that Greece might be able to default without triggering its CDS at all. Now they can add to that another worry: that Greece might be able to default in such a manner as to leave the ultimate value of the CDS largely a matter of luck.

The way that CDS auctions work, you start with a credit event. Then, using an auction mechanism, the market works out what the cheapest bond of the defaulting issuer is worth. If it’s worth, say, 25 cents on the dollar, then people who wrote credit protection end up paying 75 cents to the people who bought protection: that’s equivalent to the people who bought protection getting 100 cents on the dollar, and handing their bonds over in return.

With Greece, however, the bond exchange is going to complicate things — a lot. Remember that it has a natural deadline: March 20, when a €14 billion principal payment comes due. If Greece’s old bonds haven’t been exchanged for new bonds by that point, then things will get even uglier, and even more chaotic, than anybody’s expecting right now. So it’s very much in Greece’s interest, and Europe’s more generally, to have everything wrapped up by March 20. Bondholders too, truth be told — they hate uncertainty.

But then there’s the CDS holders. In the best-case scenario for Greece and Europe and bondholders, every €1,000 of old Greek bonds will get converted to new bonds with a face value of just €315. Those bonds will probably trade at about 30% of face value, which means the new-Greek-bond component of the exchange will be worth about 10 cents for every dollar in face value of old Greek bonds that you might currently hold. Add in another 15 cents of EFSF bonds, and the total value of the exchange will be about 25 cents on the dollar, which is why people are talking about a 75% “present value haircut”.

The important thing, here, is that Greece is issuing new bonds worth around 10 cents on the dollar, while the EFSF is issuing new bonds worth around 15 cents on the dollar. The structure of the new Greek bonds is secondary: these ones involve a nominal haircut of 68.5%, and a market price of about 30 cents on the dollar. But theoretically, Greece could have constructed bonds with a significantly higher coupon and a bigger nominal haircut — maybe the haircut would be 85%, with the bonds trading at 67 cents on the dollar. Bondholders would still receive about €100 worth of new Greek bonds for every €1,000 of old Greek bonds they hold. But instead of the new Greek bonds trading at 30 cents, they’d trade at 67 cents.

Why does it matter what the nominal price of the new Greek bonds is, so long as the total package, including EFSF bonds, is worth about 25 cents on the dollar? Economically speaking, it doesn’t. But for the purposes of the CDS auction, it matters a great deal.

The reason is that the key number in the auction is the nominal value of the cheapest-to-deliver Greek bond — that’s the price at which the auction clears. And here’s the rub: this auction is going to take place after March 20, after the old Greek bonds have been exchanged into new securities. Because Greece intends to use collective action clauses to change the terms of all its outstanding bonds, even if they’re not tendered into the exchange, there effectively won’t be any old bonds in existence by the time the CDS auction happens. The only outstanding reference securities will be new bonds.

In the auction, market participants will not be bidding on the value of the package that is being offered in return for every old bond. The new EFSF bonds are obligations of the EFSF, for instance: they’re not obligations of Greece, and they have no place in a Greek CDS auction.

The way that CDS auctions are meant to work is that once a borrower defaults on its debt, that defaulted debt continues to be traded in the market, and its value then determines the amount that credit default swaps need to pay out. But in this case, Greece’s defaulted debt might well not continue to be traded in the market. In which case, when traders need to find a cheapest-to-deliver bond to bid on in the CDS auction, they’re going to have to use one of the new bonds, rather than one of the old ones.

And now you can see why the nominal price of the new Greek bonds is so important. Right now, it seems that they’ll be trading at a nominal price of about 30 cents on the dollar, which is close (ish) to the current market price of the old Greek debt. But there’s no particular reason why that should be the case. If Greece had gone for an 85% nominal haircut rather than a 68.5% nominal haircut, then the nominal price of the new Greek bonds would be 67 cents on the dollar — and anybody who wrote credit protection on Greece would only have to pay out 33 cents on the dollar rather than 70 cents on the dollar.

In other words, Greece’s CDS really aren’t protecting holders of Greek bonds at all — or if they do, it’s more a matter of luck than of law. When they get paid out on their CDS holdings, people owning protection against a Greek default won’t get paid according to how much money they lost on their old bonds. Instead, they’ll get paid according to the nominal price of the new bonds.

What this means is that the CDS architecture is broken, and can’t cope with collective action clauses. And as a result, according to the hedge fund manager who tipped me off to the whole problem, “this Greece CDS imbroglio might be the final blow for sovereign CDS as a product.”

Now there is a possible solution here: ISDA could try to decree, somehow, that the total package bondholders receive in return for their old bonds will count as a deliverable security for the purposes of the CDS auction. Bundle up the new bonds, the EFSF bonds, the GDP warrants, everything — and that bundle can be bid on in the auction, to determine where the CDS pays out. That would be fair and right. But the problem is, it might not be legal. There’s really nothing in the ISDA CDS documentation which explicitly allows that to happen.

The whole point about credit default swaps is that they’re meant to behave in a predictable manner in the event of default; one thing we know for sure about Greece is that the behavior of its CDS is going to be anything but predictable. We don’t even know for sure whether they’ll be triggered, let alone what they’ll be worth if and when they are.

Now there are a lot of people, among them European policymakers, who would actually be quite happy if the Greek default killed off the sovereign CDS market as a side effect. But I actually believe that sovereign CDS, when they work, are rather useful things. It’s just that Greece is having the effect of showing that they don’t necessarily work. And if you can’t be sure that they’ll work when triggered, there’s really no point in buying them at all.

Peter Eavis is too smart, and knows too much, to be writing disingenuous stuff like this, about Greece’s credit default swaps:

If parties have to make good on the credit-default swaps, the situation could send shivers through the market. An important and long-planned measure that aims to strengthen the derivatives market is not yet in place, raising questions about how the financial system will react if the credit-default swaps have to pay out.

In the financial crisis of 2008, banks feared that their trading partners might not be able to meet such obligations on derivatives and other financial arrangements. The situation set off a chain reaction that paralyzed global markets until governments and central banks provided enormous financial support.

To prevent a similar disaster from happening again, finance ministers in the United States and Europe committed in 2009 to move derivatives like credit-default swaps onto clearinghouses. These organizations, if they work properly, can sharply reduce the chances that a large bank will not make good on such contracts.

There are lots of very good reasons why credit derivatives should be moved to exchanges — even though such a move is no panacea. But it’s silly to think that Greece in particular “could send shivers through the market” with respect to counterparty risk. Counterparty risk in the CDS market is highly correlated to jump risk — the risk that a seemingly-healthy company suddenly defaults on its obligations, causing a massive unexpected payout by anybody who had written protection on that name. In a case like Greece, where default is already priced in to the CDS market, there’s no jump risk at all, and anybody who has written protection has already posted enough margin that there shouldn’t be any problems at all.

More generally, the 2008 credit crunch was never related to worries over traded derivatives; it was — like all credit crunches — related to much more general worries over bank solvency and the quality of banks’ balance sheets. And in any case, the size of a bank’s derivatives obligations is unrelated to whether those obligations are settled bilaterally or centrally. If a bank has written so much credit protection that it becomes insolvent, then there’s significant systemic counterparty risk regardless of how its derivatives trades are cleared. Moving to an exchange might make its CDS counter parties more likely to get paid out in full, but it wouldn’t prevent other banks from refusing to do business with the insolvent bank, pulling their repo lines, and generally moving back in the direction of another credit crunch.

So the move to central clearing was never — could never have been — designed to prevent counterparty risk leading to a credit crunch. I welcome all wonky Peter Eavis articles about central clearing and why it hasn’t happened yet. But I’m very disappointed by this attempt to tie the issue into the Greek default in particular, which is entirely unrelated to the central-clearing issue. More generally, I think it’s a bad idea to sell central clearing as a potential means of preventing another disastrous credit crunch: it could never live up to that billing. It’s a perfectly good thing even if it doesn’t have such mythical abilities.

Noam Scheiber is raving about Dylan Ratigan’s new book, giving it his highest praise: he calls it “sensible”. Which is maybe not obvious from the title, Greedy Bastards: How We Can Stop Corporate Communists, Banksters, and Other Vampires from Sucking America Dry.

He’s wrong. It isn’t sensible at all. Scheiber says that “one of the more intriguing ideas” in the book comes from Dick Grasso, of all people, who wants to classify a large part of the CDS market as “online gaming” and therefore “null and void”. Which sounds like one of those ideas which sounds great in the middle of your third bottle of wine.

But giving Scheiber (and Grasso, I guess) the benefit of the doubt, I had a look at the page of the book in question. Here it is, page 54, in full:

We must require not only that banks retain more capital but also that when they place bad bets, they pay the price for their losing bets themselves. Otherwise we are stuck with the worst of two economic systems: like a capitalist country, we have private banks that keep their profits. But like a communist country, we have a system where banking losses are charged to the government. Only when we end this corporate communism will we realign the interests of the banks with the investors they serve. The way to do this is debt reduction or cancelation. If the system is so out of control that we can use a computer to fabricate trillions in new money by simply adding some zeros, then surely we can find a way to delete some zeros as well. By definition, if you can print it, you can cancel it.

As we have already seen, a swap can either be an insurance policy that helps to lower long-term costs for a business or a bet by an outsider on whether a given company or country will succeed or fail. Putting swaps on a public exchange would create the visibility for all to see the difference between commodity insurance that is critical to the economy and speculative bets that are not much different from gambling. In fact, Richard Grasso, former chairman of the New York Stock Exchange, suggested to me in a personal interview that the speculative bets that fueled the financial crisis could be reclassified legally as online gaming — and then cancelled. His technical explanation: “I believe regulators should require the product to be registered with a central clearing agent (like an exchange) and thus able to be monitored globally to prevent contracts being written in excess of the debt obligations they are designed to insure (corporate or sovereign). This is easily accomplished by [regulators] and Treasury issuing a cross-markets rule adopted by non-US counterparts. Any contracts written outside these requirements would be deemed null and void by regulators as simply online gaming.”

This is exactly the kind of thing we need much less of, at least in book form. It’s fine if you’re just shooting the breeze with a bunch of financially-illiterate friends, but it really doesn’t belong in a volume which aspires to present “smart policy” prescriptions.

I mean, we start off OK, with a standard-issue broadside about privatized profits and socialized losses. Got that. But what on earth is this supposed to mean?

The way to do this is debt reduction or cancelation. If the system is so out of control that we can use a computer to fabricate trillions in new money by simply adding some zeros, then surely we can find a way to delete some zeros as well. By definition, if you can print it, you can cancel it.

I’ve spent the best part of a day trying to work out what on earth Ratigan might be driving at here, and I’ve come to the conclusion that he was probably just high. Never mind the fact that he doesn’t bother to identify which debt he wants reduced or canceled; just admire the elegant way that he proves that debt cancellation is somehow the equal and opposite action to printing money. (In reality, of course, printing money is a way of canceling debts, by inflating them away.)

Even more admirable, in a sense, is the way that Ratigan throws in his “let’s just delete some zeros” idea and then jumps straight to something completely unrelated — the idea of putting all derivatives on exchanges. I mean, it’s not as though deleting zeros willy-nilly would destroy the fundamental nature of capitalism as we know it, and might therefore be worthy of, oh, another sentence or two. We’ve got Grasso to get to!

Of course, we’re not going to get into any nitty-gritty here about the difference between exchanges and clearinghouses, despite the fact that Ratigan’s talking about the former, Grasso’s talking about the latter, and the two are not at all the same thing. And we’ll not spend much time either on the silly idea that anything interesting or systemically important happens at the point at which the notional value of derivatives contracts exceeds the amount of the underlying. (It doesn’t.)

Because even putting those points aside, what Grasso is suggesting here doesn’t stand up to the scrutiny of sober thought. (Especially if debt obligations — the underlying bonds being insured — can simply be reduced or canceled by deleting zeros.)

The way that markets and exchanges work, there’s no way that a clearinghouse would ever be able to know whether the counterparties to a derivatives contract had some kind of insurable interest in the underlying. Grasso’s proposal wouldn’t put an end to what Scheiber calls “naked bets”, it would just allow speculators to crowd out genuine hedgers, to the point at which people who did have an insurable interest wouldn’t be able to do any hedging, because the speculators would have got there first and written contracts up to the maximum allowable limit.

Ratigan has a bully pulpit on the television, and his heart is pretty much in the right place. I can see why he’d want to publish a book where he can tease out his policy ideas in detail, while keeping them accessible to his television audience. But it’s irresponsible to boil complex issues down into a simplistic world of good and evil, complete with simplistic solutions (cancel debt! outlaw speculative gambling!). If anything, it plays right into the rhetoric of the Tea Party, which Ratigan hates.

There are big and hugely important issues to be addressed in the global economy; the least we can do is take them seriously. And stop pretending that being harsh on a coterie of banksters would be both necessary and sufficient to solve all our problems.