Suggested Answers to Short Quiz

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johnkarls
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Suggested Answers to Short Quiz

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Suggested Answers
Short Quiz – “It’s the Economy, Stupid” (Bill Clinton's favorite reminder)


Question 1

What is a derivative???

Answer 1

In the common parlance of financial institutions, the term historically has described solely interest-rate swaps and currency swaps.

For example, suppose a corporation issued several years ago long-term bonds. The amount payable at maturity is 500 million Euros and the interest rate is “floating” (in this case, it is geared to the London inter-bank rate which, of course, fluctuates).

Assume that the corporation believes that the US dollar is going in the toilet and that the London inter-bank interest rate is going to trend upwards.

It could act on these beliefs by retiring its long-term bonds and issuing new bonds to replace them – the new bonds payable in US Dollars and bearing a fixed rate of interest.

Alternatively, it could engage in a currency swap and/or an interest-rate swap with one of the 6-8 market makers such as Dresdner Bank which invented the concept.

The currency swap would take the form of a 500 million Euro loan from the corporation to Dresdner Bank and Dresdner Bank loaning an equivalent amount of US Dollars to the corporation – with no money changing hands. The corporation’s 500 million Euro debt to bondholders is now offset by its 500 million Euro receivable from Dresdner Bank – now leaving a US Dollar obligation to Dresdner Bank effectively replacing the Euro obligation to bond holders.

The interest-rate swap would take the form of the loan from the corporation to Dresdner just described bearing interest at the same “floating” rate the corporation pays its bondholders, and the loan from Dresdner back to the corporation just described bearing interest at a fixed rate. Now the corporation’s “floating” rate obligation to its bondholders is offset by the “floating” rate it receives from Dresdner – now leaving a fixed-rate obligation to Dresdner effectively replacing a “floating” rate obligation to bond holders.

Question 2

Which derivatives have been run the same way a bookie runs a balanced book???

Answer 2

Both interest-rate swaps and currency swaps have historically been run by the 6-8 market makers the same way a bookie runs a balanced book.

Dresdner Bank, for example, would quote terms (or “odds” to use bookie terms) that would balance the amounts that its customers want to swap from dollars into Euros, with the amounts that its customers want to swap in the opposite direction, etc.

Question 3

What derivative has been run as insurance (rather than as a balanced book)???

Answer 3

AIG pioneered the concept of writing insurance for investments in pools of sub-prime mortgages.

However, since it did not want to have to offset the insurance premiums with reserves for future losses in accordance with normal insurance practices, it called the insurance contracts “credit default swaps.”

Question 4

Since “credit default swaps” were nothing but insurance, why weren’t they regulated by the insurance regulators???

Answer 4

God only knows!!! The New York State insurance regulators were “asleep at the switch” – fooled by simple nomenclature!!! Apparently an insurance contract has to be labeled “insurance” before they will regulate it!!!

Question 5

What happens when a bookie (or a financial institution) running a balanced book goes bankrupt for entirely-unrelated reasons, such as by spending too much on booze or whores???

Answer 5

The Bankruptcy Court appoints a Trustee who collects 100 cents on the dollar from all of the bookie’s losing customers – while the bookie’s winning customers have to queue up with all of the bookie’s other creditors to see how many cents on the dollar (if any) they will be paid.

For this reason, many interest-rate and currency swaps have been structured as “notional principal contracts” rather than offsetting loans as described above. A “notional principal contract” simply provides a formula that produces the same economic results as if there had actually been offsetting loans. But instead of the corporation in our example having to pay the equivalent of 500 million Euros to a bankrupt Dresdner Bank and then queue up to see how much of that they can recover on the loan going the other way, the two loans did not exist but were merely part of a formula and the corporation only has to queue up for any winnings – if the dollar really did go in the toilet and/or floating interest rates really did trend up.

Question 6

What happens when an insurance company forms a separate subsidiary to write solely insurance covering a single risk – whether it be earthquake insurance for solely homes atop the San Andreas fault (rather than also insuring some homes in the Mississippi flood plain to balance risk), or for investors in pools of high-risk (sub-prime) mortgages???

Answer 6

The cardinal insurance principle of “diversity of risk” has been violated!!! It is not enough to charge an appropriate premium for the risk of earthquake for homes atop the San Andreas fault – because if that is the only risk that has been insured, an earthquake on the San Andreas fault guarantees the bankruptcy of the insurer!!!

Question 7

Who were the perpetrators behind the mortgage crisis??? What are they doing today???

Answer 7

Historically, though most mortgages have been initiated by local banks around the country, most of the mortgages are sold by the banks with the bulk of them purchased by Fannie Mae and Freddie Mac, two gargantuan public companies (their stock trades on the New York Stock Exchange) that borrowed prodigious amounts of money with de facto guarantees from the U.S. government with which they purchased the mortgages.

Historically, Fannie Mae and Freddie Mac purchased only mortgages for which there had been a 20% down payment and for which the income of the homeowner had been verified as sufficient to make the mortgage payments.

The Democratic Party in general – and in particular Christopher Dodd (Chairman of the Senate Banking Committee) and Barney Frank (his counterpart in the House) – compelled Fannie Mae and Freddie Mac to purchase “sub prime” mortgages (no down payments and/or no verification of ability to pay) in order to foster home ownership in inner cities.

The American voters have put the Democratic Party in general, and Christopher Dodd and Barney Frank in particular, in charge of dealing with the mess that they created.

Question 8

What are the important features of bankruptcy???

Answer 8

Bankruptcy is usually defined as either (1) an excess of liabilities over assets, or (2) the inability to pay obligations when they become due.

If either occurs, then the corporation can seek bankruptcy protection (a voluntary bankruptcy), or the creditors can compel a bankruptcy proceeding (an involuntary bankruptcy).

The Bankruptcy Court appoints a Trustee to protect all of the assets of the bankrupt, and ascertain what liabilities there are against the bankrupt (including their seniority and, if any, security).

The crucial question is then addressed – is the business of the bankrupt viable on an on-going basis if all of its contractual liabilities (stockholders, bondholders, creditors, labor contracts, etc.) are wiped out???

If not, the bankrupt is liquidated with creditors receiving only cents on the dollar in accordance with their seniority and security.

If so, the Bankruptcy Court approves a “Bankruptcy Plan” which would permit the bankrupt to emerge from bankruptcy.

For example, if General Motors went into bankruptcy, it would probably be determined that General Motors would be viable if all of its stockholders were wiped out, all of its general creditors were converted to stockholders, all of its pension obligations were wiped clean, it were permitted to reduce the number of its dealers by two thirds, and its existing contracts with its current work force were voided.

It should be noted that the US Government’s Pension Guaranty Corporation would be liable for much of General Motors pension obligations which, under bankruptcy, are wiped out as to General Motors. But not completely, since the Government’s pension guarantees are limited and the pensions of executives would be severely limited.

The Bankruptcy Plan pursuant to which General Motors would emerge from bankruptcy would, in broad outline, reflect the willingness of the current work force of General Motors to reduce their income sufficiently so that the bondholders, as the new General Motors stockholders, believe that the stock would be worth more than they would get by simply selling off the assets and liquidating the company.

Question 9

Is there a reason for not letting financial institutions running multiple-Trillion (yes, that is a “T”) balanced books of currency and interest-rate swaps go through the bankruptcy process???

Answer 9

Commercial banks are highly leveraged – typically 30:1 in terms of the loans they have made to their equity (the remaining 29/30 of the loans they have made is what they owe to their depositors).

Accordingly, very small losses can wipe out a bank’s shareholders and create panic among its depositors.

Many commercial banks, in order to increase their profits, chose to load up their balance sheets with sub-prime mortgages rather than selling them to Fannie Mae and Freddie Mac.

And, yes, it would make sense to make them “pay” for their mis-management.

But the Federal Government is “already on the hook” through its FDIC insurance of the deposits. And is reluctant to create a panic among large depositors around the nation who might start a classic “run on the banks” to withdraw their funds from every bank (whether or not there is a hint of risk – better safe than sorry), producing a total collapse of the banking system. Because the withdrawal of all large deposits around the country would trigger a “fire sale” of banking assets!!!

*****

Which brings us to the main question.

Many of the commercial banks have entered into currency and interest-rate swaps with the 6-8 large market makers in order to manage their own currency and interest-rate risks – much like smaller insurance companies “lay off” excess risk with re-insurance companies.

If one of the 6-8 large market makers in currency and interest-rate swaps becomes bankrupt, all of the commercial banks around the country that entered into swaps with the now-bankrupt market maker suffer losses which, because of their thin 30:1 capitalization, means they are wiped out.

And, in deciding whether to suffer such broad carnage, it really doesn’t make any difference why the market maker is bankrupt – whether it is a bookie who spent too much on whores and booze, or whether it is a large financial institution which, in addition to running a multi-Trillion currency or interest-rate “book,” incurred unrelated losses such as from investing in sub-prime mortgages.

Question 10

Is there a reason for not letting AIG -- which was running a multiple-Trillion (yes, that is again a “T”) UNBALANCED BOOK of insurance on high-risk (sub-prime) mortgage-backed securities ("mortgage-backed securities" is a fancy name for investments in a pool of mortgages which, in this case, were high risk or sub prime) -- go through the bankruptcy process???

Answer 10

Unfortunately, the practical considerations of letting AIG go under are similar to those for not letting the market makers for the balanced currency and interest-rate “books” go under – that most of the same commercial banks across the country gleefully purchased under-priced insurance for their investments in sub-prime mortgages from an insurance company that, in addition to under-pricing, was failing to follow the bed-rock insurance principle of diversity-of-risk.

Obviously, however, it makes one’s “blood boil” to feel forced by practical considerations to clean up an insurance mess made by an insurance company that was failing to follow elementary insurance principles.

Question 11

Is there a reason for not letting the Big-Three American auto makers go through the bankruptcy process???

Answer 11

Though severe, the dislocations from letting the Big-Three American auto makers go through bankruptcy do not begin to compare with the collapse of the banking system – after all, if the banking system collapsed and every depositor in every bank was forced to look to the FDIC, the FDIC wouldn’t have the resources to hold the depositors harmless. In effect, we would have to tax ourselves to pay ourselves.

However, the Big-Three American auto makers have an interesting moral case – that they didn’t appreciate the devastation to the American economy that could be produced by the sub-prime mortgages of Christopher Dodd, Barney Frank, and their Democratic colleagues and how that would make it impossible to sell new automobiles in the wake of the recession caused by the sub-prime mortgages.

Nonetheless, the Big-Three American auto makers have little hope of competing with the foreign car companies because (1) the American companies’ US operations are plagued by “legacy costs” (huge pension liabilities and costly medical plans for retirees, which the foreign “Johnny-come-latelies” locating in the union-free American South do not have), and (2) the American companies’ US operations have not been down-sized to their current market share (for example, they have more than 3 times the dealers in relation to their market share than do their foreign competitors – and state law often makes it impossible to eliminate dealers).

For long-term viability, the Big-Three American auto makers probably do need the kind of re-structuring that only a Bankruptcy Court can provide – for example, voiding the effect of state law in preventing the down-sizing of the dealer network, voiding the pension/medical liabilities for retirees (which would then be picked up, to some extent, by the US Government’s Pension-Guaranty Corporation and by Medicare), and voiding union labor contracts which would then have to be re-negotiated on the basis of the level of wages that would make it worthwhile for the creditors to become the new shareholders rather than simply liquidate the companies (which, in broad outline, would bring the current labor costs into line with the non-union US workers in the Southern-US factories of the foreign car manufacturers).

Question 12

What is the difference for economists between monetary and fiscal policy???

Answer 12

Monetary policy holds that currency, such as the US dollar, is simply another commodity whose supply and demand dictates its value. But, more importantly, holds that its cost can affect the level of economic activity – if interest rates are low, companies will want to borrow to finance expansion and consumers won’t mind borrowing to finance purchases.

Fiscal policy holds that economic activity can be created/increased by governmental spending (for example, on public works projects such as roads and bridges), and that economic activity is curtailed by governmental taxation (since taxation in isolation removes purchasing power from the economy).

Monetary policy, though the “Holy Grail” of the younger economists, has several drawbacks. Technically, the Federal Reserve which controls monetary policy, has no control over the total money supply (including bank accounts, credit facilities, loans, etc.), it has no control over the “velocity” of the money supply (how quickly or how often money is spent), it has no direct control over interest rates (since it is able to set only one small, specialized short-term interest rate), AND MOST IMPORTANTLY, IT IS “COMMON WISDOM” THAT WHEN INTEREST RATES HAVE BEEN LOWERED TO VIRTUALLY NOTHING AND THE ECONOMY IS STILL IN THE TOILET, THAT MONETARY POLICY IS IMPOTENT.

In addition, the models of the economy used by the Federal Reserve to help it decide how much currency to have in circulation and the rate of interest on the small specialized short-term loans that it governs, are very dated. Because very few Americans alive today have lived through a severe recession and even fewer have lived through the Great Depression – so the Fed can only guess how today’s population will react to a particular situation. It’s like racing 100 miles per hour in dense fog on San Francisco’s hills without knowing where you are or the direction in which you are headed.

*****
President-Elect Obama’s economic advisers are coming to the realization that today’s economic crisis can only be met by fiscal policy – spending on public works projects without increasing taxes.

In response, the popular press is featuring a lot of articles claiming that Franklin Roosevelt’s public works projects did not lift the American economy out of the Great Depression – only the production of war materials to fight Germany/Italy/Japan was able to accomplish that after a decade of Roosevelt’s public works projects had failed to do so.

Such articles are rather silly because economic theory was not well developed at the time and Roosevelt’s economic advisers didn’t really know what they were doing. For example, taxes were raised to pay for the public works projects – with the taxes having a dampening effect on the economy.

But, more importantly, a failure of the public works projects to lift the economy out of the Depression should compel a conclusion that the public works projects were not large enough to lift the economy out of the Depression, not that they were having a negative effect.

To test this last statement, one need only employ the “Law School 101” or “Philosophy 101” principle of taking a proposition to its extreme to test its validity – if the government put everyone on its payroll and imposed no taxation whatsoever, what would be the effect on the economy??? Obviously, zero unemployment and a tremendous demand for goods and services (many of which would not be available because of the projects on which the work force has been deployed).

The tricks, of course, are determining how much governmental spending without taxation is the right amount, and what governmental projects would be the most worthwhile.

Question 13

Is it possible for monetary-policy to employ negative interest rates???

Answer 13

“Yours truly” wrote one of his undergraduate honors economics papers on the proposition that it is!!!

However, it would require dating currency so that, just like vegetables, the currency could “spoil” at whatever negative interest rate is deemed desirable.

The easiest way of doing this would probably be replacing money with something like the electronic NYC subway cards to which you can add by making a payment into a machine that increases the balance on your card, and from which are subtracted the cost of your subway rides as you swipe it through the readers at the turnstiles.

The readers, which would now replace the credit-card readers employed by every merchant in the country, would be programmed to ascertain the last time the card had been used and to subtract from the balance a negative interest amount for the period since it had been used.

However, just like with the introduction of credit cards in the general economy and subway cards in NYC, the new system would require some psychological conditioning.

After all, there was a lot of fear when Nixon took the United States off the “gold standard” that the population would stop viewing governmental paper (aka currency) as worth anything.

Question 14

Why is it tragic that Barack Obama’s economic advisers seem to be focusing on a fiscal policy featuring building/repairing roads and bridges???

Answer 14

The fiscal policy focus is not tragic since, even if a monetary-policy advocate wanted to employ negative interest rates, it wouldn’t be practical to condition the American population psychologically to accept the new system that would be required in time to address the current situation.

However, Al Gore’s proposal to re-power the American electrical grid within 10 years to become carbon free would be preferable to building roads and bridges – as we and our friends/relatives (and their friends/relatives in an unending chain) hopefully have been telling President-Elect Obama on his “suggestion box” web site. (Please see the materials for last month on this bulletin board.)

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