If you are new to this blog, you are invited to read first “The Largest Heist in History” which was accepted as evidence and published by the British Parliament, House of Commons, Treasury Committee.

"It is typically characterised by strong, compelling, logic. I loosely use the term 'pyramid selling' to describe the activities of the City but you explain in crystal clear terms why this is so." commented Dr Vincent Cable MP to the author.

This blog demonstrates that:

- the financial system was turned into a pyramid scheme in a technical, legal sense (not just proverbial);

- the current crisis was easily predictable (without any benefit of hindsight) by any competent financier, i.e. with rudimentary knowledge of mathematics, hence avoidable.

It is up to readers to draw their own conclusions. Whether this crisis is a result of a conspiracy to defraud taxpayers, or a massive negligence, or it is just a misfortune, or maybe a Swedish count, Axel Oxenstierna, was right when he said to his son in the 17th century: "Do you not know, my son, with how little wisdom the world is governed?".

Monday, 22 June 2009

Credit Default Swaps (CDS) – a financial pyramid stabilisation system




As it has been proven in the first article of this blog, "The Largest Heist in History", the current financial and resulting economic crises are the effects of turning the financial system into a global pyramid scheme. The mechanism of this pyramid building was lending by financial institutions with loan to deposit ratios above 100%. This destroyed a long standing and proven practice of fractional reserve banking that was used to control credit supply. With loan to deposit ratio above 100%, a money multiplier was infinity (and the multiplication was happening with exponential pace). This resulted in a pyramid scheme that depleted the banking system from cash reserves and ballooned the banks balance sheets. These sheets represented bogus assets of ultimately very little, if any, market value, having been the product of pyramid scheme building process. Pyramids are bound to collapse as otherwise the banks' balance sheets would have grown unrestricted extremely quickly to massive numbers.

Credit Default Swaps are good examples of financial pyramid stabilisation system that lets it grow bigger than it would have otherwise and delays the collapse. In practical terms this risk management instrument, together with lending with loan to deposit ratio above 100%, is a lethal combination. A financial nuclear bomb. This comparison is particularly representative since similarly to chain reaction, a pyramid growth has exponential characteristics.

When a financial institution buys CDS' (from various other institutions) as an insurance against defaults on credits it granted, it spreads the risk of default on these credits amongst those institutions. When they resell them further in whole or in part, again to various other institutions, they propagate the risk further. At the limit, this way the entire system is covered by every single institution for a default on every single credit. It looks almost an ideal scenario: whenever any creditor, large or small, defaults everyone is coughing up a little bit to cover for it according to its committed resources and adopted risk profile. This way the financial pyramid grows being stabilised in the process. Whenever in multiple deposit creation cycle a default occurs on any credit, the entire system intervenes and absorbs it and the pyramid keeps on growing at exponential pace. Together with it, the value of CDS' sold keeps growing too. Even perversely, at times, over-supply of CDS’ onto the market was, in part, also driving supply of cheap, subprime, credit thereby accelerating a pyramid growth.

However since any financial pyramid is bound to collapse, at some point a default or a sequence of defaults becomes too big even for the entire system to absorb. One can say that a default size exceeds a critical mass which triggers a chain reaction of collapse. In the context of the current financial crisis, it appears that it was Lehman Brothers default that provided critical mass for chain reaction of the current liquidity crisis leading to the economic crisis as the banks stopped lending and the governments pumped enormous amounts of monies. Time will only show whether this huge money sarcophagus over the financial pyramid will stop the chain reaction inside or whether the chain reaction was simply slowed for the time being and will gather the pace again. In any event, not dissimilar to Chernobyl, the world will live with the consequences for many years ahead.

7 comments:

  1. Banks have always increased through multiples the money in circulation by lending more than they have. Obviously I agree with Greg that by the time it gets to something like Lehmann Bank (reported to be as high as 1:66) this is too high. But I don't know whether we could run a modern economy with these conduits of money to the broad economy restricted to a 1:1 ratio.

    Nicholas Frankopan

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  2. Nick

    Thanks for your comment. But I think you read my post a bit too quickly. (I also apologise that I am very brief in my explanations, but otherwise they would have got quite complex.)

    I do not postulate a money multiple to restricted to 1 (or 1:1 as you seem to call it). The relationship between loan to deposit (L/D) ratio and money multiple (MM) is as follows: MM = 1/(1 – L/D), where L/D is expressed in decimal terms (i.e. 50% = 0.5, 20% = 0.2, and so on).

    So for money multiple 1, L/D must be equal 0 and I certainly do NOT postulate that. I actually postulate that L/D must be with 0 and 1 (but less than 1). As if L/D = 1 (or above) the money multiple is infinity (if above 1 it depletes the existing reserves at exponential pace).

    I think there is a misconception between money multiple as a limit of deposit-credit cycle (if it keeps on going to infinity) and the ratio of money multiplied to initial base deposit taken after a certain deposit-credit cycle (i.e. how much money was multiplied by then).

    I actually allow for money multiple to be 66 (like seemingly with a Lehman Brothers example), although I do not think it would be wise. In any event it would have been still finite. To achieve that L/D ratio must be 98.48(48)%. More examples:
    - with L/D = 50% MM = 2
    - with L/D = 80% MM = 5
    - with L/D = 90% MM = 10
    - with L/D = 99% MM = 100
    … it is always finite, if L/D is less than 100%.

    The system becomes a pyramid if L/D is above 100%. L/D’s less than 100% but close to it (e.g. 95%) may not be particularly wise and indeed they may cause big problems. However they do not constitute a pyramid building and are not a crime.

    The problem (and indeed a crime) of Lehman Brothers appears to be that L/D ratio was above 100%. Therefore the money multiple was infinity (not 66). Lehman Brothers 66 ratio was not a money multiple but a ratio of money multiplied to initial base deposit taken at some point. If it was taken later it would be higher. If it was taken even later, it would have been even higher, heading very fast, at exponential pace, to infinity. This is what pyramid building is all about.

    This explains a fundamental difference between loan to deposit ratio below 100% and equal or above 100%. If it is below 100%, money multiple can be as arbitrary higher as you wish (66 or 666 or 6666 and so on) but still the amount of money multiplied will always have a finite limit. If it is 100% (or higher) money multiple is infinity and with loan to deposit ratio above 100%, this multiplication process happens with exponential pace so it gets completely out of control and any realistic proportion very quickly. There is no point of talking about money multiple when loan to deposit ratio is 100% or above. It is infinity. You can only talk about how much money was multiplied by a particular point (and this is something different than money multiple).

    Thanks for a very inspiring comment that I hope adds to clarification to my arguments.

    Greg

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  3. Only if you believe that the value of the deposits (or assets backing the loans) is actually zero do you get an infintesimal Loan to Deposit Ratio. I think that few would believe this to be the case. Many would say that types of deposits have some sort of value but that they are hard to price because they are concentrated amongst a few players - which means that the market cannot act as an effective clearing mechanism. If these products were actually worth nothing - we might be in a better situation. The institutions involved would have to come to terms with their losses and everyone could move on.

    Nicholas Frankopan

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  4. Nick

    You wrote: “Only if you believe that the value of the deposits (or assets backing the loans) is actually zero do you get an infinitesimal Loan to Deposit Ratio.”

    I think that you intended to write money multiplier (rather than loan to deposit ratio). Anyway both money multiplier and loan to deposit ratio are independent of considerations whether value of the deposits (or assets backing the loans) is zero or whatever. In my argument the money multiplier is infinity because, when loan to deposit ratio is 100%, (1/(1-1)) is infinity and this is independent of anybody’s beliefs.

    You could have used loan to value ratio in your argument which is something different. (And then derive something akin to money multiplier.) Indeed at the outset of pyramid building and for some time the “value” of loans actually follows exponential growth of banks’ balance sheets (i.e. loans). This makes banks balance sheets look “healthy”. But when, due to pyramid growth mechanism, the cash runs out, causing the liquidity shortage, then once so much valued assets become toxic waste (i.e. their value collapses as there is no cash to pay for them). I described this mechanism in my blog article “Example/exercise – how does it work?”: http://gregpytel.blogspot.com/2009/04/exampleexercise-how-does-it-work.html. This is what the market experienced when the current crisis broke out last autumn.

    Incidentally The Turner Review proposed to regulate loan to value ratio. I am actually of a view, for the reasons stated above, that this would not work. I wrote about it on my blog: http://gregpytel.blogspot.com/2009/04/turner-review.html

    Greg

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  5. Greg, I think you bring up good points. There are a few things I believe came out of this and for that matter will continue to show up as we go on. The idea that risk could be spread and basically eliminated or expensed let to risk being ignored. Though the concept of CDS's as they have stood this decade are new, they have been around in the form of mortgage insurance or credit insurance for a long time. The difference was that a company insuring mortgages on an individual basis had a portfolio of insurance on many mortgages spread over time and in general, the whole world couldn't buy the derivative of the risk, save for the stock of the company that insured the mortgages.

    I believe the idea that risk could be laid off led to the mispricing of risk. As long as credit and debt are expanding and the economy is on an upswing, the perception that a certain type of loan is risky diminishes. Mortgage underwriting and junk bond financing underwriting became a joke against what had been done for so long. As long as home prices were on an upward trajectory and speculators could roll the properties to each other and people seeking houses, the game went on without much loss. What we witnessed and probably still will was postponed losses. Now there is so much piled up credit that without a new burst of private lending, more is on the way of going bad. My suspicion is the government will be next to be forced to curtail spending.

    If there was a chance to head this mess off at the pass, it has to revolve around closing Citicorp. Citi had far more assets than deposits and I believe was the bank that they referred to when the talk was that banks won't lend to each other. Citi had a $400 billion fed funds imbalance. LEH, on the other hand was not a bank in the sense of being a bank, but instead was using borrowed funds to act as if it was a bank. The problem is that the deposits are necessary to make the debts good, as the deposits are created out of the debts. If, on the other hand the deposits are greater than the debts, then the banks no longer have the net worth to do anything. It is my contention that the idea of reserve requirements mean nothing today and that the real game is whether a bank has capital or not. Capital isn't a cash account, only a means of putting out cash if necessary. I believe all the cash supposedly created by the Fed has disappeared into a black hole of what was and has been already lost. The current gyration is nothing more than noise made by Goldman.

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