Tuesday, March 30, 2010

Dunkin' Donuts Lies

The popular coffee brand, Dunkin' Donuts, claims in their advertisements, “America runs on Dunkin’” They lie. America buys their coffee with credit cards; America runs on debt. I don’t need to tell you that America is riddled with debt, private and public. Anyone who has watched the news since health care reform was passed has heard that America can’t handle the cost. Everyone knows about the cost of the Iraq war (in dollars). Everyone knows about the rising cost of social security and Medicare as the baby-boomers approach retirement. People also know about all the foreclosures. Debt currently makes up very high 80% of GDP.

This is why the banks were bailed out; credit is the lifeblood of America and strong banks enable our lifestyles. For anyone to buy a home, they must take out a loan from the bank. Nobody has $200,000 in cash to buy a house. But what would happen if there were no banks to loan out money? No one would be able to buy a house, which if you believe in the free market, would drive the cost of housing down considerably. There is nothing inherent to the construction of homes that requires they cost so much.

The news makes it sound as if rising real estate prices are a sign of strength. We don’t need higher housing prices; people are so quick to forget that rising prices are a bubble. I stand here before you and say, “Housing prices are still inflated!” If people can’t afford houses, then they cost too much. That’s how every other commodity in the world works. It’s just supply and demand.

The problem is that there are so many outstanding loans made from the peak of the housing bubble that any readjustment of housing prices to lower, more reasonable levels, would send the majority of America underwater. Everyone would owe more than their homes were worth and would either default or restructure their loans. This would absolutely obliterate the banking system, because they are invested in your homes. With the banks completely destroyed, credit markets would seize to exist and you could only buy your coffee with cash.

What happens after that is open to interpretation. Either the invisible hand of the free market distributes bread in a fair manner or every industry that isn’t McDonalds loses profitability and we have 40% unemployment (also known as the Great Depression). So next time you wonder why the Government uses inflationary monetary policy, it’s because our banks invested at the peak of an asset bubble making any realignment crippling and destructive.

Monday, March 15, 2010

Credit Default Swamps

Since the whole Greece debacle, there has been a lot of talk about Credit Default Swaps (aka CDRs). Many European officials believe that CDRs exasperated problems in the Eurozone by allowing investors to speculate against Greece and other struggling members of the EU. Although there is still some debate on what impact CDRs had on the situation, there seems to be growing consensus that CDRs need to be regulated.

First lets look at what CDRs actually are. In the simplest of terms, they are bond insurance. For example, if I buy a Canadian bond, and I’m worried that Canada will default on their debt (and therefore won’t be able to pay me once the bond matures), I can buy a CDR, which will pay me in the event that Canada defaults. For investors, it can be a good way to hedge.

As is the nature of insurance, CDRs for certain bonds are costlier than others. To insure a Canadian bond would be cheap since the risk is minimal with Canada’s mature and reasonably well to do economy. Insuring a bond from some tumultuous nation with a weak economy will cost a good deal. This is why the cost of a CDR is how some people measure economic strength.

Unlike most forms of insurance, you aren’t required to own the underlying asset. For example, if I believe that Canada will default on its debt; I can buy a CDR and profit if Canada defaults. Unlike my first example, this situation doesn’t involve burning money on the bonds themselves, which makes the whole ordeal more profitable. These are called “naked” swaps.

The best way for me to articulate how demented the concept of “naked” swaps are is to give a little hypothetical. Imagine that you were never required to own underlying assets for any form of insurance. People could speculate about everything. I hear there’s a hurricane coming to Louisiana; I’m going to buy flood insurance for thousands of homes in New Orleans. I could buy insurance for every Asian woman’s’ car in the US. Geico commercials instead of selling you on the idea of saving money would have that annoying little lizard saying, “Buy ‘teenagers in sports cars’ insurance right here.” I could go and buy life insurance policies for nearly dead people. (Although that is sort of happening already.)

The major consequence of my hypothetical is that it would make insurance too expensive. Speculation about the quality of Asian women drivers would price them off the road. Speculation about flooding in New Orleans would price people out of their homes. Buying insurance for things you don’t own isn’t insurance. It’s gambling, which is a perfectly fine activity, but it isn’t something financial intermediaries should be involved with.

CDRs are one of the major reasons for AIG’s collapse, “The credit default swaps on this kind of CDO account for the lion's share of AIG's problems with default insurance.” If AIG wants to sell CDRs they should be able to, but just like Geico and every other insurance company, AIG should have to make sure people actually own the assets they’re insuring before they sell it to them.