Monday, October 20, 2008

Those Dirty "D" Words

Deflation is finally making its way into the popular media, as this editorial from the New York Times clearly shows ("The Bubble Keeps On Deflating"). After mentioning the obvious trouble in the real estate sector, the article focuses mostly on the likelihood of a rising tide in corporate bankruptcies, caused by past credit excesses, e.g. cheap and dirty loans for buyouts by private equity funds (a particular pet peeve of yours truly). There is even note of complicating factors like credit default swaps (CDS) - another item very often examined in this blog.

As the editorial points out, so far there have been few major corporate bankruptcies. The question is, however, what happens if (or more likely, when) failures start to increase rapidly. Will the CDS market be able to absorb the shocks and act as a crisis attenuator, as its adherents claimed not long ago? After all, they had piled on trillion upon trillion of unregulated credit insurance, betting heavily on continued sunny credit weather.

Or will CDSs instead become amplifiers of trouble?

Defaults may very well swamp the CDS market and create a negative amplification effect, multiplying several-fold the losses sustained by the financial system. One single corporate bankruptcy can cause many more losses than the amount of its entire debt outstanding, as multiple CDS dominoes fall and cascade through all those who issued them with abandon.

Governments and regulators are ill-equipped to handle what is happening, hampered as they are with imperfect understanding and lack of relevant experience. So, they just do what they have always done: throw money (ours) into the problem, inadvertently feeding more fuel into a growing credit fire that requires debt cancellation "water", and not additional debt "oil".

Paraphrasing the fictional Gordon Gekko, "Deflation and default are good".
Update on CDS

Today (10/21) is the day of reckoning for Lehman's CDS settlements. Some $400 billion notional is said to be at stake and we'll soon know (?) who's holding the bag. Other than AIG, who wrote credit insurance on anything that fogged the mirror and has already choked on it, several formerly high-flying hedge funds are also said to be on the hook...

This is only the first major bankruptcy and the market seems to have already dealt with it, even breathing a (temporary?) sigh of relief. I'm not sure it will do so with the next one, though...


  1. Isn't throwing our money at the system going to re-inflate the bubble, at least for awhile?

  2. "Debt cancellation"? Whose debt or all debts?

    Sorry Hell, appreciate you opinions a great deal, and do not see an optional "out" of this mess we are (and are sinking deeper), but debt cancellation would work like a monkey wrench thrown into the gears of the economy. The machine would break down and stop.

  3. Throw the monkey wrench in the machine now, or watch as the machine slowly fizzles out of energy. Either way the end result is the same. Devolution.

    America is insolvent, it's economic system is broken. I think we should start looking at other options while we have time.

    One vote for Hell's "Greenback".

  4. Why not regulate away all this CDS speculation? The language of the term sheet gives the seller of protection the ability to offer the underlying or cash, allowing naked CDS. If the wager component of this product is removed, you'll have a market that is sized proportional to the size of the bond market. I can see problems with Sovereigns but would appreciate feedback if I'm being a bit blasé.


  5. “In the long run, Americans will always do the right thing-after exploring all other alternatives,” Winston Churchill famously said during Word War II, as Americans still were debating whether or not to enter the European war theater.

  6. I would say amplifier is the operative word. Look at VIX, straight line up and oscillating wildly.

    This is akin to a system running at 100%, then going into thermal runaway and ultimately lock up/seizure.

    That is where this whole financial system is headed.

    Joe M.

  7. Hey how about that GM/Chrysler merger.... Thats like combining a mimeograph machine with a teletype machine. Sounds like a great idea, I can't wait to buy some stock in the combined company.


  8. CDS Force Majeure anyone?

    After January.

  9. RE: "...One single corporate bankruptcy can cause many more losses than the amount of its entire debt outstanding, as multiple CDS dominoes fall and cascade through all those who issued them with abandon..."

    Spanky Paulson and his band of merry scumbags are trying very hard to NOT let this happen...I guess until they are all safely living on some island off the coast of Panama or something.

    They've learned their lesson w/Lehman. These fraudsters will lie, steal obfuscate, dissemble---probably do ever worse things that we only see in movies like THE GODFATHER---to make sure that the dominoes don't start tipping....yet.

    As for the CDS fiasco, if Paulson and his band of merry fascists can keep the lid on the cauldron---by propping up fraudulent institutions through the use of OUR money whilst all the while telling us and our KNOW-NOTHING legislature that this is for OUR good---then maybe, in the short term, he and his criminal uber-boss George Bush can claim to have brought stability back to the economy.

    Eventually, of course, the lid has to be blown off this puppy. At some point it simply becomes impossible to hide 50+ Trillion dollars worth of bad paper---I mean shit, we'd have to create 4-5 QUADrillion dollars in new debt just to have enough in the way of mythical assets to cover all of the counterparty risk involved here.

    They really are scumbags, y'know.

  10. Hellasious:

    I'm a college professor and have put together a blogbook called "Cause for Depression" at
    It's got lots and lots of charts, some from your site.

    The project is deeply indebted to your instruction over the past two years. Thanks much for that. Anyway, do please check it out.


  11. "I guess until they are all safely living on some island off the coast of Panama or something."

    They will not be safe this time around. They are this epoch's Nazi war criminals.

    In the meantime, the good ship lollipop, that would
    be the U.S. economy and the U.S. government, will not survive this period intact. Many folks think this episode is on a par with the Great Depression, or perhaps, as I do, even the Panic of the 1870s. Well, while both busts, particularly the latter, are instructive to a greater or lesser degree, it is far more likely that we are now experiencing the effects of the end of a cycle that is of even greater magnitude than the cycles that brought us The Great Depression and The Panic of the 1870s. Ponder that.

  12. Since I don't have your economic culture, and will probably die before I have the time to acquire it (but then again, maybe it will become superfluous in a very short time...)

    Travaux pratiques :


    Unbelievable. What is even more unbelievable is that you can find ANYTHING in a thrift store in the U.S. these days :
    Calvin Klein jeans next to Wall Mart specials.
    With little difference in price. Beautiful heirloom commodes next to Wall Mart specials, too.

    This kind of blew me away in Paris two weeks ago : a coat made by a well known Parisian designer selling for a ludicrously cheap price in a shopping area where you could find cheap articles right next to it.
    And 80% wool coats sold for $30 or so. (Made in Thailand)

    That made me feel rotten, like, how are our children going to be able to tell the difference between what is valuable and what is not in all this glut of often worthless things ?

    Sorry, my philosophy is all I can bring to this blog.

  13. Edwardo said... "They are this epoch's Nazi war criminals"

    A little melodramatic?

    I am not happy at all with what happened but at some level what these people have done is no different than what most Americans do on an almost daily basis when they so casually squander resource which seem small to them as a % of their own net worth or as a % of the economic decisions they make. People often forget how richer they are than 99% of the planet.

    $1,000,000 is only 1% to someone worth $100,000,000 or someone who makes economic decisions worth $100,000,000.

    Similarly $1,000 is 1% to someone worth $100,000 or someone making decisions worth $100,000 (which would be almost any mid level worker-manager and almost any small business in America FWIW).

    Yet $1000 is a fortune to many people on this planet.

    Life is fractal

  14. Sometimes being in debt can be an opportunity.