December 03, 2009

I may not like Bernanke but I like the R's even less

I'm watching the super fun Senate confirmation hearing for Fed Chair Ben Bernanke. Aside from the par payouts on the CDS (Credit Default Swaps) written by AIG (many of which were lottery tickets), he's done a decent job or, at least, as decent a job as anyone could have done. The reality is that many of the problems we faced were created by Congress, not the Fed and certainly not Bernanke. That's not to say he didn't screw up or that mistakes weren't made. However, all things being equal, we aren't in the middle of a depression and that's what we were looking at a little over a year ago.

Watching Senators Bunning and Bennett (R-UT) pontificate makes me actually like Bernanke. First off, there's Bennett whining about inflation and 'Carter's inflation' in the 1970's that finally ended thanks to Paul Volcker and President Reagan. Of course, Sen. Bennett's kind of a moron. He didn't realize that it was actually President Nixon, through his control of then Fed Chair Arthur Burns who kept expansionary monetary policy in place despite pressures that were clearly building in the economy. And it was Carter's appointee to the Chair, Paul Volcker, who broke inflation, not President Reagan. Reagan's policies had absolutely nothing to do with it.

Then there's Senator Bunning. Bunning was pissed about the par payouts on the CDS contracts without even understand the terms of those contracts which really is the far bigger issue. As for the payout, Bernanke's hands actually were tied... the only way to renegotiate the payout on the contracts would have been for AIG to go into bankruptcy. Given the aftershocks of Lehman (a total freeze of the credit markets and the complete breakdown of structure finance, eliminating more than $5 trillion from the US banking system), that was wholly undesirable. If the contracts hadn't been paid at par, the creditors would have forced AIG into bankruptcy and the result would have been disaster.

That ain't the whole story, though. These contracts weren't just insurance policies (that's basically what CDS is... it's an insurance policy against risk of economic loss or to cover event risk), they were also lottery tickets. For example, with most types of insurance, the policy is for the full value of the property covered (either cash or replacement cost) or limited by a set coverage amount. That's the maximum the company will pay in the event of a full loss. However, insurers only actually pay (in property settlements) ACTUAL loss. With CDS, especially some of the crap contracts written by AIG, they were set to pay off the entire contract value, not just the actual loss. So, if Goldman Sachs had a swap contract in effect with AIG covering a Collateralized Debt Obligation (CDO) the payout trigger might be a default rate of 15% on the CDO. But, the swap didn't pay off to cover the 15% loss, it paid out the full PAR value of the CDO, even though it was worth significantly less than par.

It's equivalent to me insuring my house for $280,000. Then, if there's a minor fire in the kitchen, instead of paying to repair the damage, they just cut me a check for $280,000 and then they own the house which, watch out, was only worth $100k.

THAT'S what Bunning should have been pissed about, the fact that those contracts were honored at all even though they were clearly fraudulent since I'm sure the valuations were based on representations and warranties made by the insured. If they'd been attacked that way, the court could have issued a temporary restraining order prohibiting the counterparties (Goldman Sachs, for example) from collecting or forcing any payment. Then we could have broken it all apart.

So, yeah, instead of focusing on bullshit, how about looking at the really bad stuff, Senators?

Posted by mcblogger at December 3, 2009 01:07 PM

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