Philadelphia Reflections

The musings of a physician who has served the community for over six decades

Related Topics

Dislocations: Financial and Fundamental
The crash of 2007 was more than a bank panic. Thirty years of excessive borrowing had reached a point where something was certain to topple it. Alan Greenspan deplored "irrational exuberance" in 1996, but only in 2007 did everybody try to get out the door at the same time. The crash announced the switch to deleveraging, it did not cause it.

Whither, Federal Reserve? (2)After Our Crash
Whither, Federal Reserve? (2)


American Stock Market

Novation is a term that perhaps nobody but a specialist expert can now define, but is nevertheless destined to be politicized in the coming election campaign to the point where almost everybody could be shouting it like a war cry. That is unless the hired political consultants decide some other feature of credit derivatives serves warcry purposes better. We're talking sixty trillion dollars here, about five times the size of the domestic American stock market.

Someone owned or thought he owned pieces of paper worth this staggering sum, which can be regarded as side bets on the bond market. Just as in a horse race, where you don't usually own the horse when you bet on the winner, you needn't own the bonds to bet on whether they will default. The side bet is often between two outsiders who acquired their bets through, well, novation. The process begins as a credit derivative, in which someone gets paid an annual sum in return for agreeing to pay off -- if the bond defaults. That could be regarded as a useful insurance policy, making more credit available by making it safer to buy bonds. The bondholder gives up a little interest in return for assurance the bond is now completely safe. Sucker.

Sun Belt Mortgage

Like the Sun Belt mortgage originator, the originators of these derivatives often wasted little time clipping off a fee and passing the carcass to someone else. And that process got repeated until the accumulating fees in the chain slowed the process to a point where the weakest or most reckless holder got into danger. The game might have slowed to the point where it became self-correcting, but what actually seems to have happened is that much of the long-term debt involved was financed by short-term borrowing, and the start of some rumors triggered a run on the bank. Not exactly, of course, but when institutions which had made one-week or one-month loans stopped lending, it only took a few days for the money to run out and Bear Stearns was quickly unable to pay its bills even though it started the week with $18 billion in reserves.

Securities and Exchange Commission

That short description is about the best that can be made out of an opaque situation, based on what the Securities and Exchange Commission is willing to tell reporters about its investigation. More will be forthcoming, and no doubt some villains and fools will emerge with a lot of blame. For example, the price of credit derivatives concerning Bear Stearns debt had been creeping up steadily during the month before the explosion; whether somebody knew something bad, or whether there really was something bad is presently unclear. It's disconcerting to learn that Goldman Sachs was dumping this paper, and JP Morgan Chase was mostly buying it, but it's early days for unfounded suspicions. More will come.

Now to return to novation. We legal novices learn that novation transfer is the same as assignment transfer, except all parties have to agree to novation before it can take place. That's going to make it harder for a lot of people to deny they knew what was happening. The astonishingly large sums involved are apparently not entirely real, because in some way the old debt is not extinguished, and the new debt is merely added to the sum total outstanding. That surely means the same debt is counted several times, and the apparent sum is to some unknowable extent much larger than the underlying reality. This also accounts for the amazing speed of growth. In January 2007 the total was said to be about $25 trillion, in January 2008 it was reported to be $42 trillion, and in May 2008 it was said to be $60 trillion. Things which move that fast can quickly spin out of control, especially when short term creditors need to do nothing much for a couple of weeks as their money emerges from the pool. Some people did sell short, of course, but whether that was panic or malicious must probably be left to politicians to declaim.

Surely the most terrifying part of this simple story is that so much money could be moved around without public awareness. When the $25 trillion figure emerged, a number of people asked what in the world was going on, and kept asking that question for eighteen months. Nobody knew nothing.

Originally published: Wednesday, May 28, 2008; most-recently modified: Sunday, July 21, 2019