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Case Schiller real estate index at the Chicago Mercantile Exchange is a way to short the real estate market on a regulated exchange.

electronically traded as well.

Dr. Akhilesh Bajaj

Not to mention the obvious: speculators increase capital and help stabilize prices in a market.


You ignore the situation alleged by the SEC, in which the "speculator" stacks the deck by creating a CDO expressly designed to fail, sells it to unwitting investors who rely on the bogus analysis of one of the corrupt rating agencies, and obtains credit default swaps which pay off big time when the CDO tanks as planned. I'd say that's a mighty good reason to dislike "speculators," although once the fix is in it's hardly correct to call them "speculators."

Michael F. Martin

This is all correct as far as it goes. Problems develop, however, when the volume of sales of the underlying asset outstrips the volume of sales of insurance against its declines in value -- as indeed the volume of sales of CDOs (and CDO^2s) did outstrip the volume of CDSs, which didn't exist until late in the game.

Within particular markets -- such as particular currency or commodity exchanges -- there seems to be an appreciation for the need to balance the positive and negative feedback loops that may develop through the unpaired sale of asset bundles and insurance. In other markets, growth goes unchecked -- benefiting ultimately only the croupiers who take transactions costs regardless of the outcomes. Are not these market makers the ones in the best position to keep growth within bounds sustainable by underlying fundamentals? If not, who is better positioned?

It's interesting to note that the CDS side of the deals in the housing market could never have developed into a positive feedback loop as did the CDOs. At some point, insurance gets so expensive that it wipes out any marginal present value to the insured asset. This is a general characteristic of feedback: negative feedback is stable; positive unstable.

The other problem is that the parties and counterparties to transactions in a given market are often also parties and counterparties to transactions in many other markets. The development of positive feedback loops in one market may then trigger cascading failures throughout the system. Given the incredibly abrupt transition in LIBOR rates in the fall of 2008, it seems unlikely that many, if not most major financial institutions worldwide were unaware of the unsustainability of credit derivatives in the U.S. housing market. What nobody expected -- because nobody had access to the information to see -- was how an ensuing credit market seizure would trigger cascading defaults that ended with Iceland going up in smoke.

Rick Bookstaber's testimony to the Senate gives some insight into how the crisis transpired for risk managers.



Could someone please explain to me if this is right:

"...because the direction of those prices—up or down—WOULD AFFECT the default rate on the mortgages in which the buyers of the securities were investing indirectly."

Sorry if I was wrong. But shouldn't it be "would be affected by"?


Oh, I got it wrong.


I agree with Martin: this is good first-pass theory but ignores the dangerous feedback loops. In particular, Yves Smith argues, about the senior/super senior CDO tranches, the regulatory arbitrage (negative basis trade) allowed or promoted the yield-seeking CDS sellers to leverage their bet many times over. This "over supply" of credit protection kept synthetic spreads artificially low for too long. In turn, feeding back to keep cash bond spreads low. On this theory, CDS instruments actually exacerbate the problem as the synthetic spread has feedback on the cash


"As an alternative to short selling, you can buy a credit default swap, which is a form of insurance on debt—not necessarily your own debt. If there is a bond that you expect to go into default (it might be a bond backed by a collection of mortgages), you can buy insurance against the resulting loss in the bond’s value. So if there is a default, the issuer of the credit default swap pays you, and so you gain just as the short seller gains when the price of the stock or bond that he’s shorted falls."

............. Indeed! And with economists and savvy traders knowing of all these means of hedging more is the "mystery" that so few did. AIG, the biggest insurance company with legions of underwriters becoming the biggest bagholder for the garbage packaged up and sold by Goldman and many others for a decade?

How did they miss:

A run up in housing prices that took median home prices well out of the traditional ratio of median income to median home prices?


Advertising for nearly a decade for NINJA loans, No Docs, No credit no problem, no down, and a host of "investor loans" that created a shadow inventory as builders sold to non-occupants and went back to their banks who gleefully funded another batch of starts?

And one other fairly obvious sign few seem to mention even today; the ratio of home prices to rents. In many areas the carry costs of a home was several times the rent it would command. Another trap for those whose job changed, or they couldn't sell, that rents would not begin to cover mortgage payments.

As Posner says, "shorting is risky" and a shortie would have to get both the direction and timing right, where were the prudent captains of risk capital who should have been leaving the table? Well we know the answer to that; playing for bonuses with no concern for the capital under their control. I'm CERTAIN that many knew the end was in sight, but who is going to short tulips or dot coms or even leave the table when the bulls are running mad?

A reminder! One of the most important principles of capitalism is that of directing capital and scarce resources to their highest and best use to increase the standard of living. For having garnered 30% of all the profits of the US in recent years for the "product" of having sold off many of our jobs even before the mortgage meltdown it seems precious few of them should ever direct capital again and while it may be difficult to prove a Ponzi intent, many should be sued in civil court and some should spend some jail time


There is nothing wrong with derivatives as long as they are traded on an exchange where they are priced appropriately by market forces, where counterparty risk is mitigated by the clearing house, and most importantly where adequate collateral is required. However, there most certainly is a problem when the derivatives are private, unregulated deals between banks and hedge funds. As we have seen, these weapons of financial descruction can lead to bank insolvency and seizing up of the financial system, which caused the Great Recession. Such derivatives serve no useful societal function. They are gambling instruments that should be outlawed.


Yields-to-maturity rise when bond prices fall because the two have an inverse relationship. Lower bond prices mean that the bond needs to appreciate more in order to eventually be worth its face value upon maturity - its yield to maturity must rise. This is the bond yield which is commonly used and compared across bonds.

The yield you mention is the current yield - coupon payment/current bond price.


Speculation and the Econ. Crisis? As the old saying goes, "They don't call it Speculation for nothing". You put your money down (or someone elses if you happen to be a financial institution) and you take your chances. Unless, you happen to be the likes of Goldman Sachs and others, operating in the dark and on insider information deep within the Dark Derivatives Market, creating wonderful "pigs in a poke" and then betting on their failure.

Undoubtedly, the Crisis was created and deepened by the lack of regulatory oversite, lack of openess in the creation of these "exotic" instruments, and the lack of training and understanding of finacial experts and buyers and sellers who knew much less than what exactly they were buying and selling to each other. Except for the insiders of the "Black Finacial System" who stood to profit by deceit and fraud.

Perhaps, we've returned to commonsense form of investment based on the following principles:

1. Never put much faith in a Bank or Financial Institution
2. Think twice before buying any complicated finacial product
3. Be wary, very wary, before investing in something that doesn't make much sense.
4. When in doubt, ask the seller if they have got their money invested and how much?

Remember "cavaet emptor", or "of course we're no longer the liars, cheats, thieves, frauds and scroundels we once were. Of course we can be trusted"!


Pentagron: I'm wondering if derivatives deserve any place in our financial sector and especially not in simple mortgage backed securities.

Consider, the objective of mortgage lending is the prudent lending of the small savings of many to those needing to borrow to buy a home.

In the much simpler past we've had "private mortgage insurance" which allocates the risk on the first 20% of a mortgage at a higher premium to cover the added risk. We've also had 80/10 mortgages with low fixed rates for the 80% and a higher rate for the 10% 2nd.

Also there has long been a futures market for those wishing to gamble on the direction of interest rates on Ginnies and other mortgage products. It's good for us to remember that those taking high risks for higher short term rewards don't come out much better (if at all) than those taking prudent man risks at lower rates.

So why even tolerate cumbersome and complex derivatives that actually have the effect of dicing up a consumer's mortgage in a manner that there exists no actual lender who can make a decision when a borrower is in trouble. This mess means many in the small trouble of a job change or perhaps a bout with our medical insurance system may be as likely to be clobbered with a foreclosure action as one who's hopelessly in big trouble.

One thing is certain! That no matter what the gambles are called, there is no way that "loaning" at 30 times assets on a "sure thing" like ever accelerating home prices will stand up to even the slightest breeze of an ill wind.

We've experienced nearly two generations now of money growing on homes in all but the areas of declining population, which is not the historical norm. Homes are typically built on land worth 1/5 of the the sale price and the home representing 80% of the cost depreciates of time while the desirable land in successful developments tends to appreciate.

We've added a huge distortion to housing, first by making interest a deductible expense, which wasn't so bad when it was difficult to refinance a home and loans were held until sale or retirement -- with a ONE time, over 55 exemption for the accrued capital gain.

We've made it more of a mess by making refi's simple and creating an "investment" in which interest is deductible and capital gains not taxes at all.

That distortion in housing has cost us not only in housing, but as a whole generation has come to think that their best investment is in a bigger and more costly home of more interest deductions and a bigger payoff in tax-free capital gains. Naturally, traditional savings and investment in American business has suffered as more capital became tied up in housing -- with much of it disappearing today.

"When homeowners sell their main home, they can exclude up to $500,000 in capital gains from income tax. The Housing Assistance Tax Act of 2008 changes the rules. The amount of profits from the sale of a house that can be excluded is now based on the percentage of time when the house was used as a primary residence."

And "Even better, there's no limit on the number of times you can use the home-sale exemption. In most cases, you can make tax-free profits of $250,000 (or $500,000 depending on your filing status) every time you sell a home."

Is this the kind of non-productive speculation we should incentivise? Perhaps we should go back to the pre-1997 world in which interest was still deductible, but the cap gains exemption was a once in a lifetime benefit at over 55? And later on rolling back some of that deductibility with the incentive going more to business investment and risk capital for start-ups?


I agree with Jack that the duductibility of mortgage interest is grossly unfair to renters. And, the tax exemption on capital gains when houses are flipped could very well have been a factor fueling the inflation of the housing bubble.

Chris Graves

While I agree with the general economic analysis that Judge Posner and Professor Becker outline as a rationale for market speculation in real commodities, I disagree that various forms of financial derivatives follow exactly the same principles. The key difference is that the creation of credit by central banks is not tied to any real production of anything. Without some sort of standard such as a monetary rule or the Gold Standard, credit creation is simply a slight of hand engaged in at will by a monetary authority that can then act to create confusion in the marketplace. When the money supply increases beyond the current productive capacities of the economy, prices are distorted so that entrepreneurs, investors, and consumers are misled into overinvesting and overconsumption that, at some point, will be reigned in by the reality of a lack of real wealth to sustain these excesses.

As Judge Posner observes: "As an alternative to short selling, you can buy a credit default swap, which is a form of insurance on debt—not necessarily your own debt. If there is a bond that you expect to go into default (it might be a bond backed by a collection of mortgages), you can buy insurance against the resulting loss in the bond’s value. So if there is a default, the issuer of the credit default swap pays you, and so you gain just as the short seller gains when the price of the stock or bond that he’s shorted falls."

The problem here is that since this type of financial contract insulates the party who is extending credit, this process might very well serve to act as an accelerator on increasing credit in times of expansionary monetary policy. The problem here is one of moral hazard. If people are shielded from the negative effects of carelessly extending credit, then credit will expand even more, thereby exacerbating the distortive effects of inflation. The unsustainable boom will be even greater followed by a subsequently greater depression to correct for the inflationary boom.

Financial derivatives are the natural outgrowth of discretionary Keynesian monetary policy. People are reasonably trying to hedge against an uncertain future since no one knows what to expect from the monetary authority. Artificial credit expansion breeds these sort of derivatives, which in turn, fuels even greater and more irresponsible growth in credit. When we become unmoored from Say's Law and do not allow the market to constantly maintain a balance in all sectors of the economy, including allowing the market determined interest rate to equilibrate savings and investment, then bubbles and their bursting, with all that entails, are bound to occur.


Chris: You seem to be trying to shoot a few arrows into the heart of the Fed instead of nearer the source of the current mess.

If the Fed got the overall money supply wrong we should have seen inflation in areas other than the anomalies of medical care and "cost push" on products impacted by rapidly rising oil prices.

"When the money supply increases beyond the current productive capacities of the economy, prices are distorted so that entrepreneurs, investors, and consumers are misled into overinvesting and overconsumption that, at some point, will be reigned in by the reality of a lack of real wealth to sustain these excesses."

I and most would agree with the above, however the culprits were those, beginning at grassroots, fraudulently "creating value" via everything from phony appraisals, the income streams of the home buyers, and on up to Goldman and the rest who were "creating" money supply at 30 times underlying, and likely phony, assets. The became "the central banker" but only for housing, though, loose housing money did make it's way to the car lots and other sectors, via "profits" from house flipping and an unprecedented wave of "cash out refi's".

I'd have to disagree that derivatives are a "natural" outgrowth of anything, other than the schemes of those unwittingly or purposefully constructing the latest greatest Ponzi.

Looking back at what seemed to happen after we went off the gold standard (ha! when we could not own gold bullion or coins) with inflation and oil going through the roof, we might long for the good old days. But, it was a combo of WWII and Vietnam costs "hidden away" that made it impossible to maintain gold at $35/oz. In short going off the GS was a devaluation.

Do you recall those days of Bretton Woods with nations "being allowed" to "float" in certain ranges? and when they blew out of those ranges there'd be huffing and puffing, but they'd just change the ranges. Perhaps we're on the real gold standard today, as if your government pursues policies that weaken your currency you're free to exchange it for gold, and the gold bugs have done pretty well as the dollar has weakened in recent years.

Other than the housing mess, where are we after back to back deficits during the Bush administration, tax cuts for upper income folk that should spur demand?? combined with relatively low interest rates? Instead of the inflation many fear of too much money chasing too few goods, we're instead mired in a demand limited world of too few dollars chasing far too many goods.

Chris Graves

Jack, I agree that there was a lot more going on in the housing market bubble than the Fed artificially lowering the interest rate. I do not disagree with the thrust of what you have said about the problems in the housing market debacle. There was even more going on that we discussed when the bust occurred. But even then, the Fed policy did provide the necessary conditions for the bubble to materialize.

As for your comments about the nature of inflation, I too used to accept basically what you say about how inflation would show up. I think the experiences that we have had with the recessions of the early 1990's and ten years later preceding the near meltdown that we had a couple of years ago show that inflation can lead to bubbles that burst without much of a rise in the general price level accompanying the expansionary phase of the cycle. While it is true that disproportionate increases in the money supply can lead to a general rise in the price level, it need not do so. In these cases, inflation still can misdirect actors and resources in the economy. As F.A. Hayek argued against Monetarism, inflation's most insidious effect is to change relative prices that cannot be clearly distinguished from changes in relative prices simply due to market fluctuations. On Hayek's view, it is entirely possible for inflation to occur without a rise in the general price level. It is at these times that we are especially vulnerable to bubbles developing in particular markets.

So, simply stimulating demand in the aggregate too little or too much is not the main concern if we are interested in stable and sustained economic growth as much as it is preventing the distortions in the production process as well as misallocation of resources among various markets. These distortions that give rise to bubbles that by their very nature cannot be sustained are precipitated by the central bank tinkering with the supply of money. If the money supply grows at predictable rates, then the price system is more likely to send reliable information to producers and to consumers about which goods and services are needed coupled with information about their continued availability.

Every indication is that we are now re-inflating the economy creating new bubbles that will later pop. It also appears that the same derivatives are providing a similar multiplier effect to the money supply as happened in the last decade.

Josh Fulton


Sorry for going off-topic. I'd email this, but I don't see that contact info on the page.

I wrote an article I think you guys might be interested in. It's about Dodd's new financial regulation bill.





That may be so, but don't forget about all the unnecessary government spending that just dug this country further into the hole. It should also be noted that the unnecessary spending trend continues to this day: http://lawblog.legalmatch.com/2010/03/29/insurance-claims-in-the-obama-care-era/


Josh: It does seem Congress is on tenterhooks about REAL reform and one hopes the Dodd bill is the beginning of the debate. But! with the amount of lobbying money flooding into DC it may well take some demonstrations of public outrage before we'll see anything approaching the necessary reforms.

Norman: Many, as you seem to rue the NECESSARY government spending, rather than FAR more that was LOST in the private sector.

Just now the options are:

Extending and paying out gobs of unemployment, welfare, medical costs and having nothing to show for it but a downward spiral of what's left of our economy.

Or, some mixture of direct government employment, government incentives to rapidly gin up a new economy of energy conservation, alternatives, biotech? and public private investment in tackling a couple trillion of long delayed infrastructure maintenance and needed upgrades.

Both will result in huge deficits, while the latter will put something on the asset side of our national ledger and buy us time while we get our priorities straight and figure out what WE are going to sell to an ever more competitive world of slave labor and criminal working conditions.


As for all of the "unnecessary" spending the Federal Government has authorized as of late; I take it that includes the massive expendidtures for the War on Terror, the massive expenditures on finanacial and corporate bailouts that saved the Economy and us from a greater depression than the Great Depression. Or the extension of unemployment comp. and Cobra Health Ins. to the undeserving who were terminated in this "Great Depression/Recession". While we're at it, let's not talk about unnecessary Revenue that was eliminated by tax cuts for the upper ten percent income brackets and various corporations. Or the elimination of tariffs and duties on artificially cheap products from overseas that has torpedoed our productive capacity and our ability to raise taxes and hence revenue.

What are you guys trying to do, destroy the Nation?


NEH.... and the tax deductibility of mortgage interest accompanied by no taxation of the capital gain which is another benefit that accrues largely to upper income folk and reduces the revenue we have for paying our bills.

Chris: I think we have to completely throw out the Great Housing Ponzi of the last decade as an example of anything other than another reminder of the need for keeping our fences repaired when hoards of clever cattle thieves are on the prowl. We saw the very same scam when S&L's were "deregged" and small town bankers quickly became big time gunslingers backed by the FSLIC. I'm not sure if Jesus was the first to see the need to turn over the tables of the moneychangers in the temple but the history of scammers surely goes back even further.

If someone is telling you that low interest rates were the cause of the entire banking system becoming corrupt, I'd check to see if they're shilling for 'em.

As for the over concern of inflation, let's consider the capital that was wiped out in 1999 with the collapse of not only the "dot.coms" but the entire stock market, and the even larger losses of the recent mess.

Further, you don't have to look very far to see the severe restraints on lending on most businesses as well as many of those trying to buy a home today.

How about at least a few years of full employment, with our "factories" running at 90% of capacity and working folk able to make gains in income, and interest rates creeping upwards because there ARE productive uses for capital before standing on the brakes?

My guess is that the unusually high rate of employment during the 90's, combined with productivity increases and the infinite supply of labor in the world that it's unlikely that we could create inflation with our best efforts, though the massive spending needed to revive this dog could result in lowering the value of the dollar -- about our just due for a host of poor policies of opening our huge consumer market to the world without assurance they'd play fair or increase the miserable living standards of their people. Giving China permanent MFN status serves as a case in point.

Chris Graves

Jack, the entire fractional reserve banking system could be considered a Ponzi scheme. What is necessary to keep it from going completely haywire and taking down the entire financial foundation of our economy are some constraints on how much financial institutions can expand the money supply.

As for the 1990's high rate of employment, much of the real gains in those years were built by allowing a greater role for the market to allocate resources resulting from the policies of deregulation and lower taxes pursued by the Reagan years along with the entrepreneurial ethos that Reagan encouraged that had become dormant due to the New Deal regulations and attitudes it spawned. But, I am sorry to say, that much of the economic growth of those years was predicated on the same easy money policy that characterized Alan Greenspan's Modus Operandi when he served as chairman of the Fed leading to the corrections that you deplore, such as the dotcom bubble bursting. The problem is not so much that the capital was wiped out in these busts, but that adequate capital was not there in the first place to sustain these periods of growth. Simply stimulating aggregate demand without the necessary capital to continue funding projects leads to these booms and subsequent busts.

Here is a link to a summary of Hayek's theory of the business cycle written by contemporary economist Roger Garrison that might clarify my analysis here:



Chris: Well, it looks as though Hayek was catching on, but still suffering from the over-reaction to the hyper inflation in Germany during the 20's which still influences there economic policies to this very day. They must hate being in bed with Greece!

The most intractable problem of all the problems of capitalism is that of it being a 9 seat lifeboat for a crew of ten... with one having to be willing to be in the water to make it work for the other nine. Be it Hayek's "natural" auto-pilot or a central bank, there is always going to be the problem of dialing in a capitalism that allows most of us to contribute via productive employment without "overheating" the economy or eroding the value of the dollar and the savings of those saving in dollars.

So, what is the history of the Fed and its biases and errors? Since it IS staffed entirely by bankers, with no representatives of labor, the bias has been largely in favor of protecting capital at the expense of labor.

Leaving out their foolish response to an external increase in the price of oil in the 70's that should have been allowed to just work its way through the economy, as "inflation" and thus creating "stagflation" the most likely thing to set them to jacking up the cost of money is that of low unemployment and may god forbid, any increases in middle and low income wages.

In an era of static productivity, of course, increases in wages would be as fruitless as many misguided "conservatives" like to claim today. But! productivity is not static, so higher incomes for working folk would simple indicate they too were sharing in the increased productivity of which they surely played a strong role. Further, while increases in wages for those engaged in inherently labor intensive enterprises, may run the risk of seeing those jobs "offshored" for the most part our creative genius responds to higher labor costs with yet higher productivity.

If we feared increased productivity (as seems something of the case today) would result in massive unemployment it seems all we'd have to do is look back as 90% of those once engaged in farming were "forced" (drawn?) off the land for better and more productive jobs building machines, electronics and such never envisioned while manually tilling the land.

It's all far more complex than when Hayek was theorizing, and one thing is certain, that as all these nations relate more closely in a vast economy that weird harmonics will result in more world-wide tidal waves and require more man-made shock absorbers than ever.

The question of the day, might well be whether the Fed has enough power rather than too much power. For example if interest is "too high" in the US might companies more easily raise capital abroad either with bonding or stock sales? In this recent mess I doubt that any reasonable tightening by the Fed would have counter balanced the creation of "capital" out of fraudulent underwriting greatly amplified by tremendous leverage.

"An artificial boom is an instance in which the change in the interest-rate signal and the change in resource availabilities are at odds with one another. If the central bank pads the supply of loanable funds with newly created money, the interest rate is lowered just as it is with an increase in saving. But in the absence of an actual change in time preferences, no additional resources for sustaining the policy-induced boom are freed up. In fact, facing a lower interest rate, people will save less and spend more on current consumables. The central bank’s credit expansion, then, results in an incompatible mix of market forces."

As for "nonexistent capital" sure we've seen some examples of that sort of bubble, but to a major extent "capital" and "labor" are interchangeable. For example were 10 million unemployeds working at productive endeavors for $50k each, that's $500 billion of primary economic activity. "Capital" will be created!

But now? The Fed is out of tools, so it's deficits, deficits and deficits whether you want them to come from unemployment costs and low revenue or from direct employment and government incentives plus whatever can come from the private sector to get folks working again.

I doubt that Hayek could offer a solution nor could his theories could have prevented the Great Bank Heist of the early 2000's.

Chris Graves

Thanks for your comments, Jack. Briefly, three things to keep in mind on these controversies we are touching on here:

1. On Hayek's view, the economy, in his time and in ours, is too complex for any one mind, apart from God, to take in and process. That is one big reason why a central bank should not attempt to respond to the immediate flux of circumstances with changeable monetary policy. There is no way to accurately anticipate all of the responses in the marketplace to alternating policy. Such changeable policy also can confuse market players since they are groping for relevant information as are policy-makers. The difference between the actors in the market and policy-makers such as the Chairman of the Fed is that those in the market do not have to see the big picture to make, at least, satisficing decisions for the resources for which they bear responsibility, whereas policy-makers must make Olympian decisions with very fragmentary information about the entire system. So, if things are more complex now, which I agree that they are, then Hayek's analysis is even more applicable.

2. Even if fraud and other shady practices occur in the banking system, they are not as likely to be threatening to the entire monetary system unless the central bank enabled them to expand credit excessively. The artificially lower interest rate loosens constraints on everyone who is involved in the process including both those extending credit as well as those borrowing. The sub-prime bubble of the past decade was accurately identified and the bust was predicted accurately by contemporary economists using Hayek's theory.

3. Keynes and Monetarists both lack a clearly developed theory of capital. Keynes simply did not see the need to raise and sustain the figurative capital fund.


Chris, As for Keynes on Capital, "Au Contrere". As for Hayek and the Austrian School with it's deification of Mises (who happens to be sixty years behind the times and functioning as if nothing has changed) are sounding a bit like a broken record (or are we practicing propagnda here, "if you repeat something long enough it'll become truth" better known as the big lie).

Perhaps a better starting point would be, "Comments on Hayek and Keynes on Capital" by G.R.Steele, out of the University College, London.

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