Stock Injection and the bailout

[David Farber <dave () farber net>]

Begin forwarded message:

From: Scott Alexander <salex () dsalex org>
Date: October 5, 2008 8:12:27 PM EDT
To: David Farber <dave () farber net>
Subject: Stock Injection and the bailout

I'd also like to suggest that people listen to the This American Life  
episode for this week ("365: Another Frightening Show About the  
Economy" http://www.thisamericanlife.org/Radio_Episode.aspx? 
episode=365).  As was mentioned on IP earlier this week, it gives a  
nice description of the stock injection approach that seems to have  
snuck into the law and that seems to provide better protection for the  
taxpayers instead of for Wall Street executives.

Additionally, it is the clearest description that I've heard of how  
CDSs work, why they became such a problem, and how that problem was  
the creation of a lightly regulated financial industry.  After  
listening tot he show, I've come away with the belief that the  
problems with poor mortgages (while bad enough on their own) were  
really only the thing that happened to bump into an elaborately  
leveraged network of trust relationships where no one was allowed to  
know anyone except their one hop neighbors.  Any of a number of bank  
failures or corporate failures could have equally produced the impetus  
to failure.

In particular, they explain that the original concept of a CDS was as  
an insurance policy.  Thus, if one held a bond, one could, for a  
percentage of the value of the bond, get a CDS that guaranteed to pay  
off the principal of the bond if the bond ended up in default.   
However, lack of regulation meant that 1) you didn't have to actually  
hold the bond to get a CDS (meaning that speculation became possible)  
and 2) to issue the CDS, you didn't have to have reserves sufficient  
to cover the payout if the bond defaulted.  This was combined with a  
system where company B would get a CDS from company A, say for 2%.  If  
the bond issuer suddenly seemed shakier, B would turn around and issue  
a CDS to C on the same bond for 4%.  B now believes that it is earning  
2% without needing to be concerned about paying off the CDS (since A  
will pay it in event of default).  However, if the bond goes into  
default and A is bankrupted (because it didn't have reserves to cover  
that outcome), then B may well also be forced into bankruptcy.

As someone who often listens to This American Life and enjoys its  
quirky style and finding unusual aspects of life to look at, I was  
surprised at how current and topical this episode was.

Best,
Scott Alexander





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