April 07, 2010
Links for 2010-04-07
A few items from the 'sphere that you might find interesting.
Correlation seeking. Alex Tabarrok notes a paper by Richard Squire that expands on the familiar idea that firms with more debt may be inclined to take more risk. Contingent debt, Squire argues, can induce management to seek assets whose negative outcomes occur in the firm's bankruptcy state. Squire writes:
Conduct that is consistent with correlation-seeking played a central role in the 2008 financial crisis, causing the deep losses suffered by the three firms to receive the biggest bailouts: AIG, Fannie Mae, and Freddie Mac. Yet current and proposed legal rules for derivatives and other contingent debt contracts ignore matters of correlation, increasing the risk of another financial crash in the future.
Fed's balance sheet. David Merkel has details of some of the AIG assets held by the Federal Reserve, though I don't share his assumption that the Fed didn't know they were getting junk.
Posted by James Hamilton at April 7, 2010 09:04 AMdigg this | reddit
Actually, the first linked post is by Alex Tabarrok, not his co-author, and well known bon-vivant, Tyler Cowen.
Posted by: Fat Man at April 7, 2010 09:31 AM
Fat Man: Thanks much. I've corrected the mistake above.
Posted by: JDH at April 7, 2010 09:42 AM
Didn't Minsky state the same thing 30 years ago?
Posted by: Adam at April 7, 2010 11:16 AM
I just read the Econ Browser Recession Indicator page on the side of this site. One graph shows that recessions become more likely in quarters where GDP falls. Really? A recession (a quarter where GDP falls according to your data link) is highly probable in the middle of a recession? I think there might be a flaw in that....
Posted by: Cassius at April 7, 2010 07:52 PM
Maybe I did not phrase it well, but the Fed certainly knew it was getting junk, but did not anticipate the deterioration. My own experience with junk-rated structured securities is that they almost always deteriorate rapidly. The rating agencies are slow, and so are prices.
They bought the bonds at a large discount to par. I am saying it was not a big enough discount.
Posted by: David Merkel at April 7, 2010 10:53 PM
The definition of a junk rating, per the rating agencies, is that it is highly unlikely that the principal will be paid back when the underlying bonds mature.
The Fed (to quote Ben) has characterized itself as the patient investor whom is willing to hold its investments until their eventual worth is realized in a stable market.
So in that context, anything paid for the "assets" in Maiden Lane amount to a cash gift to the sellers. (since my understanding is these were not taken as collateral against a Fed loan that comes due, in which case would be paid back provided the bank did not fail, but where instead outright purchases.)
Posted by: Cedric Regula at April 8, 2010 06:36 AM
Professor and David Merkel,
Thanks much for the information concerning the AIG paper purchased by the FED. Once again we see demonstrated how the government attemtps to mislead and hide their disasterous interventions.
I am surprised that the FED complied with the FOI. It seems that today the law only applies to those who are not politically connected.
Posted by: RicardoZ at April 8, 2010 07:32 AM