Online Futures Game

Playing this online futures game by CME.... You can simulate a speculator or hedger and try to make money. It is a very popular game apparently.

I played 15-20 times simulating a "speculator".



I was averaging $700-$900 when listening to the "news" of the game. When I turned the sound off, I was averaging $1500-$2000. That's interesting!

In defense of Securitization

Credit crisis is about to claim its latest victim: securitization. This mechanism is now blamed by some as one of the important causes of this crisis. Lately, America’s most influential economist, Paul Krugman, was very harsh on securitization and the government’s efforts to revive it. He noted that “Bear Stearns failed; Lehman failed; but most of all, securitization failed”. I believe Krugman is making a big mistake here.

There is no doubt that securitization has been an enabler for banks to take ever larger risks. Yet, securitization is just a tool, like many others. It brings benefits, but it has its costs and risks as well. Using securitization to add more leverage, the bank managements were missing the larger picture. Systemic risks posed by this mechanism were not understood, even when the individual portfolios of securitization products were risk managed in excruciating detail. There was very little questioning of the systemic risks! What would occur in a dynamic, interactive system when everyone follows the same strategy. What was the extent of liquidity? How could you take it granted that markets would trust the accounting of banking books ignoring market realities?

Such risks of systemic nature are not unique to securitization. Every financial product, every financial mechanism is subject to abuse and misuse. Even good regulatory systems are no guarantee of stability. Paths of financial crashes follow the same contours: ever increasing risk exposures in the face of diminishing margins, overcrowding and eventual collapse. Consider Iceland’s financial crash in late 2008, for example. That has been achieved thanks to no help from securitization markets. From Asian crisis, to 2000 tech crash, we observed the same: the rush of capital to an increasingly crowded, competitive market, followed by the inevitable flush. Just as it would have been wrong to stop globalization, to stop influx of money to internet ventures at those times, it is wrong at this time to stop the securitization engine.

Let’s remember that securitization was only one part of the credit bubble. Our credit risk taking was not limited subprime mortgages. It involved prime mortgages, commercial mortgages, company debts, levered buyouts and acquisitions that inflated the equity markets and a lot more. Even without securitization, we had reached to an over-levered financial system primed to burst in short order.

Let’s consider also what would happen if there were no securitization. A large part of the world lives under such constraints. Obtaining credit in such countries is difficult or impossible. Financing is largely done by individual savings. Getting a house, financing a new business venture is prohibitive. Existence of securitization in richer countries has benefited their borrowers.

Just to put a number on it, I have made some calculations. I have found some figures on the debt accumulation of households and non-financial corporations in United States. The data I found indicates $16 trillion cumulative borrowing by them since 1995 (approximately the point when securitization has accelerated). I assume 50% of this borrowing has benefited from securitization. Here is my critical assumption: I suppose these borrowers may have paid 2%-3% less on their loans they would have otherwise, thanks to securitization. Assuming 2.5% less interest rate on the loans for every year, I guesstimate the total reduction in interest paid by these borrowers might have added up to nearly $2 trillion. Credit crisis has been costly, but perhaps it has not yet erased all the savings achieved so far.

As usual, the story is a lot more complex than this simple calculation shows. Dismantling the securitization machine would not help us to prevent future bubbles and crashes. Instead, it is likely to make us poorer. We should focus instead on how to limit our systemic risks.

A Year after Bear Died

Bear Stearns died a year ago. Its stock was sold for $2 per share to JP Morgan. That was a shocking offer to market. We though the wires had a typo, they probably meant $20. A lot of wealth got destroyed, a lot of people got unemployed at that time. It was tragic!

Looking back, it seems naïve of us that we got shocked by what happened then. We lived up seeing much worse. Bear employees and stockholders actually got lucky in some ironic sense. $2 stock offer was raised to $10. Much better than $0 it would have reached otherwise. Most of the employees who were laid off found jobs elsewhere. The job market was not as bad at the time.

Still, it was not that hard to predict that economy and markets would get worse. Despite the two month long rally following the Bear’s fold into JP Morgan’s hands, this was a clear sign that the credit crisis had gotten to a new stage. Already, the government was the only hope, only reasonable solution out of this crisis. Over those months, many financial firms resorted to distortions to minimize their damage. History showed that a financial crisis was always costly, very costly.

Yet, things could have turned around by the end of 2008. It was not certain but possible. Paulson committed huge mistakes in September 2008. His mistakes were avoidable. He saved Bear Stearns because it was a system-critical player and then he let Lehman go bankrupt. Even though Lehman was several times more inter-connected or critical than Bear, he did not seem to have the wisdom or courage to do the same for Lehman.

I was surprised at that time not so much by Lehman’s bankruptcy but by the inaction of the US government. They did not seem to have a plan ready to put to action. Everyone knew after Bear Stearns, Lehman was next. Fed knew it! They asked even hedge funds about their exposure to Bear Stearns *and* Lehman Brothers in March 2008. Six months is plenty time to develop contingency plans.

Perhaps, you could say, the government was indeed prepared. Let Lehman die, but save AIG. Either there was no plan, no preparation or this indeed was the plan itself.

Credit Investments of Warren Buffett

What is the greatest investor doing in this credit crisis? He is spending most of his cash on corporate debt or preferred stock. We don’t see him making large company acquisitions as of yet. He sees value in debt not equity.

Table: Warren Buffett’s investments in credit since the start of credit crisis:

This speaks volumes!

Buffett is not alone in going where the value is. The world’s richest person by some ranking, Carlos Slim, also likes this idea. He recently lent $250 M convertible debt to New York Times company at 14%. Another shrewd investor, Carl Icahn, was reported to be collecting the debt of MGM at 38 cents on dollar in March ‘09.

CDS of GE

GE is in the news once again! This venerable company, probably the best industrial firm in the world, is being hugely discounted in the market. Its equity below $7, market cap below $70 B, credit markets are pricing its bonds and CDS as if it might go bankrupt.

Two questions can be asked: Does GE have a real risk of bankruptcy? If not, what is the reason for such violent reaction in the markets?


First, does GE have real bankruptcy risk? GE’s CDS has quickly shot up, going beyond the levels where Bear Stearns and Lehman were trading before their collapse. To emphasize again, these are the danger territory that not even Bear and Lehman has reached before their end. CDS markets indeed imply that there is a large probability of bankruptcy for GE. The cumulative probability of default over 5 years is about 50% as implied by the market spreads of roughly 1000 bps for 5 year CDS (arbitrarily assuming 40% recovery rate given default). At 20% upfront with 5% coupon over 5 years, protection buyers are paying almost half the notional that they will recover in case of default:


This reaction in CDS markets have been followed by equity and equity derivatives markets.


Taking Feb 11 as base (where there has not been a particular news for GE), we can observe the reaction in equity markets has been less moderate and lagging compared to CDS markets:



Part of the reason for more violent reasons in CDS markets arise from the put option like characteristics of CDS. Even taking into account the optionality of CDS, it is hard to reconcile the CDS market’s violent reaction with the fundamentals.

GE’s problems stem from the concerns with its looming rating downgrade. GE’s financial arm, GE Capital, is a AAA-rated company which by no means deserves that rating in this new environment where the counterparty risk is paramount. GE Capital has benefited from its AAA rating in past, but that might be now its Achille’s Heel. It might have to post collateral for certain transactions in which it has provided credit protection.

It is well known by now that the rating agencies will soon cut the rating of GE. The only question is how harsh that downgrade would be. Depending on the extent of this downgrade, GE could require substantial cash to post as collateral for its certain derivatives trades. Like a lot of highly rated companies, the financial engineers in GE were no doubt monetizing this credit rating during the credit bubble. Credit intermediation trades, credit guarantees, providing long-term liquidity with short-term funding, these are just some of the well known examples. It is not inconceivable that GE might experience what happened to AIG, a spiral down scenario where downgrade begets further credit weakness.

Is bankruptcy of a GE Capital a reasonable scenario then? Not really! Yes, GE may have to post a large amount of collateral (or come up with cash) in case of a harsh rating downgrade. But, here is the rub! GE Capital benefits from the easy funding facilities provided by US Treasury. This company is selling bonds, guaranteed by FDIC, under the TGLP program with very low spreads to US Treasuries. These bonds have a large demand, because they are effectively guaranteed by US government.

In order to GE to go bankrupt, the government will have to reverse its programs and ideology of supporting the large financial institutions. This is of course possible, but not very likely in the near term. Just as the AIG analogy is harmful to GE, the explicit and implict support of government is beneficial for GE.

Sharp moves in GE’s CDS are by and large involves the dysfunctionality of CDS markets. Fundamental credit indicators do not indicate a bankruptcy at all (adjusting the parameters for the new financial world). GE’s CDS has climbed up in huge amount mostly because of the lack of liquidity in CDS markets. CDS market has lost substantial liquidity. There are no natural sellers of protection. As soon as a bad news hits, it creates a demand for protection which finds a supply only at extraordinarily high rates. In old times, there would be many people who would be willing to take this risk. They could then lay off this risk in different ways. For example, dealers could have sold bespoke CDOs where the risk is sold off. No more of that in this environment. As a result, those couple of players who really need to get protection, will pay for it through the nose.

Then, we have the second question: If the bankruptcy risk is not concordant with the CDS levels, what is driving the valuation? GE’s issue is not bankruptcy but the potential for further equity dilution as it may have to raise capital. The government may not be so generous in future as now and GE Capital may have to come to market. This is somewhat similar to what happened to Citigroup and other financial institutions. Such a huge entity cannot be supported endlessly by the government. GE Capital will have to stand on its merits. Time might be a healer, but the market is not giving the company the benefit of doubt.