Life is a series of natural and spontaneous changes. Don't resist them-that only creates sorrow. Let reality be reality. Let things flow naturally forward in whatever way they like
—Lao Tse quotes from the Tao Te Ching
The Spiritual Masters at Citi have learned some Chinese Wisdom: Crisis = Opportunity. Both Mish and Barry Ritholzt picked up on Citi plans crisis derivatives, but I thought you'd like the Decline of the Empire take on this startling new development.
Here's the skinny—
Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis. The firm has drawn up plans for a tradable liquidity index, known as the CLX, on which products could be structured that allow buyers to hedge a spike in funding costs.
Like the untraded US rates liquidity index (USRLI), the CLX is constructed as a sum of the Sharpe ratio – deviations from the mean divided by volatility – of various market factors, such as equity volatilities, Treasury rates, swap spreads, corporate bond swaption-implied volatilities, and structured credit spreads. Citi will make the CLX tradable by using fixed historical values for the mean and volatility parameters, eliminating the need for costly recomputation from lengthy time series.
The planned index "serves as a proxy measure for liquidity" but according to Master of the Tao Terry Benzschawel, also "tracks more traditional measures such as bid-ask spreads, trading volumes and the USRLI. He compares the potential impact of CLX to that of the interest rate swaps market." FYI, the interest rates swap market is much, much larger than any other deriviatives market. Terry bubbles over with enthusiasm when he talks about his new baby—
"The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don't worry about interest-rate exposures any more – they just pay a fee to hedge it," he says
Of course this new financial product will reduce the create systemic risk in the industry. But as you will readily see, that doesn't matter. Let's get to the crux of the matter. Chris Rogers, chair of statistical science at Cambridge University, said the only participants able to sell CLX-based products would probably be those who are too big to fail. He has some concerns.
"This is basically a kind of insurance product. The main issue is: how good is the party issuing it? If it's going to be paying out huge numbers in the event of a crisis, will it be able to meet it obligations? Insurers can buy reinsurance for their liabilities, but the buck has to stop somewhere – there's a limit to how much a private insurer can pay out. Only the government can cover unlimited losses," he says.
Citi's Terry Benzschawel is a quick & avid learner, he knows how the Empire works, he already knows that only the government can cover unlimited losses. On the other hand, Professor Rodgers seems woefully behind the times.
And "how good" is the party issuing this product? Will they be as sound as A.I.G., which offered Credit Default Swaps (CDS) to Goldman Sachs, the Royal Bank of Scotland, and other miscreants worthies, so these banks could "hedge" their risks? Allow me to quote forensic accountant Richard Zabel, C.P.A. on CDS, another form of "insurance"—
Even though CDS appear to be similar to insurance, it is not a form of insurance. Rather it is an investment (more akin to an option) that "bets" on whether a "credit event" will or will not occur. CDS do not have the same form of underwriting and actuarial analysis as a typical insurance product; rather [it] is based on an analysis of the financial strength of the entity issuing the underlying credit asset (loan or bond). There are no regulatory capital requirements for the seller of protection (such as exists with insurance companies and banks).
Yes, it sounds like Citi's new CLX product is much like A.I.G.'s CDS product, but that does not matter. You might want to know what counterparty risk is—
Counterparty risk, otherwise known as default risk, is the risk that an organization [like A.I.G.] does not pay out on a credit derivatives, credit default swap, credit insurance contract, or other trade or transaction when it is supposed to. Even organizations who think that they have hedged their bets by buying credit insurance of some sort still face the risk that the insurer will be unable to pay, either due to temporary liquidity issues or longer term systemic issues.
But this does not matter either. Let's cut to the chase.
- Citigroup and other financial institutions sell crisis "insurance"
- The Too-Big-To-Fail Banks, including Citigroup, create another Financial Crisis
- The Counterparties demand paybacks on the "insurance" they bought
- But Sellers can't cover, in other words, they default, they are bankrupt but they are too big to fail
- Uncle Sam steps in to bail-out the Sellers, and payoff the Counterparties, who get 100 cents on the dollar on the "insurance" they purchased to hedge the Crisis they themselves, together with the Sellers, helped to create.
Perfect! This "socialize the losses" financial model is entirely sound. It is risk-free. Sellers can't lose, buyers can't lose, it's a Win-Win all around. As Citi's Terry Benzschawel might say, life is a series of natural and spontaneous changes. Don't resist them-that only creates sorrow. Let reality be reality. Let things flow naturally forward in whatever way they like.
Finally, what about this Chinese wisdom that Citi has taken to heart? Oh, that turns out to be bullshit.
There is a widespread public misperception, particularly among the New Age sector, that the Chinese word for “crisis” is composed of elements that signify “danger” and “opportunity.” I first encountered this curious specimen of alleged oriental wisdom about ten years ago at an altitude of 35,000 feet sitting next to an American executive. He was intently studying a bound volume that had adopted this notorious formulation as the basic premise of its method for making increased profits even when the market is falling. At that moment, I didn't have the heart to disappoint my gullible neighbor who was blissfully imbibing what he assumed were the gems of Far Eastern sagacity enshrined within the pages of his workbook. Now, however, the damage from this kind of pseudo-profundity has reached such gross proportions that I feel obliged, as a responsible Sinologist, to take counteraction.
A whole industry of pundits and therapists has grown up around this one grossly inaccurate statement. A casual search of the Web turns up more than a million references to this spurious proverb...
Read the rest of Professor Mair's article if you want the details, but don't tell Citigroup's Spiritual Masters. Truly, they know that Crisis = Opportunity.