Debt revamps hindered by credit default swaps Dealscape

Chrysler files bankruptcy.  Let’s be clear about who is responsible here.  It is the banks, bondholders, and Wall St. that created the derivatives and Credit Default Swap (CDS) monster.  Derivatives have already created the current economic depression (Bear Stearns, Lehman, Merrill, etc).  Now the presence of CDS’s distorts the normal workings of a market economy and prevents the proper functioning of institutions.  In times past, the threat of bankruptcy (itself a centuries-old institution) worked to make all stakeholders: labor, capital, and management work together through difficult and unforeseen times.  Now, no longer.  Now capital demands full compensation with no risk.  It demands sacrifice by all others, but not itself.  It kills the goose in order to get a larger share.

THE DEAL PIPELINE SNEAK PEEK: Credit default swaps are complicating efforts to work out bank, auto and other restructurings outside of bankruptcy.

As the holders of billions in credit default swaps against a bankruptcy of General Motors Corp. and Chrysler LLC, the automakers’ lenders have so far rejected the government negotiators’ demands to greatly reduce their claims on the car companies.

Emboldened by credit default swaps, bondholders in other restructurings have resisted efforts to reduce the amount of money they are owed or refused to accept offers to swap debt for equity in hopes of at least sweetening the deal after a bankruptcy filing. They also are fighting to reserve their right to CDS payoffs, bankruptcy experts and analysts said.

The prevalence of credit default swaps has been blamed for at least worsening the financial crisis. Now they are complicating efforts to clean up balance sheets, ease debt burdens and unwind the tangle of financial obligations between financial firms and their counterparties — critical steps in reviving the economy.

GM: Some Bondholders Want Bankruptcy – BusinessWeek

Business Week catches up to Econproph from last month.

The barriers to getting a deal done with GM bondholders, and negotiating away enough of that debt to strike a deal and avoid a planned, government-assisted bankruptcy, remain very big, with five weeks to go before the deadline.

…And second, some of the bondholders own credit default swaps, which amount to an insurance policy against the debt and pay them in full if GM defaults. Those bondholders actually fare much better if GM goes into bankruptcy.

Using Anti-trust to remedy “too big to fail”

Simon Johnson, along with Joseph Stiglitz, and Thomas Hoenig argued yesterday in hearings that we need to break-up “too big to fail” banks. I heartily agree.

But of course our argument, both in the Atlantic and more broadly, is not against finance per se. In fact, we’ve received some strong expressions of support from within the financial sector – just not particularly from firms that are Too Big To Fail – as well as from many in the risk-taking entrepreneurial sector. And here Thomas Hoenig – President of the Kansas City Fed, with long experience regulating, winding down, and generally overseeing banks; and very far from being a sensationalist – absolutely nailed it towards the end of yesterday’s hearing. My recollection of his exact wording is: whenever you have banks that are too big to fail, you will get oligarchs yes, he said oligarchs.

But, we need to realize more than an act of congress is needed.   Ideology, economic theory, and the lure of oligarchs can prevent enforcement of even a recently passed anti-trust law. Remember it was almost 2 decades after the Sherman Act was passed before it was really enforced.

If we start looking at anti-trust as a way to prevent “too big to fail banks” (which I whole-heartedly endorse doing), we will run into another ideological roadblock from our freshwater economic friends. In this crisis we have already encountered the freshwater economic views of New Classical & RBC macro theories. These theories started with the assumption that the macro econ is at a general equilibrium and the (surprise!) draw the conclusion that no generalized glut or similar disequilibrium is possible.

Anti-trust has been neutered since Reagan I. With the exception of the Microsoft case and some explicit price-fixing cases, anti-trust enforcement has stalled. Anything goes. Bigger is better has been the Justice dept philosophy. And the intellectual foundation for the abandonment of anti-trust has been “contestable markets” theory and game theory – the idea that no market power will be exercised for fear of encouraging new entrants. It’s a theory that holds that 2 or 3 firms will engage in the same degree of competition that a plethora of small and medium firms will. In much the same way that macro became infatuated with elegant DGE models regardless of their empirical emptiness or uselessness, oligopoly and monopoly theory in IO has become enamoured of elegant game theory formulations that offer clever expressions of intriguing hypothetical situations, but they offer little empirical content, testability, or practical policy guidance. Just as macro needs to go back and re-learn some of Keynes’ (and Fischer and Wicksell) messy, inelegant insights into real economies, IO will need to re-discover structure, conduct, and performance.

As long as contestable markets and similar “the free market is self-regulating and self-limiting” ideology persists in Anti-trust division, even a new bill from Congress won’t help.

Macro: an awful mess today

I was not alone.  Apparently Tim Harford of was also confused and disappointed while learning the modern macro models and theories.  I however figured it was a bunch of nonsense.  The assumptions made by modern macro models, particularly the Rational Expectations stuff of New Classical and New Keynesian theory are the problem.  By making assumptions that enable them to use their elegant math, they assume away any possibility of the model being useful.  The assumptions are not just “simplifying”, they are contra-reality.  It is as if I were to create a theory of flying in physics by first assuming that gravity cannot exist.  There’s a lot of work to be done in macro now to repair this failed research program.

I am struck by the soul-searching that has gripped the profession in the face of the economic crisis. The worry is not so much that macroeconomists did not forecast the problem – bad forecasts are more a sign of a complex world than intellectual bankruptcy – but that macroeconomics seems unable to provide answers. Sometimes it cannot even ask the right questions.

Willem Buiter, a former member of the UK’s Monetary Policy Committee who blogs for the FT, complains that macroeconomists have simply discarded the difficult stuff to make their models more elegant: “They took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.”

Mark Thoma offers additional insight at Economist’s View.