Well, the premise is that you don't need to look at pricing with cpty failure, because, really, you ahould be able to hedge your net aggregate exposure to a given counterparty through the CDS or bond mkt. Problem is that everyone sort of fell asleep at the wheel and assumed nothing bad can ever happen. Moreover, it's not like pricing with default assumptions is impossible. It's just more difficult, so people have taken the easy way out and chose to forget about it.
Forget about rational explanations. Much less scientific explanations. Mr. Market is irrational and wayward. America was living beyond their means, this was not sustainable in the long run and by ergodicity (long time) it went bust. PS What a GREAT book Fooled by Randomness!
The way it works is if A & B have a deal and the legal doc has been signed and executed, if A wants to unwind it with C they have to get B's permission, otherwise it is not valid. It is called an assignment or novation. A could enter into complete opposite position with C directly as means to net out gains and effectively unwind however A will have 2 'LIVE' trades on ...one with B and one with C.
To say everything seems more rational in hindsight is to say horse races are easy to handicap two minutes after the gate opens or that Monday is a great day to pick last Sunday's winners. The statement has no more meaning than to say the sun rises in the East. Astute observers did get it right in real time. The number of them was small compared to the number who hold financial instruments but we are still talking about thousands not dozens. It is certainly a hard game to time properly but it is just that hard ... not impossible. Which asset classes acted out of step with the crash? The flight to quality was completely predictable enough that I had my brother open up with Wells Fargo's Short Term Gov't Fund in June. They closed it in September when the tidal wave of cash overwhelmed them. It is THE fund for those that want a short term Full Faith & Credit stance.
Insanity in individuals is something rare; but in groups, parties, nations, and epochs it is the rule. - Nietzsche
Hmmm, not sure I see your point about hindsight. It's a difficult idea to argue about, though, so let's leave it... Yes, there were some astute observers that foresaw how the various pieces of the puzzle were going to evolve. However, if you're suggesting that there were people who saw how the whole system is going to collapse, I would not believe you for a second. Even the people who were expecting flight-to-quality couldn't imagine a situation in the money mkt where you couldn't fund govt bonds in the repo mkt/couldn't borrow term cash. The sudden and total evaporation of liquidity in repo/depo/gc, i.e. the money mkts was a shock. That in turn led to all sorts of forced liquidations and unwinds, which meant that normal asset class correlations broke down. For example, something as basic as cash bonds vs bond futures, on-the-run vs off-the-run, high-coupon vs low-coupon bonds, etc... It was proper madness.
I hope I did not leave the impression in any of my posts (for it was never my intent) to suggest that the way things would unfold in any panic could be foreseen in full detail by even the most astute observer. After all ... we are not fortune tellers ... lol. That said some broad outlines if not anticipated could at least have been seen as distinct possibilities. Counter party risk was, I believe, at the heart of the problem and Bear had gone down precisely because of the counter part issue and Lehman was coming under pressure because their most sophisticated counter parties were increasingly cutting that exposure. Why wouldn't the repo market, commercial paper and other money market mechanisms seize up? As they are all over-the-counter transactions without even a clearing house to buffer the potential blows (the CME at least has seven or eight billion to ease -- if not eliminate-- sleepless nights) if you are not concerned with counter party risk (including the risk of very late delivery causing your own creditors to doubt you) what in the world would trip the alarm. As a well know author once said -- and I paraphrase -- "you can't expect the market to deliver a brief". You not only could imagine the short term borrowers having life or death problems but if one knew anything about classic credit squeeze induced panics,1907 comes to mind (as you probably know called by one and all "the rich man's panic") you could anticipate it as a real possibility -- not in any way an outlier. In real panics, not market declines, it is the refusal to fund short term flotations of any description that allows lenders to protect their own liquidity without taking the immediate "haircut" the market demands of a seller of longer maturities. It cuts counter party risk -- the premier and it "builds" cash balances fast. Every 24 hour period shows a stronger cash position and a slightly reduced counter party risk but only compared to the alternative of parting with those funds. It has happened with great predictability in panics throughout history. The smoothing effect of the political system and the FED has created great complacency. Again not all of the "rearrangements" of the correlations could have been anticipated; the blow-by-blow -- the legal brief -- can only be read in hindsight but to be net short in size did not and never does require what one can never have in the moment I have long been concerned with how sanguine the financial markets have become with lending long or carrying difficult to liquidate positions in massive size financed with short term and even overnight funding. I thought the decision years ago of the treasury to stop floating 30 year debt was an act of insanity. Financing an economy of this size and this importance to world security even world peace should cause decision makers to relentlessly shorten their deby schedule. Again, insanity. During the 70's my partner and I owned two tiny investment banks -- one in London and one in Lugano which was by at least one important benchmark a major financial center. Just 30 years ago it was the world's fifth or sixth largest recipient of deposits. It was the tax haven/flight money capital of the universe. The third leg of our tiny stool was a "pseudo" investment bank in New York. I say pseudo because we were not NASD or SECO registered and took the stance that because we never sold any investment product of any nature to an America citizen or resident we could run our "bank" totally outside the established regulatory structure. At that time we saw how aggressive many broker dealers were in an era of stringent net capital rules limiting leverage to 19 to 1. If, during your regulatory reviews, it was seen that you commonly leveraged much over 15 to 1 it was commented on and you were told to "watch it". Seeing leverage north of 30 to 1 concerned me and I am sure I was not the only long term observer that believed 35 and 40 to one was a huge risk to the system. The rules had been changed and the models showed very long term stability but most of that stability was from data that was the result of the older much more strngent set of rules. Replace a twelve year old kid's mat of fire crackers with a box of dynamite and then talk to me about the occasional finger or eye that is blown away. That is ignoring reality. When you say that all the correlations and details could not be predicted I agree. But just because one couldn't know that the S&P would take the express elevator below 750, stop and then collapse to 666 does not mean it was hard to realize that the observable facts (in August of '08) indicated that the odds were stacked in favor of a large and fast additional leg to the decline that had been trending down for over a year and had exhibited little ability to bounce back after weakness in over six months. To present that all was so unpredictable because much/some of the detail was impossible to see from a distance is not a useful way for a speculator to view markets. It is demanding a clarity that never exists but, thankfully, are not needed for a great hitter to bat 340 in a season and north of 300 lifetime.
I forgot the most important comment. I like this thread and like the thinking of those contributing to it. Please don't mistake my iconoclast (and, sadly, sometimes over the top) views with the slightest lack of respect for the points made by others. I am 61. That doesn't make my view more valid but it does make it different.
Mr Swan, allow me to express honest and humble admiration. Your previous post was truly excellent. To me it epitomizes the benefits of superior experience and I thank you for sharing it here. It's all, as you say, about avoiding not seeing the forest for the trees.