Monday, 23 March 2009

Fundamental problems

Axiom 1: Never depend on someone who won't be able (or willing) to help you out in a crisis.
Axiom 2: Fool me once, shame on you. Fool me twice, shame on me.
Axiom 3: There is no such thing as a free lunch.

These clearly aren't all simultaneously true axioms (held as self-evident) as people believed that they could get a free lunch (house prices continuing to rise inexorably) or that if they failed, that someone would be able to help them out (AIG, perhaps?) Finally, the government bailout of banks (some of them are asking for a third dose) which doesn't require change in management (or even fundamental strategy).

Markets, over 20 year cycles certainly can get fooled again (credit crunch, dot-com, LTCM, etc all valued products above any rational analysis).

Some people are now questioning the ability even of governments to pay up. Ultimately, sovereign bonds (loans to countries of various durations) are the safest loans you can make. They even offer "index-linked" loans, so that you can guarantee your final payment in current prices (as the face value of the bond increases with inflation).

If people are now doubting the ability of the USA to pay its debt, then who can you trust? CDS (credit-default swaps) on US bonds currently charge 16 basis points (1.6%, which "usually" is typical of a company, not THE most trusted borrower in the world, ever). Who is buying these products? If the US defaults, do they seriously expect to be bailed out for the fact that their counterparty (the guy/firm/crook) who sold them the insurance (for that is what a CDS is, although it needn't be tied to possession of an asset at risk) to be able to pay out?! Would the dollars they receive be worth anything in a situation as bleak as one in which the US government reneged on its promises to pay? No. So, why buy them? Answers on a postcard (or carrier pigeon, if the postal service collapsed, too).

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