Ben Stein Watch: September 28, 2008

Faced with Hank Paulson's request for $700 billion to bail out troubled banks, everybody has their own idea which they think will work better. Including, heaven help us, Ben Stein:

If we are actually thinking about tossing the Constitution out the window, why not simply annul these credit-default swap contracts? With that done, the incomprehensibly large liability of the banks would cease, and we wouldn't need this staggering bailout. Shouldn't we consider making the speculators pay some of the price?
We have survived housing-price corrections before. Why is this one causing so much anguish? It must be the side bets, the credit-default swap bets, multiplying the effect of the housing downturn many times over. Maybe we should just get rid of these exotic bets and start again without them.

Where to start. First, annulling CDS contracts would constitute a massive and completely unanticipated flow of hundreds of billions of dollars away from people who had hedged their credit exposure and towards whiz-bang financial rocket scientists who created synthetic CDOs and other such exotica. Anybody holding a synthetic bond rather than the real thing would get a completely undeserved windfall. And any bank which had hedged its bond and loan exposure would probably go bust overnight.

Second, "the incomprehensibly large liability of the banks" would not cease. Remember that the Treasury plan is to buy up mortgage-backed assets, not credit default swaps. The liability of the banks comes from the fact that they're holding huge amounts of super-senior CDO tranches and the like on their balance sheets. It does not come from the fact that they wrote, on net, a lot of default protection. That was a problem for AIG and other insurers; as far as we know, it has not been a problem for banks.

Third, the present financial crisis is not the fault of speculators who happened to be right that mortgage-backed bonds were massively overvalued. Making people pay for being right? Seems like a bad idea to me. Especially since the biggest speculators of all -- people like John Paulson and Andrew Lahde -- have already unwound their positions and taken their profits.

Fourth, we have not survived a house-price "correction" of this magnitude before. The last time that national house prices dropped this much was during the Great Depression. OK, in a sense you can say we survived the Great Depression. But only with a lot more anguish than is currently being felt.

Fifth, the CDS market does not multiply the effect of the housing downturn. As Stein does, to his credit, understand, a derivatives market such as that in credit default swaps is a zero-sum game. All it can do is transfer risk from one part of the global financial system to another. There's no magnification going on. AIG was not involved in writing or securitizing mortgages, but it was ultimately brought to its knees by the mortgage market, because it used the CDS market to insure them.

There are well over $10 trillion of residential mortgages in the US. That's more than enough money right there to cause massive chaos in the financial system if a large proportion of those mortgages all go sour at the same time. By Occam's Razor, you don't need to blame the CDS market for this one.

But Ben's angry -- and when he's angry, he seems to lose the ability to think coherently. A bit like when he's calm, really.