To me the most striking/exciting way to extend this model and what assumption to question is the zero sum assumption.
If the equilibrium is such that both ice cream sellers stay near the median, we might also imagine that the # of customers available to both sellers depends on how far they have to walk. I don't think it's unrealistic to imagine that the # of willing customers decreases as distance to the nearest seller increases. So in the case described by the article, some of the people on both ends of the beach might decide agaist buying ice cream at all, given they have to walk half way across the beach.
This is exciting to me because it might indicate that if both sellers were to cooperate (@ .33 and .66 distances along the dimension) both sellers could be better off in the aggregate because the potential number of customers they are splittig could be larger than at the nash equilibrium described in the article.
Expading the scope beyond even the sellers, we might also imagine that as a result the entire system is better off because the average customer saves time walking by having more evenly spaced ice cream sellers. That means even if we were to imagine the demand function was completely inelastic with respect to distance to nearest seller, at the very least the customers save time on average walking to the stands. This time could more productively be used to dream, plan, create the next startup, come up with the next big idea for society, etc.
The value of cooperation, expading the pie, and not assuming a zero sum game...as an optimist, these are the themes I take away from something like this.
And without the government backstop, your savings would not exist today (and anyone else with cash in a money market or savings account).
The chain of collapse without a backstop is not a robust argument in general, becuase at the point you say Morgan, etc. fail without a government backstop and then try to assume that those firms were the only (or majority) beneficiaries, it becomes shaky. Why? Because if the banks failed as you described, nearly most would have as well and then anybody holding cash in a bank (read all of us sans the mattress crowd) would have been in horrendous trouble. Remember, the government had to backstop not just investment banks, but money market funds as well (which were failing due to the related crisis of confidence issues). Remember the northern rock episode with huge lines of people unssucessfully trying to withdraw their money in the UK?
Imagine not being able to withdraw your cash from a money market or savings account. Banks being structurally exposed to runs and therefore requiring government backstops is actually a well understood issue. The point is we all benefited from the federal backstop, and this argument that, why should banks benefit from an implied or explicit backstop ignores the fact that all of us are backstopped by this as well, whether you realize it or not. Nobody can claim that people keeping their life savings in a money market or savings account and earning 5% interest a year is not also implicitly benefiting from government backstops in general, so let's not single out the investment banks in this case.
As for AIG, this has been discussed in infinite more detail so the interested reader can look up articles on this, but the essence of the point is that of the 13 billion owed, most of it was already collateralized (which means they would have just kept the US treasury collateral had AIG collapsed). Yes, there was a smaller portion that was hedged via CDS that could have failed as insurance, but let's not claim this is the entire 13 billion, in fact, it was far from that. And let's also remember had CDS truly failed it would have reflected a state of the world where most banks were in default, and forget about some investment bank not being able to collect their insurance, we are talking about ATMs not working anymore at this point. So the point is the backstop prevented things from getting to this nightmare, saving banks but also the rest of us as well.
> Why shouldn't they lose money for taking bad counter-party risks?
I don't really know how else to explain this. They shouldn't lose money for taking counter party risk...because they were willing to pay the price to insure themselves on the counter party risk. Why do you keep insisting that they need to lose money? They had 7.5 in collateral, and they insured themselves for the other 2.5 in the event they defaulted. This is the definition of protecting yourself from bad counter-party risks.
> They were planning to keep the money that they made for assuming said risks, so why shouldn't they take the hit when things work out badly?
...because they insured themselves. Imagine someone who bought a share of Google stock and then also bought a put option on it to protect themselves. Then the stock goes down. It's like asking why that person shouldn't take the hit because they were going to keep the money if Google had gone up. Goldman doesn't take the hit because 1) they were prudently collateralized and 2) they PAID for CDS protection on the rest that was owed to them that was not collateralized. CDS is not free, of course.
If they were willing to pay the insurance and demand collateral, why should they have to take a hit at all?
> I'll pay $7.5B for $10B.
So would I, but this is obviously a mischaracterization. It's like a homeowner who defaults on their mortgage and gives a house worth 250k to the bank who lent them 500k to buy it. They are not "paying 250 for 500".
> Maybe, maybe not, but in any event, not by the US govt.
This is not really a maybe, maybe not situation. Clearly with the collateral and insurance arranagements, Goldman would not have lost money as a counterparty to AIG. If you have an explanation otherwise I would be interested to hear it.
How does purchasing CDS insurance on a counterparty imply that they knew full well it could never be satisfied? If I purchase hurricane insurance on my home do I know full well a hurricane is going to destroy my house? It was a precautionary measure for an amount that was the difference between what they were owed and how much collateral was pledged. It indicates nothing of the sort that they knew full well the world was going to blow up and AIG would default
And what I say is true, there are many many public disclosures on exactly what their positions were.
> Goldman Sachs was owed $10B. 7.5B was available in pledged securities. Goldman got $10B in cash because of govt flow-through via AIG.
If someone has pledged the majority of what is owed to me in collateral, it is wrong for people to imply that the 10 billion flowing through the government was just some windfall flowthrough. They got what they were owed, and the taxpayers got their 7.5 billion in collateral back. If the taxpayers did not pay the 10 billion, then they wouldn't have gotten 7.5 billion worth in treasuries returned to them--Goldman would have had the right to keep it, and this is the whole point of having collateral pledged to them in the first place.
> Shouldn't the insurer be paying off, if solvent, and not the US govt? And, if the insurer is not solvent, why shouldn't Goldman take the hit?
Are you talking about the CDS insurer? The insurance only needs to be paid if AIG defaults. If AIG defaults then the US govt doesn't have to pay anything, the insurer does. Since AIG was bailed out, no credit event was triggered and the CDS insurance becomes worthless. The upside is of course they actually get their money. In either case, whether AIG was allowed to fail or not, they would have been made whole.
Goldman was not treated differently in this case. Many other banks were treated the exact same way. Yes, Goldman was paid out in their insurance. So is any individual who took out insurance with AIG--they will actually get paid what is owed to them as well now.
I really don't understand this continued suspicion of the AIG/Goldman flowthrough.
What they did was a textbook case of how to protect yourself against a counterparty going bankrupt. It will be used as a case study one day of how to exercise prudence.
Direct from the conference call that explained their exposure:
"When AIG was rescued, Goldman Sachs had $10 billion of
exposure to the insurance company that was offset with $7.5
billion of collateral as well as credit-default swaps that would
have paid off in the event of an AIG bankruptcy, Viniar said on
the March 20 call."
So Goldman had $10 billion of insurance with AIG. As the insurance started going in their favor, as is common banking practice, they demanded collateral be pledged (treasury securities) that they could seize in the event of bankrupty. This was 7.5 billion worth of collateral in extremely safe treasury bonds. So in the event of default, Goldman would have kept the securities in lieu of getting the cash settlement. Because they did not default, AIG had the securities returned to them and they paid out cash instead (this is the 10 billion number that "went from tax payers to goldman" that everyone keeps saying). The remainder 2.5 billion was the disagreement between the parties as to where the insurance should actually be marked. So to be prudent, they bought CDS protection that would pay 2.5 billion in the event of default.
As someone else mentioned, you should not subtract 10 billion from the income number because it is not included in the profit in the first place. It is a loan, which they pay 5% for the first 5 years and 9% for the years after that to the American taxpayer.
Additionally, 13 billion "looted" from AIG/taxpayers is a complicated issue that is being completely misinterpreted. As with a lot of transactions that involve questionable counterparties, they took collateral. So as the insurance contracts started to go into their favor, they asked for collateral to feel safer that they would be paid off even if they went bankrupt. The idea goes like, insurance is looking like it is in my favor, pledge me an asset so that I know there is a good chance I will be made whole on this. So in this case, those assets were treasury bills.
As they have stated many times, their contracts with AIG were largey collateralized. This means if they were owed 13 billion, then AIG pledged, for instance, something along the lines of 8-10 billion in treasury securities. Had AIG gone bankrupt and not been saved by the US taxpayer, they keep the treasury securities and lose a few billion, but certainly not the full amount like everyone thinks. If they are saved, which they were, then they give back the collateral and take in the cash.
We should be careful and not equate what they have the option of doing to what they are actually doing. They in particular have been sticklers in marking to market no matter what, regardless of if they are a bank holding company or not (In the conference call this is reiterated many times).
It would not have been a far greater loss under the old rules, that much is clear from reading the balance sheet and disclosure of the relatively small size of legacy assets (the assets that would be impacted by different marking methods). Income was driven in pure trade faciliation, good old fashioned buy low and sell high in the capacity of a financial intermediary.
Effectively infinite risk? So you think a regulatory agency in the US will allow prices of a stock, say, GE to reach an unbounded number and still require settlement in derivative contracts to this? And I would not be as quick as you are in calling a professional stupid for doing something that any professor of finance would tell you is important for smooth functioning of capital markets.
You seem to just not grasp the magnitude of what you assume people should do in this crazy option proposal. It is not unusual for a stock to have a 25% short interest. That means a quarter of the shares are sold short. So you are saying a quarter of shareholders should sell calls to every short seller who wants to hedge? What if most shareholders do not want to sell options, and not give up the upside in doing so (indeed, there is a tradeoff in "juicing" your return, you lose the upside). In fact, most do not, so this is entirely impractical of course.
The whole point is with proper regulation that prevents the case of a squeeze or errant prices that are not sound, you prevent the "unlimited" downside (if a company ever becomes infinitely valuable, we will have other more interesting issues to deal with). This happens all the time--exchanges can cancel trades done at what are called "obvious error" prices. Regulation effectively clips the tail, which is why dealers have no problem shorting shares to ensure liquid markets.
Actually, what you said is not how it works at all. Most covered calls are in the end, handled by wall street dealers who hedge their deltas with short sales (trust me about this). Retail investors that do covered calls do own the stock, but the net effect is not what you described, it is significantly more complicated. (by the way, the transaction you describe is equivalent to selling a put)
Without closing out the short sales that were done, usually there is always unlimited downside to at least ONE player in this transaction. Why is this intuitive? Abstract for a second. Treat the short sale as a contract, which it is, where you agree that you have to buy some object back in the future in return for a FIXED dollar amount now. If you assume that object (a stock in this case) can go up to an arbitrarily high price, then you always have unlimited downside as long as this contract is in effect.
The point is even if you disallow these artificial short squeezes, you are STILL discouraging "stupid speculative bets", becuase the price can go up naturally (when the thesis of betting against the stock is economically wrong). These are the right times for it to happen, and in fact happens all the time without a volkswagen type squeeze. The point about short squeezes is that someone can make a "smart speculative bet" (which society as a whole needs people to do) but still get blown up for non economic reasons.
Exactly. But let's take it a step further. Once the call seller covers himself (by buying stock in proportion to the delta of the option), he is essentially causing someone else to be short it as well. The unlimited downside is now passed to him. You can see how this just continues to propagate.
The point is that in any situation where shorting occurs, and therefore an excess amount of stock is floating, there is a non hedgeable unlimited downside risk that SOMEONE has to bear. Whether you pass it off in option or stock form is not relevant. Not everyone can hedge unlimited downside. Proper rules try to make sure these artificial squeezes do not happen, so as not to discourage short sellers (who are extremely, extremely important).
Now, that isn't to say that VW should be forced to reveal their position. It is not a trivial question what is the optimal way to stop this kind of thing. But it's important to discourage this activity where people deliberately accumulate shares to squeeze shorts. No economic value is created in this type of activity, just a transfer of wealth, whereas shorting serves a very important economic function.
Not every trader could have just hedged out the risk of a blowup. that is becuase derivatives are a zero sum game. For every trader who purchased the out of the money call, someone sold it. Therefore that person is now responsible for unlimited downside.
If the equilibrium is such that both ice cream sellers stay near the median, we might also imagine that the # of customers available to both sellers depends on how far they have to walk. I don't think it's unrealistic to imagine that the # of willing customers decreases as distance to the nearest seller increases. So in the case described by the article, some of the people on both ends of the beach might decide agaist buying ice cream at all, given they have to walk half way across the beach.
This is exciting to me because it might indicate that if both sellers were to cooperate (@ .33 and .66 distances along the dimension) both sellers could be better off in the aggregate because the potential number of customers they are splittig could be larger than at the nash equilibrium described in the article.
Expading the scope beyond even the sellers, we might also imagine that as a result the entire system is better off because the average customer saves time walking by having more evenly spaced ice cream sellers. That means even if we were to imagine the demand function was completely inelastic with respect to distance to nearest seller, at the very least the customers save time on average walking to the stands. This time could more productively be used to dream, plan, create the next startup, come up with the next big idea for society, etc.
The value of cooperation, expading the pie, and not assuming a zero sum game...as an optimist, these are the themes I take away from something like this.