1. When I was seven years old, my parents gave me a colorful wind-up alarm clock. I thought it was beautiful. They taught me how to wind it up each evening so that I would wake up to go off to first grade. Being a boy, after a while, I wondered how tight I could wind it, but there seemed to be a limit to that. One night, I found I could wind it one “click” tighter than usual. A week or so later, another “click” tighter. After some time, I wound it one click to many, and I heard a snap, after which the clock rapidly moved in reverse for about 30 seconds, and then moved no more. I was heartbroken, because I really liked the clock. Perhaps its “death” was not in vain, because it is a great analogy for a full swing of the credit cycle. The spread tightening in the bull phase of the cycle is initially relatively rapid, and gives way to smaller bits of incremental tightening, until it is too much, or an exogenous force acts on it. Eventually, when cash flow proves insufficient for debt service, the credit cycle turns, and the move to spread widening is rapid. Once spreads get really wide, the cycle can resume when those with strong balance sheets can tuck bonds away and realize a modest return in the worst scenario, if they just buy-and-hold. Though it did not happen for me, it would be the equivalent of buying the little kid a new clock. Then the cycle begins again.
  2. Economically, Japan has had a lost decade. It is beginning to verge on two decades. During this time, interest rates have been low, and growth has not been forthcoming. The main reason why low rates did little to stimulate the economy is that the banks were impaired, and could not lend. The secondary reason was demographic; equity markets tend to do well when there are more savers versus spenders. For Japan, that peaked in the early 90s. For the US, that will peak in the early teens. Now, it is possible that the more market-oriented culture of the US has reacted to this factor faster than Japan would, thus the relatively stagnant equity market in the 2000s in the US. This is also a cautionary note to those that thing that lower short-term rates will benefit the US markets; after all, what good have they done for Japan?

Thanks to all my readers, and especially my commenters. You make the blog worthwhile to me. I hope to better for all of you in 2008. Happy New Year to all of my readers, whether here, or at other sites that use my posts. May God bless you richly in 2008.

I learned from a dear friend of mine who manages high yield at Dwight Asset Management (one of the largest fixed income management shops that you never heard of), that with high yield bonds, spreads over Treasuries aren’t the most relevant measure for riskiness of the bonds.  Because they are more equity-like, high yield bonds have intrinsic risk that is independent of the level of yields in high quality bonds, the leading example of which are Treasury bonds.

In general, Treasury bonds can be thought of as a default-free debt claim (not perfectly true, but people think so), while other bonds must carry a margin for default losses.  As one moves down the credit spectrum, the riskiest corporate bonds act like equities, largely because as a company nears default, the equity of the firm is worthless, and true control of the firm is found in some part of the debt structure.
Spread curves of high yield bonds tend to invert when the Treasury yield curve is steeply sloped.   The slope of the Treasury curve for that effect to be active now, particularly since high yield spreads have widened out from earlier in 2007.  The effect can be seen though, in higher quality investment grade bonds.  Given the lower spreads over Treasury yields on investment grade debt, the relative uncertainty in the present economic environment, and the lack of liquidity in the short end of the yield curve, it’s no surprise to find the spread curve inverted on Agencies, and flattish, but still positively sloped for single-A and BBB corporates.

What this means is that there are intrinsic levels of risk affecting the yields on high quality corporate debt, lessening the positive slope of their spread curves, or with agencies inverting the spread curves.  As the Treasury curve gets wider in 2008, those corporate  spread curves should flatten, and then invert, unless more macroeconomic volatility leads to still wider credit spreads, or a rise in short term inflation expectations causes the yield curve to stop widening.

Another way to say it is that if the short end of the Treasury yield curve falls dramatically, don’t expect the yields corporate debt to follow suit to anywhere near the same degree.

When I wrote this post on Berkshire Hathaway, the main point I was going for was that the price of Berky was not unreasonable if one attributed value to what Berky could do in a crisis. When I trotted out the Ambac scenario, the idea was to illustrate how Buffett could if he wanted to, take advantage of a situation where values are depressed because the moats of competitors have been broken. (Think of what he did in manufactured housing finance after all the competitors were nearly destroyed. He bought the one healthy remaining company inexpensively.)

Now, had I been more thorough, I also would have pointed to pieces referencing Buffett and his experience with Gen Re Financial Products. The thing is, Buffett doesn’t like to be an external money manager or lender (for the most part), and
does not like structured finance exposure (even in its infancy, a la Salomon Brothers), he does recognize where there can be a clean, core business with defensible boundaries (a moat), where he can earn above average returns over time — insuring municipal bonds.

One key decision that any businessman must come to when entering a new field is build versus buy. Buy can be more attractive when there might be synergies between the acquirer and the target, or if the purchase price is sufficiently low. Build can be more attractive when the necessity of having something new that is unaffiliated with the old order is more attractive (no legacy liabilities), and where your competitors are viewed as being compromised, whether in balance sheet terms, or ethically. For the latter, think of the revenue lost by major insurance brokers after the Spitzer investigations. New players ate into the business models by avoiding conflicts of interest.

So, the announcement of Berkshire Hathaway Assurance Corp [BHAC] is no surprise here. Warren sees an opportunity, and he will pursue it.

Now here are three weaknesses of doing it this way. Buffett is not going to be the low cost provider, in a business where basis points matter as to who gets the business, and who does not. This strategy implies that he suspects that the major bond insurers have problems more severe than have been discounted by the equity and debt markets, and that their AAA bond ratings will remain under threat for some time. Second, it assumes that the managements of his competitors won’t take some action that significantly dilutes their equity in order to retain the solvency of their franchises, benefitting their own bondholders, those guaranteed by their firms, and management themselves (assuming they aren’t ousted). So far, the infusions to the financial guarantors have been significant, but not significant enough to remove doubt. The purpose of a AAA rating is that it is beyond doubt.

Third, a new startup will have higher fixed costs to amortize over the new business written. Mr. Buffett wants to charge more. Well, he will need to charge more, though perhaps that disadvantage is minimized because his competition faces higher costs in a different way from financial stress:

  • Distraction of management over structured finance exposure
  • Distraction with the rating agencies
  • Distraction over shoring up the capital structure
  • A much higher cost of capital than was previously available
  • Shareholder lawsuits (coming)

But, if I were in the seat of the competitors, I would tell my municipal divisions to ignore the problems of the company as a whole, and keep writing good business at pricing levels below that of BHAC. That will contribute to the value of the firm, and, the ratings agencies know that the marginal amount of capital needed to write that business against a mature block is almost zero. So keep writing, and protect the franchise.

Finally, it looks like this subsidiary is separately capitalized, and not guaranteed by Berky. It likely gets a AAA on its own, with only implicit support from the holding company. This gives Buffett the option to write a lot of business by providing more capital as needed, preserving flexibility at the holding company, while limiting downside if that subsidiary should ever run into trouble (very unlikely, given their business plan).Tickers mentioned: BRK/A, BRK/B, ABK

In 2002, we used to comment at the office that unless a company was dead, it could always get financing through a convertible bond offering.  The more volatile the situation (up to a point), the more the conversion option is worth, which can significantly reduce the effect of higher credit spreads, at a cost of possible dilution.

So, with the difficulties in getting financing at present, is it any surprise that we are having record issuance of convertible bonds?  I expect to see more of it, particularly for areas involved with housing, commerical real estate, mortgage finance, financial guarantee, and the investment banks.  High volatility and a need for financing begets convertible bond issuance.  That’s where we are now.

Just a short post this evening because I’m tired, and not feeling that well. Here is an Excel file containing my industry ranks for year end 2007:

Year End 2007 Industry Ranks

Remember, this can be used two ways. In the short run, the “hot industries,” the ones in the red zone, can be bought if one follows a fast turnover momentum-type strategy. For those of us with lower turnover value-type strategies, we buy industries in the green zone, but insist on quality, and attempt to analyze how transient the industry troubles are likely to be. Note that I’m not looking at all industries in the green zone — areas affected by the housing and finance sectors, for example.

One more brief note, since a couple of readers e-mailed me on this. It looks like the forced sellers of National Atlantic are done. Also, the compensation decisions for the three senior executives give them some compensation if a deal goes through. I’m not smiling on this one yet, and things could still go badly wrong. Use caution here.

Full disclosure: Long NAHC

I’m not sure what to title this piece as I begin writing, because my views are a little fuzzy, and by writing about them, I hope to sharpen them.  That’s not true of me most of the time, but it is true of me now.

Let’s start with a good article from Dr. Jeff.  It’s a good article because it is well-thought out, and pokes at an insipid phrase “behind the curve.”  In one sense, I don’t have an opinion on whether the FOMC is behind the curve or not.  My opinions have been:

  • The Fed should not try to reflate dud assets, and the loans behind them, because it won’t work.
  • The Fed will lower Fed funds rates by more than they want to because they are committed to reflating dud assets, and the loans behind them.
  • The Fed is letting the banks do the heavy lifting on the extension of credit, because they view their credit extension actions as temporary, and thus they don’t do any permanent injections of liquidity.  (There are some hints that the banks may be beginning to pull back, but the recent reduction in the TED spread augurs against that.)
  • Instead, they try novel solutions such as the TAF.  They will provide an amount of temporary liquidity indefinitely for a larger array of collateral types, such as would be acceptable at the discount window.
  • We will get additional consumer price inflation from this.
  • We will continue to see additional asset deflation because of the overhang of vacant homes; the market has not cleared yet.  Commercial real estate is next.  Consider this fine post from the excellent blog Calculated Risk.
  • The Fed will eventually have to choose whether it is going to reflate assets, or control price inflation.  Given Dr. Bernanke’s previous statements on the matter, wrongly ascribing to him the name “Helicopter Ben,” he is determined not to have another Depression occur on his watch.  I think that is his most strongly held belief, and if he feels there is a modest risk of a Depression, he will keep policy loose.
  • None of this means that you should exit the equity markets; stick to a normal asset allocation policy.  Go light on financials, and keep your bonds short.  Underweight the US dollar.
  • I have not argued for a recession yet, at least if one accepts the measurement of inflation that the government uses.

Now, there continue to be bad portents in many short-term lending markets.  Take for example, this article on the BlackRock Cash Strategies Fund.  In a situation where some money market funds and short-term income funds are under stress, the FOMC is unlikely to stop loosening over the intermediate term.

Clearly there are bad debts to be worked through, and the only way that they get worked out is through equity injections.  Think of the bailing out of money market funds and SIVs (not the Super-SIV, which I said was unlikely to work), or the Sovereign Wealth Fund investments in some of the investment banks.

Now, one of my readers asked me to opine on this article by Peter Schiff, and this response from Michael Shedlock.  Look, I’m not calling for a depression, or stagflation, at least not yet.  At RealMoney, my favored term was “stagflation-lite.”  Some modest rise in inflation while the economy grows slowly in real terms (as the government measures it).   A few comments on the two articles:

  •  First, international capital flows from recycling the current account deficit provide more stimulus to the US economy than the FOMC at present.  Will they stop one day?  Only when the US dollar is considerably lower than now, and they buy more US goods and services than we buy from them.
  • Second, the Federal Reserve can gain more powers than it currently has.  If this situation gets worse, I would expect Congress to modify their charter to allow them to buy assets that it previously could not buy, to end the asset deflation directly, at a cost of more price inflation, and spreading the lending losses to all who hold longer-term dollar-denominated assets.  If not Congress, there are executive orders in the Federal Register already for these actions.
  • Third, in a crisis, the FOMC would happily run with a wide yield curve — they will put depositary institution solvency ahead of purchasing power.
  • Fourth, the Fed can force credit into the economy, but not at prices they would like, or on terms that are attractive.  In a crisis, though, anything could happen.
  • Fifth, I don’t see a crisis happening.  It is in the interests of foreign creditors to stabilize the US, until they come to view the US as a “lost cause.”  Not impossible, but unlikely.  The flexible nature of the US economy, with its relatively high levels of freedom, make the US a destination for capital and trade.  The world needs the flexible US, less than it used to, but it still needs the US.

One final note off of the excellent blog Naked Capitalism.  They note, as I have, that the FOMC hasn’t been increasing the monetary base.  From RealMoney:

David Merkel
The Fed Has Shifted the Way it Conducts Monetary Policy
12/21/2007 11:56 AM EST

Good post over at Barry’s blog on monetary policy. Understanding monetary policy isn’t hard, but you have to look at the full picture, including the presently missing M3. I have a proxy for M3 — it’s total bank liabilities from the H8 report –> ALNLTLLB Index for those with a BB terminal. It’s a very good proxy, though not perfect. Over the last years, it has run at an annualized 9.4%. MZM has grown around 12.8%. The monetary base has grown around 3%, and oddly, has not been spiking up the way it usually does in December to facilitate year-end retail.

The Fed is getting weird. At least, weird compared to the Greenspan era. They seem to be using regulatory policy to allow the banks to extend more credit, while leaving the monetary base almost unchanged. This is not a stable policy idea, particularly in an environment where banks are getting more skittish about lending to each other, and to consumers/homebuyers.

This has the odor of trying to be too clever, by not making permanent changes, trying to manage the credit troubles through temporary moves, and not permanently shifting policy through adding to the monetary base, which would encourage more price inflation. But more credit through the banks will encourage price inflation as well, and looking at the TED spread, it seems the markets have given only modest credit to the Fed’s temporary credit injections.

I am dubious that this will work, but I give the Fed credit for original thinking. Greenspan would have flooded us with liquidity by now. We haven’t had a permanent injection of liquidity in seven months, and that is a long time in historical terms. Even in tightening cycles we tend to get permanent injections more frequently than that.

Anyway, this is just another facet of how I view the Fed. Watch what they do, not what they say.

Position: noneThe Naked Capitalism piece extensively quotes John Hussman.  I think John’s observations are correct here, but I would not be so bearish on the stock market.

After all of this disjointed writing, where does that leave me? Puzzled, and mostly neutral on my equity allocations.  My observations could be wrong here.  I’m skeptical of the efficacy of Fed actions, and of the willingness of foreigners to extend credit indefinitely, but they are trying hard  to reflate dud assets (and the loans behind them) now.  That excess liquidity will find its way to healthy assets, and I think I own some of those.

It is easy to take pot shots at the rating agencies.  Barron’s did it this weekend.  What is hard is coming up with a systematic proposal for reform that will do more good than harm, as I pointed out on my last piece on this topic.   Ordinarily, I like the opinions of Jonathan Laing, but not this time.  In my opinion, Barron’s failed the test of coming up with a systematic solution that recognizes market realities.

From my last article, I will repeat the market realities:

  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.  The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.  The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
  • Ratings can be short-term, or long-term, but not both.  The worst of all worlds is when the ratings agencies shift time horizons.

From the Barron’s article:

MAKE NO MISTAKE: THE LATEST debacle dwarfs the rating contretemps earlier in the millennium. In all, $650 billion of 2006 subprime mortgages were securitized in the past year. Moody’s officials point out that only 15% or so of the dollar amount of that rated debt — counting all tranches — has gone bad, requiring downgrades. But the ripple effect of those downgrades has wreaked havoc throughout the global credit markets.

Having been a mortgage and corporate bond manager back then, I’m not sure I agree.  The ABS, CMBS and whole loan RMBS markets are about the same size as the corporate bond markets.  The degree of stress on the system was higher back in 2002.  To give one bit of proof, look at the VIX, which is highly correlated with corporate credit spreads.   Why was the VIX in the 40s then, and around 19 now?  What’s worse, the banks were in good shape back then, and there are more questions about the banks now.  Most of the current problems exist in exotic parts of the bond market; average retail investors don’t have much exposure to the problems there, but only less-experienced institutional investors.

The Barron’s article suggests five areas for reform:

1. The SEC must encourage more competition by approving more rating agencies.  Rating fees would drop and diversity of opinion would lead to more accurate and timely ratings.

I’m all in favor of more rating agencies.  I don’t think rating fees would drop, though.  Remember, ratings are needed for regulatory purposes.  Will Basel II, and NAIC and other regulators sign off on new regulators?  I think that process will be slow.  Diversity of opinion is tough, unless a ratings agency is willing to be paid only by buyers, and that model is untested at best.

Regarding John Coffee, Jr. in the article:

Industry expert and Columbia Law School professor John Coffee Jr. has suggested an elegant solution to bolster rating-agency quality control, both to Barron’s and in recent congressional testimony. He wants the SEC to require raters that have been granted official status to disclose in a central database the historical default rates of all classes of financial products that they’ve rated. Regulators and investors would thus have an effective means of assessing the raters’ rigor.

Furthermore, Coffee argues, the SEC should discipline miscreant agencies by temporarily yanking their registration in areas where their ratings have been notably wrong.

And after that,

2. All rating agencies should be required to disclose default rates on all classes of securities that they’ve rated.  Agencies with bad results should have their SEC approvals yanked temporarily.

Disclosing default rates is already done, and sophisticated investors know these facts; this is a non-issue.  Yanking the registration is killing a fly with a sledgehammer.  It would hurt the regulators more than anyone else.  Further, what does he mean by “miscreant” or “notably wrong?”  The rating agencies are like the market.  The market as a whole gets it wrong every now and then.  Think of tech stocks in early 2000, or housing stocks in early 2006.  To insist on perfection of rating agencies is to say that there will be no rating agencies.

From the article:  One investor-subscription-based rating service, Egan-Jones, has been trying fruitlessly to win official agency status for more than a decade. In that time, the Philadelphia concern has been miles ahead of the established agencies in downgrading the likes of Enron and WorldCom and more recently the mortgage and bond insurers, mortgage originators and investment banks caught up in the subprime-mortgage crisis.

“It’s tremendously liberating to just work for investors and not worry about angering the issuer community,” partner Sean Egan tells Barron’s. “Not only have we been able to give investors earlier warnings of corporate frauds and other negative credit situations, but in many cases we’ve led the industry on upward credit revisions of worthy recipients.”

I like Egan-Jones, so it is with pleasure that I mention that they have achieved NRSRO [nationally recognized statistical rating organization] status.  That said, their model that I am most fmailiar with only applies to corporate credit.  Could they have prevented the difficulties in structured credit that are the main problem now?

3. Agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.

If this were realistic, it would have happened already.  The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit.  They don’t want the conflicts of interest either, but if it is conflicts of interest versus death, you know what they will choose.

4. Agencies no longer should have exclusive access to nonpublic information, to even out the playing field.

Sounds good, but the regulators want the rating agencies to have the nonpublic information.  They don’t want a level paying field.  As regulators, if they are ceding their territory to the rating agencies, then they want he rating agencies to be able to demand what they could demand.  Regulators by nature have access to nonpublic information.

5. Agencies must say “no” to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.

Were GICs [Guaranteed Investment Contracts] exotic back in 1989-1992?  No.  Did the rating agencies get it wrong?  Yes.  History would have said that GICs almost never default.  As I have stated before, a market must fail before it matures.  After failure, a market takes account of differences previously unnoticed, and begins to prospectively price for risk.

Look, the regulators can bar asset classes.  Let them do that.  The rating agencies offer opinions.  If the regulators don’t trust the ratings, let them bar those assets from investment.  The ratings agencies aren’t regulators, and they should not be put into that role, because they are profit-seeking companies. Don’t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.  But if the regulators bar assets, expect the banks to complain, because they can’t earn the money that they want to, while other institutions take advantage of the market inefficiency

Look, sophisticated investors don’t rely on the rating agencies.  They employ analysts that do independent due diligence.  Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime.  My proof?  Look how little exposure the insurance industry had to subprime mortgages.  Teensy at best.

There will always be differences in loss exposure between structured securities and corporate bonds at equivalent ratings.  Structured securities by their nature will have tiny losses for long periods of time, and then large losses, relative to corporate bonds.  The credit cyclicality is even bigger than that of corporate bonds.

Let’s get one thing straight here.  The rating agencies will make mistakes.  They will likely make mistakes on a correlated basis, because they compete against one another, and buyers won’t pay enough to support the ratings.

Barron’s can argue for change, but unless buyers would be willing to pay for a new system, it is all wishful thinking.  Watch the behavior of the users of credit ratings.  If they are unwilling to pay up, the current system will persist, regardless of what naysayers might argue.

This is an off-topic post for people who want to read the Bible, but have never been able to make it all of the way through. In my opinion, it is difficult to understand Western Civilization without having read the Bible. No single book, or collection of books has had such a profound effect on the cultures of Western Civilization, both positively and negatively. I.e., people react for and against what the Bible says.

I write this because I have met many people in my time who have said that they wanted to read the Bible, and started to do it, but couldn’t get through the five books of Moses. A few would tell me that they made it through the books of Moses, but could not make it through the prophets. Almost no one made it to the New Testament.

Face it, as a collection of ancient books, the Bible has a lot of different literary genres, and some are more congenial, and some less congenial to the modern mind. The Bible is an intricately woven set of books written over a 2100 (or so) year time span by 44 or so human authors. There are many themes and symbols that get visited and revisited in many different ways. Even for someone who does not want to believe the Bible as true, there is an appreciation to be had in it as literature. Think of it as a book with recurring themes that ties them all together from beginning to end. If I have to give an analogy, think of an author who has several different story lines that converge at the end of the book. In that, the Bible is similar.

Think of the following:

Where did man come from, and where is he going?
Why is there suffering? Why is there joy?
Why have the Jews (a relatively small group) been critical to the history of the world?
Why is Jesus Christ (Y’shua Ha’mushiach) so controversial?

Anyway, back to the practical. What I am about to share with you is what my family does every evening at our family devotions. We read a chapter of the Bible, talk about it, pray, and sing two psalms. When my kids were little, we would go straight through the Bible, and eventually my dear wife Ruth would say to me, “Why do I have to wait three years to hear the Gospels, and then I hear them all at once?”

Good question. With that, I set about to find a way to go through the Bible systematically, but not linearly. I divided the Bible up into its main genres:

  • Books of Moses and Old Testament History
  • Wisdom Literature, minus Psalms and Proverbs
  • Psalms
  • Proverbs
  • Prophets
  • Gospels and Acts
  • Epistles (Letters)

After that, I counted the number of chapters in each book and group, apportioned the Psalms and Proverbs into ten groups each, paying attention to logical dividing lines in each set, and calculated how they could be evenly interspersed as seven groups of writings. The list came out as follows:

Psalms 1-14
Proverbs 1-3
Psalms 15-27
Proverbs 4-6
I & II Corinthians
Psalms 28-41
Proverbs 7-9
Psalms 42-57
Proverbs 10-12
Psalms 58-72
Proverbs 13-15
Proverbs 16-18
Psalms 73-89
I & II Thessalonians
I & II Samuel
Proverbs 19-21
Psalms 90-106
I & II Timothy
Song of Solomon
I & II Kings
Proverbs 22-24
Psalms 107-119
Proverbs 25-27
I & II Chronicles
Psalms 120-134
I & II Peter
Proverbs 28-31
Psalms 135-150
John’s Epistles I, II & III

I can’t improve on the Bible, but reading it in this way still gives the thrust of its progress, while keeping people from boredom from “genre overload.” It has proven very useful to my family as we read the Bible, and keeps things fresh as we switch from genre to genre, while still moving through the Bible linearly overall. It has worked well for my family the last four times through the Bible.

If this list proves useful to you, and it actually enables you to successfully read through the whole Bible, please drop me a note.

Coming in the near term, I should have articles on the following:

  • The economics of Central Banking (can the Fed go broke?)
  • A critique of the Barron’s article on the Ratings Agencies
  • The Fundamentals of Market Bottoms (companion to this RealMoney article, The Fundamentals of Market Tops)
  • Predicting Consumer Price Inflation — What Works Best?  (Does anything work?)

That’s what is on the current schedule, together with other articles/events in the news flow.  I will be publishing through the so-called holiday season, so you may see some of this on Monday through Wednesday.

Also, in the near term, my left sidebar will include links and the Amazon widgets from my book reviews.

Thanks for reading me.  I really appreciate your patronage of my blog.

I’ve seen a number of articles recently about what dangers the investment banks face from counterparty risk.  Counterparty risk is what happens when an investment bank enters into a derivative transaction with another party (the counterparty), and when the investment bank ends up on the winning side of the trade, the counterparty is unable to make good on the necessary payments to the investment bank.

Think about history here for a moment.  Investment banks do take losses.  We saw that in the past week.  But almost all of that came from their own risk-taking, not from counterparties.  Now think about hedge funds that have gone bust.  What was the final trigger event?  The investment banks moving to foreclose when there was still enough margin to do so.  (LTCM, Granite, Amaranth, Neiderhoffer (how many times?) and more… the investment banks are very good at protecting their own hides.)

I have a few concerns about counterparty risk, but they aren’t big.  I worry more about mispricing within derivative books.  The risks that no natural counterparty wants to bear must be held by a speculator, who gets a bit of a bargain for taking down the risk.   Speculators are usually not thickly capitalized, so the investment banks, while grateful that they got the toxic waste off their books, watches the margin of solvency like a hawk, and more so for larger players.

The record of the investment banks of cutting off leverage to the impaired is pretty good.  There is some modest reason for concern here, but I think the investment banks have more potent means of shooting themselves in the foot.