Can we be speak frankly for a moment with the American people? OK, here goes:
Large investors are going to make a lot of money from the default or near-default of the U.S.
If we don't see an increase to the debt ceiling by the deadline, that as much as any ideological rigidity about taxation, is like to be why.
Republican donors will make money off of it.
And, just in case that quickens your capitalistic pulse, remember this:
Small fry like most of us can't capitalize on it.
You probably need an explanation. Check down below the cloud from which Wall Street views mere mortals.
A quick review of some basics of large-scale speculative arbitrage investing.
First, what does "arbitrage" mean? It means "buy low, sell high" -- and not necessarily in that order due to short sales. But even more than that, what it means is: "buy fleetingly low, sell fleetingly high." For that, you have to be able to withstand the risk losing a lot of money -- and that in turn means that you probably won't have to lose much.
"Speculate" means that you are guessing as to the future prices of things -- by which I mean anything, anything that has the possibility of changing in value and a market where you can place your bets on its price. (This sometimes involves buying and selling things, but generally you won't need much storage space.)
Put those two together and you realize two critical things:
(1) Investment markets depend on volatility. Volatility that gives you fleeting spikes and fleeting plunges in price can be especially good -- so long as there are people ready to buy or sell when you're ready to do the opposite.
(2) Information is King. Not only that, but illegally obtained information is Emperor, and information that you create is Ruler of the Freakifying World.
Now, illegal information -- insider trading -- is illegal. Unfortunately, the number of people who go to jail, or have to disgorge all of their profits, for using it is relatively small. Regulators are overstaffed; defense attorneys are overwhelming. People evade these sorts of prosecutions all the time -- especially if they have powerful friends and they haven't pissed off anyone with even more powerful friends (see Madoff, Bernie), especially in easily identifiable ways.
But, like Archimedes, give me plausible deniability and a leverage long enough and I shall move the world! Or at least I'll move the market.
The best sort of information, of course, is what you make yourself, ahead of time. And what we're seeing right now is one of the King Kong King Hell Beast of market manipulation opportunities in recent times.
Default of the United States! Talk about market fluctuation! The markets will swing like chandeliers on the Titanic! See, part of the beauty here, from the perspective of some investors, is that institutional investors -- like pension funds -- have no choice about whether to hold their stocks and other instruments if they start to plummet in value. They have to live by certain rules. And if you know that the markets are going to drop that much, you know that you will have willing sellers. In other words, you can: buy low.
That, of course, is not the end of it: if you know that the danger to the markets will pass -- especially after a certain amount of time, you can also sell high.
But just because you can buy low and sell high doesn't mean that you should! When the price of something goes lower, that could mean that it has temporarily fluctuated downward -- or it could mean that it was overvalued before or that its price depends on some uncertainty in the future of the market. So, how does it help people to know that prices are going to drop -- or in the case of hedge commodities like gold -- rise, if you don't know what the price drop means?
It's simple: you do know what it means if you control events. And Republicans are, right now, taking their cues from Wall Street -- not just the Tea Party -- as to how far they can go and when they have to stop. So what we're seeing right now could be -- and I speculate is -- market manipulation.
To see why, realize that Republicans are the ones who will decide when this is over. Democrats have come a long way from where they want to be -- and President Obama can't get "yes" for an answer. Obama -- let along Pelosi and Reid -- don't know when this game is going to end.
Republicans, by contrast, can know that information.
This doesn't mean that Republicans are illegally transmitting information back to their donors -- although that would not shock me if it were true. Hell, there are ways to do this that become really hard to prove. But the main thing is that if they are jumping to the strings their donors are pulling, they don't /have to convey any such information. All they have to do is listen to their donors to know when "things have gone far enough" and it's time to take the Democrats' latest best offer -- which, if we get into a default, will probably be pretty damn great.
Stocks get lower, lower, lower ... bond interest rates get higher, higher, higher ... and the people pulling Republican strings know exactly when to buy low. Brilliant, isn't it?
And that's not even the best part. The best part is this: a permanent bonus for rich investors. It's called a "risk premium."
A risk premium means that you get more money for engaging in a riskier investment. Only fair, right? But what if you know that what seems like a risky investment isn't really risky at all? Then that "risk premium" is actually unnecessary -- it's like taking out life insurance on someone that you know has already died, but the body hasn't been discovered yet. Or it's like a fixed horse race. Or it's like getting more money for supposedly "risky" government bonds where there was never really any risk there in the first place. That last one is what we may be seeing now.
Here it is graphically:
Bond interest rates will rise on the spike. But then they won't come all the way down -- because now the "unthinkable" will have happened, and so this investment will now "require" a risk premium to be able to attract buyers.
You think that this sounds nuts? Well, take a look at this Bloomberg story linked to on today's front page Midday Open Thread, which describes investors preparing to do exactly this.
I provide a quote below that should pop your eyeballs out of your head on springs, so you may want to put a bowl over your keyboard before you continue. I'll wait.
The name of the article, by the way, is -- I swear this is true and you can check for yourself -- "U.S. Default Bets Eclipsed By Super Bowl Wagers: Credit Markets". Ask yourself, given what comes next, if you think that that's a really good way to describe what's important and interesting about this article.
OK, is your bowl ready?
Credit-default swaps traders seeking to profit from concern that the U.S. will default as lawmakers clash over the debt ceiling are betting a missed payment may trigger a payout of about 22 times the cost of the contracts.
While Depository Trust & Clearing Corp. data show a 57 percent increase this year to $4.8 billion in the net amount of swaps bought and sold on the U.S. government, the amount is about 0.05 percent of total marketable U.S. public debt outstanding. It's also less than half of what's estimated to be bet on the National Football League's Super Bowl game.
While the derivatives are signaling a less than 1-in-20 chance of default within five years, banks, hedge funds and money managers are using the insurance-like contracts to bet that failure by President Barack Obama and congressional leaders to reach a budget agreement may lead to profits of as much as 13 percentage points at a cost of about 0.6 percentage point for the next year.
"It's all about the increased potential that the government will come to a political impasse, causing a credit event," said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York. "It's a massive tail event in our view, but nonetheless people are trying to take advantage of the market and hedge some of that tail risk."
Of course, there is no real risk. The debt crisis could be solved any time we wanted it solved, with a clean bill, like those that have happened literally hundreds of times before. We're good for our credit. This means that people will be getting the investment equivalent of "combat pay" for a desk job in a training camp in Des Moines.
And where does this money come from? From you and me, suckers!
That's right -- default once, or even come too close to it -- and the money comes out of the federal budget in terms of higher interest rates for bonds, which now must include a risk premium. If you want to drown the government in the bathtub, there's your water faucet.
So that means that, rather than simply "OMG we might default," the real headlines may be:
REPUBLICANS LOOT PENSION FUNDS
(because they can force institutional investors to sell what they're prepared to buy low), and
REPUBLICANS LOOT U.S. TREASURY
(because they can force the government to have to pay a risk premium to investors for the indeterminable future.)
What can Congress do? First: BRING THIS UP. Note that what the Republicans are doing invites market manipulation as surely as rubbing toxic sewer waste into an open would invites infection. Ask them what they want to do to prevent it.
Second, here's an idea: tax profits off market manipulation at 100%. (Maybe that's hyperbole. Maybe not.) That is tax both the spike and the risk premium -- before it happens! We can estimate what bond interest rates should be based on historical figures -- anything above that: confiscatory taxes! No one should make money off of torturing the U.S. economy and screwing over the federal budget. We need to take the profit out of such activities.
I'm sure that others can think of better ideas to approach the legislative sides of things. And, of course, I have no direct evidence (beyond what is implied in that article) that Republicans are actually doing any of this. But they're making it possible -- making it easy -- and that is bad enough.
So let's raise this prospect and get the public thinking about this loathsome possibility, because, to paraphrase LBJ, "I want to hear the sons of bitches deny it."
If they can, that is.
8:00 PM PT: Ray Pensador has been compiling quite a diary series on this theme; check it out in his comment below.
9:05 PM PT: kurious has a couple of interesting cites for you to read if you're interested in the legality of market manipulation by politicians -- more legal than you'd think!
9:10 PM PT: Celtic Pugilist has an interest suggestion for what we should do if there's a default (or, I'd add, if we come within 48 hours of one): close the markets:
and leave [them] closed until a new debt ceiling is agreed. That way Wall Street and those manipulating the market take an unexpected bath. No trading would cost them a lot of money...you can't skim on trades if there are none. And options don't help if they expire while the market is closed.
What do you think? It would certainly amp up the pressure, as well as preventing dirty dealing.
9:11 PM PT: nosleep4u provides the link I thought I remembered about Cantor's investments.
Sun Jul 24, 2011 at 8:38 AM PT: And here, Aeolus sets the record straight re bond downgrades. Definitely worth a glance -- actually, it will demand more than that from you!